October 23 2009 Europe: Portfolio Strategy The four phases of the equity market cycle The equity market moves in cycles. as the market moves away from the trough in March, it becomes increasingly important for investors to identify alternative points of reference, against which to think about potential investment strategies. Here, we develop a framework of such reference points through out the cycle. We show how each of the five cycles from one peak of the market to the next since 1973 can be divided into four distinct phases, each with its own economic context, drivers of stock market returns and investment strategies Our analysis comes in two parts. In this report, Part I of the series, we identify the phases, discuss their relationship to the economic cycle, and most importantly show that earnings growth is only to a very limited extend paid for when it occurs. In Part l of the series we will show the systematic historical patterns of asset classes, styles and sector performance for each of the phases The division of the cycle into phases is illustrated in Exhibit 1. We identify the phases by determining the extent to which the index price performance is driven by actual profit growth and by expectations, measured as changes in the P/E multiple. The four phases we define are: 1. The Despair phase is defined as the period where the market moves from its peak to its trough. This correction is mainly driven by P/E-multiple contraction as the market anticipates and reacts to a deteriorating macroeconomic environment and its implications in terms of lower future earnings Exhibit 1: The equity market moves in cycles Cycle of the Equity Market for Europe ex UK all growth rates are annualized averages) market moves from peak to trough xpectations are disappoi Poor earnings growth, -7.3% Weak eamings growth, 2.3% Poor earnings growth, 0.7%October 23, 2009 Europe: Portfolio Strategy Goldman Sachs Global Economics, Commodities and Strategy Research 2 The four phases of the equity market cycle The equity market moves in cycles. As the market moves away from the trough in March, it becomes increasingly important for investors to identify alternative points of reference, against which to think about potential investment strategies.1 Here, we develop a framework of such reference points through out the cycle. We show how each of the five cycles from one peak of the market to the next since 1973 can be divided into four distinct phases, each with its own economic context, drivers of stock market returns and investment strategies. Our analysis comes in two parts. In this report, Part I of the series, we identify the phases, discuss their relationship to the economic cycle, and most importantly show that earnings growth is only to a very limited extend paid for when it occurs. In Part II of the series we will show the systematic historical patterns of asset classes, styles and sector performance for each of the phases. The division of the cycle into phases is illustrated in Exhibit 1. We identify the phases by determining the extent to which the index price performance is driven by actual profit growth and by “expectations”, measured as changes in the P/E multiple. The four phases we define are: 1. The Despair phase is defined as the period where the market moves from its peak to its trough. This correction is mainly driven by P/E-multiple contraction as the market anticipates and reacts to a deteriorating macroeconomic environment and its implications in terms of lower future earnings. Exhibit 1: The equity market moves in cycles 4. Optimism P/E multiple grows faster than earnings - Expectation extrapolated - Second best return, 27.1% - Weak earnings growth, 2.3% 1. Despair Market moves from peak to trough - Expectations are disappointed - Worst return, -24.9% - Poor earnings growth, -7.3% 3. Growth Earnings grow faster than the P/E multiple - Reality catches up to expectations - Second lowest return, 10.9% - HIghest earnings growth, 22.5% Cycle of the Equity Market for Europe ex. UK (all growth rates are annualized averages) Volatility increases Volatility decreases 2. Hope P/E multiple expands - Expectation of a better future - Highest return, 51.2% - Poor earnings growth, 0.7% Source: Goldman Sachs Global ECS Research. 1 We would like to thank Hanyi Lim for her contributions to this report