October 23 2009 pe: Portfolio Strategy The phases can be interpreted in relationship to the economy The phases are clearly linked to the economy. this allows for a clearer interpretation of the phases and helps in identifying when we are moving from one phase to the next. The output gap falls in the Despair and Hope phase as output falls behind potential. The trough occurs between the middle and the end of the Hope Phase. In the growth Phase the We measure investors' forward-looking return requirements in terms of the Real Required Return(RRR)defined as the equity Risk Premium plus the 10 year nominal bond yield minus five year historical average inflation. this measure generally increases in the Despair and growth phases and decreases in the Hope and optimism phases. We interpret these movements in investors' forward-looking return requirements across the phases as follows During the Despair phase, investors get increasingly concerned about future prospects, and therefore require an increasingly high future expected return for holding equities. this reaction happens against a backdrop of an increase in volatility an increase in the output gap and in four out of five cycles the start of a recession during this phase in the US. This leads to lower P/E multiples and a falling market. In the Hope phase, an end to the crisis starts to be visible and this visibility caps the potential downside risk Investors respond to the lower tail risk by accepting lower future expected returns. This drives up multiples and the market. While volatility is still high, it tends to fall towards the end of the Hope phase. In this phase investors essentially prepay for the expected recovery in earnings during the growth phase In the beginning of the growth phase, investors have been through a period with high volatility. This is likely to make investors perceive equities as more risky and therefore less attractive. Investors have also already been paid for expected future earnings growth during the Hope phase, but the growth has yet to materialize. The output gap typically peaks some time during the Hope phase, but remains very high at the beginning of the growth phase. the onset of the growth phase is therefore a reasonable point in time for investors to question long- run growth expectations. These initial negatives tend to make investors less willing to pay for the earnings growth they see in the early stages of the growth phase. this gives lower rates of return, which reinforces the negative picture of equities and makes investors less willing to pay for the improvements in fundamentals that they see on an ongoing basis. The result is that value in terms of expected future returns are rebuilt during the Growth phase as earnings growth outpaces returns, and volatility declines Another likely driver of the higher real return requirements in the equity market that are built up during this phase is the increase in the real yield which is seen in bond Eventually, in the Optimism phase, the built-up value becomes large enough to attract investors and to reverse the dynamic of poor returns keeping away investors despite strengthening fundamentals In the Optimism phase, returns outpace earnings and expected future returns consequently decline. Towards the end of the phase volatility picks up as the sustainability of the high returns are being tested by the market. In the next sections we develop these conclusions in more detail. First we show how investors pay for most of the earnings growth before it occurs in the hope phase and after it occurs in the Optimism phase. We then cover each cycle in detail, showing the cut-offs we have chosen for the phases, and the performance of earnings growth and multiple expansion for the two markets(Europe ex UK and the UK)that we consider. We also oldman Sachs Global Economics, Commodities and strategy ResearchOctober 23, 2009 Europe: Portfolio Strategy Goldman Sachs Global Economics, Commodities and Strategy Research 5 The phases can be interpreted in relationship to the economy The phases are clearly linked to the economy. This allows for a clearer interpretation of the phases and helps in identifying when we are moving from one phase to the next. The output gap falls in the Despair and Hope phase as output falls behind potential. The trough occurs between the middle and the end of the Hope Phase. In the Growth Phase the output gap increases as actual output growth outpaces potential growth. We measure investors’ forward-looking return requirements in terms of the Real Required Return (RRR) defined as the Equity Risk Premium plus the 10 year nominal bond yield minus five year historical average inflation. This measure generally increases in the Despair and Growth phases and decreases in the Hope and Optimism phases. We interpret these movements in investors’ forward-looking return requirements across the phases as follows: • During the Despair phase, investors get increasingly concerned about future prospects, and therefore require an increasingly high future expected return for holding equities. This reaction happens against a backdrop of an increase in volatility, an increase in the output gap and in four out of five cycles the start of a recession during this phase in the US. This leads to lower P/E multiples and a falling market. • In the Hope phase, an end to the crisis starts to be visible and this visibility caps the potential downside risk. Investors respond to the lower tail risk by accepting lower future expected returns. This drives up multiples and the market. While volatility is still high, it tends to fall towards the end of the Hope phase. In this phase investors essentially prepay for the expected recovery in earnings during the Growth phase. • In the beginning of the Growth phase, investors have been through a period with high volatility. This is likely to make investors perceive equities as more risky and therefore less attractive. Investors have also already been paid for expected future earnings growth during the Hope phase, but the growth has yet to materialize. The output gap typically peaks some time during the Hope phase, but remains very high at the beginning of the Growth phase. The onset of the Growth phase is therefore a reasonable point in time for investors to question long-run growth expectations. These initial negatives tend to make investors less willing to pay for the earnings growth they see in the early stages of the Growth phase. This gives lower rates of return, which reinforces the negative picture of equities and makes investors less willing to pay for the improvements in fundamentals that they see on an ongoing basis. The result is that value in terms of expected future returns are rebuilt during the Growth phase as earnings growth outpaces returns, and volatility declines. Another likely driver of the higher real return requirements in the equity market that are built up during this phase is the increase in the real yield which is seen in bond markets. • Eventually, in the Optimism phase, the built-up value becomes large enough to attract investors and to reverse the dynamic of poor returns keeping away investors despite strengthening fundamentals. In the Optimism phase, returns outpace earnings and expected future returns consequently decline. Towards the end of the phase volatility picks up as the sustainability of the high returns are being tested by the market. In the next sections we develop these conclusions in more detail. First we show how investors pay for most of the earnings growth before it occurs in the Hope phase and after it occurs in the Optimism phase. We then cover each cycle in detail, showing the cut-offs we have chosen for the phases, and the performance of earnings growth and multiple expansion for the two markets (Europe ex UK and the UK) that we consider. We also