October 23 2009 Europe: Portfolio Strategy The early 1980s: Markets recover as multiples expand The cycle in the early 1980s was the second best in Continental Europe and the Us only overshadowed by the bubble in the 1990s. In the UK it was the best of the five cycles. The strong performance was driven mainly by multiple expansion ranging from 58% in the UK to 112% in the US Real earnings growth in this cycle was the lowest of all five cycles in both Continental Europe and the Us but the second highest in the UK. This disconnect between very strong price performance and weak real earnings growth in Continental Europe and the Us suggests that even across cycles, investors do not necessarily pay for earnings growth when it occurs. The valuation at the outset matters significantly, as we have discussed in more detail in our March 23, 2009 report: " Forecasting returns:Fair Value Part II The 1981 recession was caused by tightening of monetary policy in order to get inflation under control. It marks the initiation of a trend decline in real interest rates which has nd driven P/E multiples higher The growth phase was relatively short, consistent with the recession in the early part of the cycle being driven more by monetary policy tightening than large structural changes Exhibit 8: Division of the early 1980s cycle into phases for Europe ex UK Europe ex UK Cumulative Change <o--Hope---> <-Grow th-> <---.-Optimism--m--> 140 Oct-78 Oct-79 Oct-80 Oct-81 Oct-82 Oct-83 Oct-84 Oct-85 Oct-86 Despai Start date20/10197817/08/198201/02 End date17/08/19820102/198401041 101987 45.9 17.5 14.0 30.1 Real Return -40.4 4.4 38.8 57.7 -24.8 Proportion of return 3.3 23.3 hange in .5 0.2 23 adscape, He oldman Sachs Global Economics, Commodities and strategy ResearchOctober 23, 2009 Europe: Portfolio Strategy Goldman Sachs Global Economics, Commodities and Strategy Research 10 The early 1980s: Markets recover as multiples expand The cycle in the early 1980s was the second best in Continental Europe and the US only overshadowed by the bubble in the 1990s. In the UK it was the best of the five cycles. The strong performance was driven mainly by multiple expansion ranging from 58% in the UK to 112% in the US. Real earnings growth in this cycle was the lowest of all five cycles in both Continental Europe and the US but the second highest in the UK. This disconnect between very strong price performance and weak real earnings growth in Continental Europe and the US suggests that even across cycles, investors do not necessarily pay for earnings growth when it occurs. The valuation at the outset matters significantly, as we have discussed in more detail in our March 23, 2009 report: “Forecasting returns: ‘Fair Value’ Part II”. The 1981 recession was caused by tightening of monetary policy in order to get inflation under control. It marks the initiation of a trend decline in real interest rates, which has lasted until today and driven P/E multiples higher in the process. The growth phase was relatively short, consistent with the recession in the early part of the cycle being driven more by monetary policy tightening than large structural changes. Exhibit 8: Division of the early 1980s cycle into phases for Europe ex UK Europe ex UK 20 40 60 80 100 120 140 160 180 Oct-78 Oct-79 Oct-80 Oct-81 Oct-82 Oct-83 Oct-84 Oct-85 Oct-86 US Recessions Returns Earnings PE Cumulative Change h <-----------------Despair---------------> <-Grow th-> <---Hope---> <------Optimism------> Despair Hope Growth Optimism Start date 20/10/1978 17/08/1982 01/02/1984 01/04/1985 End date 17/08/1982 01/02/1984 01/04/1985 05/10/1987 Length (in months) 45.9 17.5 14.0 30.1 Real Return -40.4 56.9 4.4 69.1 Real Earnings Growth -33.1 -0.6 38.8 9.3 P/E expansion -11.0 57.7 -24.8 54.8 Proportion of return (%) 43.6 3.3 53.0 Annualized Real Return -12.7 36.1 3.7 23.3 Earnings Growth -10.0 -0.4 32.6 3.6 Change in real interest rate (pp) 2.1 -0.5 -0.2 2.3 Source: Worldscope, Haver Analytics, Datastream, Goldman Sachs Global ECS Research