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North America Equity Research

12 December 2012

U.S. Year Ahead 2013

Be Selective

Portfolio Strategy

Thomas J Lee, CFAAC

(1-212) 622-6505

[email protected]

Director of Americas Equity

Research

Noelle V. Grainger

(1-212) 622-6504

[email protected]

J.P. Morgan Securities LLC

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US Year Ahead 2013

2


December 2012

US Year Ahead 2013

J.P. Morgan Securities LLC Equity Research 383 Madison Avenue, New York, NY 10179 3

December 12, 2012

Dear Investor,

While 2012 comes to a close amid continued uncertainty, the U.S. equity market looks

to end the year more than 12% higher than at its start. Some of the gains posted early

in the year were pared in the second quarter as economic momentum slowed and

macro overhangs loomed. However, the S&P 500 advanced steadily from June

through October leading up to the presidential election, after which investor focus

shifted to the likelihood of a compromise in Washington.

Optimistic expectations at the beginning of the year have given way to the realization

that the U.S. recovery is more likely to be a marathon than a sprint, and fiscal

challenges present a major hurdle along the way. We anticipate that some, but far from

all, of the austerity implied by the fiscal cliff will be realized next year and expect the

expansion to soldier on, in spite of the fiscal policy headwinds, with housing carrying

the baton. Our economists expect inflation could move even lower and look for

supportive monetary policy to offset some of the drag from fiscal actions.

Following solid performance this year, we remain constructive on U.S. equities. Tom

Lee, J.P. Morgans Chief U.S. Equity Strategist, expects the secular bull market to

continue for a fifth year and has established a year-end 2013 target for the S&P 500 of

1580, which would represent a new all-time high. He anticipates stronger performance

in the second half after a tricky first half, as policy clarity and acceleration in durable

goods spending should lead to multiple expansion.

We designed this report as a sector-by-sector guide to equity investing in the United

States for the upcoming year. We asked our analyst teams to identify key drivers of

sector stock prices and to present their best investment ideas, framed by commentary

from our economists, strategists, as well as derivatives and accounting experts. One of

the most common themes was the need for investors to be selective, given

uncertainties related to fiscal policy and notable risks to both upside and downside.

Against this backdrop, we highlight 73 best ideas.

As always, we aim to provide analysis that proves helpful in your investment decision-

making process and hope you find this report useful.

Noelle Grainger

Director of Americas Equity Research

US Year Ahead 2013

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December 2012

US Year Ahead 2013

5US Year Ahead 2013North America Equity Research

December 2012

Table of Contents

Macro

Portfolio Strategy ............................................................................. 7

Accounting & Tax Policy................................................................. 42

Economics..................................................................................... 45

Equity Derivatives .......................................................................... 49

Equity Derivatives & Quantitative Strategy ...................................... 58

Equity Quantitative Strategy ........................................................... 63

Capital Goods/Industrials

Aerospace & Defense .................................................................... 65

Boeing Company (BA)

Airfreight & Surface Transportation................................................. 66

Canadian Pacific Railway (CP)

Electrical Equipment & Multi-Industry.............................................. 67

Danaher (DHR)

Engineering & Construction............................................................ 68

Quanta Services, Inc. (PWR)

Environmental Services.................................................................. 69

Waste Connections (WCN)

Machinery...................................................................................... 70

Eaton Corp. (ETN)

Marine Transportation .................................................................... 71

Teekay Offshore Partners (TOO)

Consumer

Airlines .......................................................................................... 73

Delta Air Lines, Inc. (DAL)

Autos & Auto Parts......................................................................... 74

Harman International (HAR)

Beverages ..................................................................................... 75

PepsiCo (PEP)

Food Manufacturing ....................................................................... 76

Hershey (HSY)

Food Retail .................................................................................... 77

Whole Foods Market (WFM)

Gaming.......................................................................................... 78

Las Vegas Sands Corp. (LVS)

Homebuilding & Building Products.................................................. 79

PulteGroup, Inc. (PHM), KB Home (KBH)

Household & Personal Care Products............................................. 80

Newell Rubbermaid Inc. (NWL)

Leisure .......................................................................................... 81

Harley-Davidson (HOG)

Consumer (cond)

Lodging.......................................................................................... 82

Wyndham Worldwide (WYN)

Restaurants Casual Dining .......................................................... 83

Brinker International (EAT), DineEquity Inc. (DIN),

Texas Roadhouse (TXRH)

Restaurants QSR ........................................................................ 84

Starbucks (SBUX), McDonalds (MCD)

Retailing Broadlines, Apparel & Footwear .................................... 85

Macys (M)

Retailing Hardlines/Discounters ................................................... 86

Target (TGT)

Retailing Specialty....................................................................... 87

Urban Outfitters (URBN)

Tobacco......................................................................................... 88

Reynolds American (RAI)

Energy

Electric Utilities............................................................................... 89

Duke Energy Corp. (DUK)

Energy MLPs ................................................................................. 90

Oneok Inc (OKE), EQT Midstream Partners (EQM)

Independing Refiners ..................................................................... 91

Phillips 66 (PSX)

Integrated Oils and Major Producers............................................... 92

Suncor Energy (SU.TO)

Oil & Gas Exploration & Production................................................. 93

Denbury Resources (DNR)

Oilfield Services & Equipment......................................................... 94

Schlumberger (SLB)

Financials

Asset Managers, Brokers and Exchanges....................................... 95

Invesco Ltd. (IVZ)

Banks Large Cap......................................................................... 96

Bank of America (BAC)

Banks Mid- and Small Cap .......................................................... 97

First Republic (FRC)

Insurance Life ............................................................................. 98

Prudential Financial (PRU)

Insurance Non-Life ...................................................................... 99

Allstate Corp. (ALL)

REITs/Real Estate Services.......................................................... 100

ProLogis (PLD)

Specialty & Consumer Finance..................................................... 101

Capital One (COF)

US Year Ahead 2013

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December 2012

US Year Ahead 2013

Health Care

Biotechnology ...............................................................................103

Gilead (GILD)

SMid Biotechnology ......................................................................104

Onyx Pharmaceuticals (ONXX)

Healthcare Technology & Distribution ............................................105

McKesson Corporation (MCK)

Life Sciences Tools & Diagnostics .................................................106

Agilent Technologies (A)

Managed Care ..............................................................................107

Cigna (CI)

Medical Supplies & Devices ..........................................................108

Heartware International (HTWR)

Medical Technology SMid Cap ..................................................109

Intuitive Surgical (ISRG)

Pharmaceuticals Major...............................................................110

Pfizer Inc. (PFE)

Pharmaceuticals Specialty..........................................................111

Mylan (MYL)

Materials

Chemicals Specialty, Commodity & Agricultural...........................113

LyondellBasell Industries (LYB)

Coal..............................................................................................114

CONSOL Energy (CNX)

Gold .............................................................................................115

Goldcorp Inc (GG)

Metals & Mining ............................................................................116

Carpenter Technology (CRS)

Paper & Packaging .......................................................................117

MeadWestvaco (MWV)

Silver............................................................................................118

Silver Wheaton (SLW)

Media & Telecom

Internet ........................................................................................ 119

eBay (EBAY)

Media .......................................................................................... 120

CBS Corporation (CBS)

Telecom, Cable & Satellite............................................................ 121

Comcast (CMCSA)

Technology

Alternative Energy LED ............................................................. 123

Cree Inc. (CREE)

Alternative Energy Solar PV....................................................... 124

First Solar (FSLR) Avoid

Applied & Emerging Technologies ................................................ 125

Verint Systems (VRNT)

Business Services........................................................................ 126

Robert Half International (RHI)

Communications Equipment & Data Networking............................ 127

Ciena Corp. (CIEN)

Computer Services & IT Consulting .............................................. 128

Visa Inc. (V)

Education Services....................................................................... 129

American Public Education (APEI)

Information Services..................................................................... 130

Nielsen Holdings N.V. (NLSN)

IT Hardware................................................................................. 131

Apple Inc. (AAPL)

Semiconductor Capital Equipment ................................................ 132

Nanometrics Incorporated (NANO)

Semiconductors ........................................................................... 133

Texas Instruments (TXN)

SMid Semiconductors................................................................... 134

Broadcom Corporation (BRCM)

Software ...................................................................................... 135

Oracle Corp. (ORCL)

Software Technology.................................................................... 136

Guidewire Software (GWRE)

Disclosures .................................................................................. 140

US Equity Research Staff List.................................................... 144

Note: Unless otherwise noted, all stock prices and coverage lists in

this report are as of the close on December 6, 2012, and target prices

for December 2013.

US Year Ahead 2013

7


December 2012

Portfolio Strategy

Year-End 2013 S&P 500 Target Is 1580: Tricky 1H, Clearer 2H

Tricky 1H, Clearer 2H

We remain constructive on equities overall with an expectation of upside risks for

2013. Our base case (and framework) remains that we are in a secular bull market,

which started in March 2009 and will continue beyond 2013. We are establishing a

year-end 2013 target for the S&P 500 of 1580, based on a P/E multiple of 13.5x our

2014 EPS estimate of $117, and see the drivers of this 12% upside as (1) clearing of

policy uncertainty (Washington and Europe) aiding the multiple, (2) acceleration of

durable goods spending lifting P/E, (3) resultant pickup in earnings growth (hence

estimated EPS of $117) and (4) fifth years in bull markets historically being

unusually strong.

Tricky 1H, Clearer 2H. We see risks building in 1H and, thus, expect the

S&P 500 to be range-bound in 1H13 with a mid-year target of less than 1400

(discussed below) related to the following: (1) uncertainty from fiscal cliff

overhang is likely to suppress P/E multiple; (2) economic growth in 1H13 is

forecast to slow to 1.25%, reflecting partial impact of cliff (slowing consumption

and government spending); (3) strategists, in our view, are broadly optimistic

about 2013 prospectsthus, we expect a rocky 1H to reduce bullishness; and

(4) historically fifth years of bull markets have tended to be flattish in 1H and

stronger in 2H (1982-1987 best analogy, see Figure 17 and Figure 21).

We believe the housing recovery that started in 2011 stands at the front-end

of a larger recovery in durable goods. Currently, durable goods spending

stands at 21% of GDP and, as shown in Figure 22, is at the lowest level since

World War II. This should bode well for P/E expansion as historically a rise in

durable goods spending has tended to lift P/E by 1.8 turns (see Figure 23). We

define durable goods spending as capex plus construction (both residential and

non-residential) plus consumer purchases of durable goods, among which

spending is significantly below trend in Housing, Autos, capex and commercial

construction. In other words, the underinvestment is broad-based. Capex (as % of

sales) for corporates at 6.2% is barely above the 2009 lows of 5% and well off the

8% seen at cycle highs (see Figure 31).

Another incremental positive in 2013 is the anticipated easing of bank

lending standards. There is a misconception that an ease in mortgage lending

standards precedes or coincides with an upturn in US housing. As we highlight in

Figure 30, bank lending in the prior three housing cycles eased 16-37 months

after the start of the housing up-cycle. We anticipate mortgage lending standards

to ease in 2013, further accelerating the recovery in durable goods spending. This

is supported by household debt-service ratios at the best level since the early 90s

(Figure 34).

History has shown that returns in the fifth year of bull markets have been 19%,

with P/Es expanding by an average of 0.75x, implying more than two-thirds of

the gains have been due to EPS growth (we forecast 5% y/y). As shown in

Figure 17 and Figure 18, there have been eight bull markets lasting four years in

duration and five extended beyond the fifth year. Of the three that expired, two

Thomas J Lee, CFAAC

(1-212) 622-6505

[email protected]

Katherine C Khor

(1-212) 622-0934

[email protected]

J.P. Morgan Securities LLC

Bloomberg JPMA TLEE

Ma

cro

US Year Ahead 2013

8


December 2012

were due to recession (42 bull and 57 bull) and the third saw GDP growth

decelerate from 10% (real) to 2% (probably felt like a recession, 62 bull).

We favor remaining Cyclical and our top picks are Materials, Technology and

Energy. Cyclicals have outperformed in 2012 by 200bp and we still see them as

attractive with above-average expected EPS growth (2013E EPS growth of 6%)

and P/E multiples that still stand at a substantial discount to those for Defensives

(98% vs. 122% on 2014E P/E). History also has shown that Cyclicals typically

have led in the fifth year of a bull market. Moreover, we believe investors should

focus on capital gainsthat is, stocks with potential to re-rate. We found that

companies with high FCF yields and low dividend yields have tended to

outperform in the fifth year of a bull market.

Bottom line, we remain constructive. Our year-end target represents an all-time

high for the S&P 500 (previous peak was 1565 in October 2007) and would validate,

in our view, the ability of equities to generate real returns (above inflation). Our

target represents upside of about 11% with a total return of 13% (with dividends).

We list the 2013 best ideas of J.P. Morgans fundamental equity analysts. There are

72 LONG ideas and 1 AVOID idea. The Long ideas are: A, AAPL, ALL, APEI,

BA, BAC, BRCM, CBS, CI, CIEN, CMCSA, CNX, COF, CP, CREE, CRS,

DAL, DHR, DIN, DNR, DUK, EAT, EBAY, EQM, ETN, FRC, GG, GILD,

GWRE, HAR, HOG, HSY, HTWR, ISRG, IVZ, KBH, LVS, LYB, M, MCD,

MCK, MWV, MYL, NANO, NLSN, NWL, OKE, ONXX, ORCL, PEP, PFE,

PHM, PLD, PRU, PSX, PWR, RAI, RHI, SBUX, SLB, SLW, SU.TO, TGT,

TOO, TXN, TXRH, URBN, V, VRNT, WCN, WFM and WYN. The Avoid idea is

FSLR.

US Year Ahead 2013

9


December 2012

TARGET: Year-End 2013 Target of 1580

1H13 Tricky, Then 2H Rally to 1580

We are establishing a year-end 2013 target of 1580 for the S&P 500, based on a

target P/E multiple of 13.5x our 2014 EPS estimate of $117 (see Figure 1).

This target represents price appreciation of about 11.5% (from current levels),

slightly lower than the 2012 return for the S&P 500 (13% plus 2% dividends, or

15% total return).

We forecast the forward P/E to rise from 12.9x currently to 13.5x, consistent with

trends in maturing bull marketstypically P/E has expanded in the fifth year of

bull markets.

Moreover, we see 2013 as likely to be back-end loaded, and believe markets will

be flattish in 1H13.

Figure 1: Year-End 2013 Target Sensitivity

S&P 500 Target

EPS

2014E EPS $117.00P/E

1580 $109 $113 $117 $121 $125

Target YE P/E (2014E) 13.5X12.5X 1,365 1,415 1,465 1,515 1,565

2013E Target 1,58013.0X 1,415 1,470 1,520 1,575 1,625

13.5X 1,470 1,525 1,580 1,635 1,690

14.0X 1,525 1,580 1,640 1,695 1,750

14.5X 1,580 1,640 1,695 1,755 1,815

Source: J.P. Morgan.

Contrarian on Timing: Consensus Sees New Highs in 2013

(Therefore Positive to Start), Suggesting 1H Could Be Weak

In contrast to last year, investors and strategists seem optimistic about 2013. We

expect equity markets to rise in 2013 but believe this optimism needs to be

challenged. Hence, our belief equity markets will perform poorly in 1H13.

Seven of 10 strategy forecasts (NI WGT ) look for all-time highs for the

S&P 500 in 2013. (Recall, as noted above, more than half did not think 2011

highs would be exceeded in 2012.)

Moreover, our sense from clients is that they missed the 2012 rally (and

underperformed) and intend to compensate for this by moving to risk-on in 2013.

This does suggest the potential for a big January effect for small-cap stocks.

Thus, the consensus seems constructive to start the year. This creates a tricky

dilemma for us. On the one hand, we see reasons to be constructive for the year.

However, in past years the 1H has seemed to run counter to consensus. Thus,

given the constructiveness noted above, and the past pattern of markets foiling

consensus, we see downside risks in 1H.

US Year Ahead 2013

10


December 2012

Why Flattish 1H13? Cliff, Economy, Sentiment and History

The main reasons we expect a flat 1H are listed below in Figure 2. But, simply, US

economic momentum should be better in 2H than 1H, sentiment is too bullish (in our

view) and history has shown that there is more likely to be a rally in 2H.

Figure 2: Why 1H13 Is Likely to Be Flattish

Fiscal cliff overhang into 1H13 is likely to create uncertainty, suppressing P/E multiple.

Economic growth in 1H13 is forecast to slow to 1.25%, reflecting partial impact of the sequestration and tax cut

expiration (slowing consumption and government spending).

Strategists, in our view, are broadly optimistic about 2013 prospectsthus we expect a rocky 1H will reduce

bullishness.

We see 1982-1987 as the best analogy and markets were sluggish during 1H during that time frame (see

Figure 17 to Figure 21).


Investors Need to Be Contrarian to Consensus

One of the frustrations for investors over the past few years has been that consensus

base case rarely has been realized. Rather, the outcomes, particularly market

direction, have been either meaningfully better or worse than consensus. Figure 3,

below, lists year-ahead S&P 500 targets since 2009 (Bloomberg: NI WGT

).

As highlighted, in three of the last four years, the market meaningfully

outperformed consensus (and we were ahead of consensus as well). The

exception was 2011 but, as we highlight, the Street was very optimistic on

2011hence, the outcome was worse than expected.

On 2013 expectations, we believe the Street is probably not bullish enough on the

full-year outcome (we believe 1526 is too low). That said, we believe the Street

may be too optimistic on 1H13hence, our view that 1H is likely to be tricky. In

other words, the need to be contrarian on timing.

Figure 3: Year-Ahead S&P 500 Targets, 2009-2013

Consensus Average from Bloomberg (NI WGT )

Source: J.P. Morgan and Bloomberg.

Delta

Year

Date target

published JPM Target

Consensus

Target

Actual YE

closing price

JPM vs

consensus

Actual vs

consensus

2009 12/17/08 1100 1061 1115 +39 +54

2010 12/10/09 1300 1225 1258 +75 +33

2011 12/10/10 1425 1384 1258 +41 -126

2012 12/9/11 1430 1344 1430 +86 +86

2013 12/12/12 1580 1526 +54

Consensus

OPTIMISTIC

US Year Ahead 2013

11


December 2012

Drivers in Place to Support Rally in Spread Product in 2013

J.P. Morgans fixed income strategists also see positive returns in their respective

markets in 2013 (see 2013 Outlook dated 9/21/12); this should support higher

equity returns (due to comparative return). As shown in Figure 4 below, basically,

every major fixed income market is expected to rally in 2013.

High grade is expected to tighten from 170bp STW to 125bp STW, or 45bp.

High yield, which is most correlated to equities, is expected to rally from 613bp

to 585bp STW.

Emerging market bond spreads are expected to fall from 307bp to 238bp.

Overall, a positive year for credit should mean positive returns for equities.

Figure 4: J.P. Morgan 2013 Return Forecasts and Analytics

From 2013 US Fixed Income Outlook by Terry Belton and Srini Ramaswamy

Interest Rate Forecast Financial Markets Forecast

Source: 2013 US Fixed Income Outlook by Terry Belton and Srini Ramaswamy. Note: For chart on the left-hand side, * Fed funds assumed to be 0.125% for Fed funds/3m Libor calculation. For the

chart on the right-hand side, * spread to Treasuries, while ** spread to swaps.

US Year Ahead 2013

12


December 2012

EPS Forecast: 2013E/2014E of $110/$117

We are maintaining our 2013 EPS forecast of $110 and establishing a 2014 EPS

estimate of $117, representing 6% growth, $9 below consensus.

In our view, $7 of incremental EPS in 2014 appears reasonable and reflects

meaningful contributions from Energy ($1.52), Technology ($1.13), Financials

($0.88), Discretionary ($0.82) and Industrials ($0.85).

As for point contribution to our target of 1580, the largest contributors are

Technology (39 pts), Energy (28) and Financials (27). However, on a

percentage basis, Basic Materials (up 22%) is the largest.

Figure 5: 2013E/2014E EPS Summary

$ per share

B/U consensus JPM Strategy EPS EPS % (JPM)2014 P/E Relative 2014E P/E Point Contribution

JPM

Strategy

Rating 2012E 2013E 2014E 2012E 2013E 2014E

'13E

vs.

'12E

'14E

vs.

'13E Current Target

Long-

Term

Avg Current Target

Long-

Term

Avg Current Target

Point

Upside

%

Upside

Cyclicals

Materials OW $3.29 $4.21 $4.59 $3.95 $4.20 $5.04 6% 20% 9.4x 11.5x 16.5x 78% 85% 94% 47 58 10 22%

Industrials OW $10.38 $11.43 $12.55 $10.40 $11.30 $12.15 9% 8% 11.7x 12.8x 16.5x 97% 95% 96% 142 156 14 10%

Discretionary OW $9.67 $11.13 $12.93 $9.70 $10.30 $11.12 6% 8% 14.3x 15.8x 17.9x 119% 117% 101% 159 176 17 10%

Technology OW $21.54 $24.32 $26.96 $21.50 $22.50 $23.63 5% 5% 11.7x 13.4x 23.6x 98% 99% 131% 277 316 39 14%

Near Cyclicals

Energy OW $12.86 $13.10 $15.25 $14.75 $15.15 $16.67 3% 10% 8.7x 10.4x 14.8x 73% 77% 82% 145 173 28 19%

Financials OW $17.71 $19.87 $21.94 $16.65 $17.65 $18.53 6% 5% 11.3x 12.7x 13.2x 94% 94% 75% 209 236 27 13%

Defensives

Staples UW $10.19 $11.08 $12.04 $10.30 $10.70 $11.14 4% 4% 15.1x 16.2x 17.5x 126% 120% 103% 168 180 12 7%

HealthCare OW $12.28 $13.04 $13.91 $12.30 $12.55 $12.87 2% 3% 13.1x 14.7x 19.6x 109% 109% 115% 169 189 21 12%

Telecom N $1.99 $2.33 $2.91 $2.20 $2.40 $2.70 9% 12% 16.0x 16.9x 16.6x 133% 125% 96% 43 46 2 6%

Utilities UW $3.14 $3.14 $3.36 $3.25 $3.25 $3.25 0% 0% 14.7x 15.5x 12.3x 122% 115% 72% 48 50 3 6%

S&P 500 $103.04 $113.68 $126.44 $105.00 $110.00 $117.09 5% 6% 12.0x 13.5x 19.8x 1,407 1,580 173 12%

S&P ex-Fin $85.33 $93.81 $104.50 $88.35 $92.35 $98.56 5% 7% 12.2x 13.6x 17.3x 101% 101% 99% 1,198 1,344 146 12%

Cyclicals $44.88 $51.10 $57.03 $45.55 $48.30 $51.94 6% 8% 12.0x 13.6x 18.6x 100% 101% 105% 625 705 80 13%

Near-Cyclicals $30.57 $32.98 $37.19 $31.40 $32.80 $35.20 4% 7% 10.1x 11.6x 14.0x 84% 86% 79% 354 409 55 15%

Defensives $27.59 $29.60 $32.22 $28.05 $28.90 $29.96 3% 4% 14.3x 15.5x 16.5x 119% 115% 97% 428 466 38 9%

Cyclicals vs. Defensives $17.28 $21.50 $24.80 $17.50 $19.40 $21.98 3% 4% -2.2x -2.0x 2.1x -19% -15% 9% 197 239 42 395 bp


US Year Ahead 2013

13


December 2012

How Close to Peak? We See Peak EPS of $145-$160 by 2017

In our view, an S&P 500 EPS earnings peak will coincide with the next recession.

Given the potential for a durable goods boom in the US (fueling another leg of

S&P 500 EPS growth), we remain constructive on the potential for meaningful gains

in S&P 500 EPS. In Figure 6 below, we have noted peaks and troughs for S&P 500

EPS since 1952, and also noted the change in every decade:

S&P 500 EPS has gained 50%-100% every 10 years. In other words, whatever

the prior peak in EPS has been from the last cycle (i.e., 2007 of $92.15), EPS has

increased 50% beyond that ($147-165) over the following decade.

The exception was probably in the early to mid-80s as inflation fell. With EPS

distorted by inventory profit gains (LIFO plus inflation, adding as much as 40%

of reported EPS in the 1970s and 1980s), reported EPS stagnated as inflation fell.

Still, historical trends argue for further strong advances in S&P 500 EPS.

Figure 6: S&P 500 EPS

Since 1952

3/51

$2.83

12/55

$3.62

12/66

$5.55

9/69

$5.89

9/74

$9.11

3/80

$15.29

12/84

$16.64

6/89

$25.22

9/00

$57.37

6/07

$92.15

6/52

$2.34

12/58

$2.89

9/67

$5.30

12/70

$5.13

9/75

$7.76

3/83

$12.42

6/87

$14.42

12/91

$18.48

3/02

$44.19

6/09

$51.97

$2.00

$20.00

$200.00

12/50 12/55 12/60 12/65 12/70 12/75 12/80 12/85 12/90 12/95 12/00 12/05 12/10 12/15

S&P 500 EPS

(LTM)

Peak two cycles

back

$147 to

$165

+53%

+160%

+65%

+127%

+61%

+60%-80%


Historically EPS Has Peaked BEFORE Profit Margins

Profit margins have been flattish for the past eight quarters, and this has raised

concerns about whether S&P 500 EPS may have peaked. Since 1980, EPS peaks

have preceded profit margins peaks. In other words, the fact that margins have been

flattish recently does not necessarily argue that profits have peaked, in our view. The

logic being profit margins generally have rolled over after EPS peaked.

We believe the current period, with EPS moving higher since October 2011, may

be more analogous to the mid-90s (Figure 7). At that time, profit margins dipped

for a few years before recovering. And this was below the peak in margins.

Moreover, we think the drivers are in place for S&P 500 profit margins to

expand. Labor slack remains substantial and pricing power of companies over

their suppliers is high.

US Year Ahead 2013

14


December 2012

Sales as % of GDP at 61% not near peaks of 65% in 2000 and 64% in 2008

Ultimately, top line is the primary driver of further margin expansion. The S&P 500

top line is approximately $10T (LTM) but around 61% as a percentage of US GDP.

As shown below in Figure 8, this is lower than the peaks of 65% in 2000 and 64% in

2008. Thus, we see room for further margin expansion as top line expands further.

In terms of incremental sales, an increase to peak levels (61% vs. peaks of 64-

65%) would represent about $300 billion on top of incremental sales generated by

global GDP expansion. Thus, we see a case for top line to expand and arguably at

a faster rate as capital spending recovers (see discussion of Capex in the Durable

Goods section).

Figure 7: Net Profit Margins (All Stocks)

Since 1980

2

3

4

5

6

7

8

9

10

12/80 12/84 12/88 12/92 12/96 12/00 12/04 12/08

Ne

t p

rofi

t m

arg

in (a

ll s

toc

ks

)

Recessions Net profit margin (all stocks)

S&P EPS Troughs S&P EPS Peaks

Source: J.P. Morgan, BEA and DataStream.

Figure 8: Sales vs. Nominal GDP

Since 1993

2000

65.3% 2008

64.4%

2009

57.2%

2012 LTM

60.8%

52.0%

54.0%

56.0%

58.0%

60.0%

62.0%

64.0%

66.0%

1993 1996 1999 2002 2005 2008 2011

Sales as % of Nominal GDP

Source: J.P. Morgan, FactSet and BEA. Annual data for S&P 500 Index. Latest data as of

12/2011.

US Year Ahead 2013

15


December 2012

SECTORS: Cyclicals Should Outperform

Again in 2013; Focus on Materials,

Technology and Energy

We are sticking with the Cyclical play given better economic visibility (particularly

in 2H13) coupled with valuations that are more attractive than those for Defensives.

Take a look at Figure 9 below.

Cyclicals EPS are projected to grow 300-400bp faster than those for Defensives

in 2013/2014 and Cyclicals still have lower P/E multiples (average discount of

10-15%).

We understand the appeal of Defensives; however, they underperformed the

S&P 500 by 300bp in 2012 and we expect 300bp of 2013 underperformance.

Figure 9: Summary Sector Views on 2013

$ per share

JPM Strategy EPS EPS % (JPM) 2014 P/E

JPM

Strategy

Rating 2012E 2013E 2014E

'12E

vs.

'11

'13E

vs.

'12E

'14E

vs.

'13E Current Target

Long-

Term

Avg

%

Upside Comments

Cyclicals

Materials OW $3.95 $4.20 $5.04 -1% 6% 20% 9.4x 11.5x 16.5x 22% Works best in 5th yr. Better '14 EPS gth plus low valuation

Industrials OW $10.40 $11.30 $12.15 7% 9% 8% 11.7x 12.8x 16.5x 10% Play on global recovery plus US durable goods boom

Discretionary OW $9.70 $10.30 $11.12 7% 6% 8% 14.3x 15.8x 17.9x 10% Leader in a bull market and consumer supported by better housing

Technology OW $21.50 $22.50 $23.63 8% 5% 5% 11.7x 13.4x 23.6x 14% Still defensive growth. Low multiples and benefit from global recov ery

Near Cyclicals

Energy OW $14.75 $15.15 $16.67 -8% 3% 10% 8.7x 10.4x 14.8x 19% Should improv e as EPS growth recov ers in '13e/'14e

Financials OW $16.65 $17.65 $18.53 25% 6% 5% 11.3x 12.7x 13.2x 13% Play on US housing and durable goods boom

Defensives

HealthCare OW $12.30 $12.55 $12.87 0% 2% 3% 13.1x 14.7x 19.6x 12% Still like lower P/E and GARP'y names in this group

Telecom N $2.20 $2.40 $2.70 0% 9% 12% 16.0x 16.9x 16.6x 6% Improv ing EPS growth positive

Staples UW $10.30 $10.70 $11.14 2% 4% 4% 15.1x 16.2x 17.5x 7% Fairly expensive group

Utilities UW $3.25 $3.25 $3.25 -4% 0% 0% 14.7x 15.5x 12.3x 6% Trades at a meaningful premium to the S&P 500

S&P 500 $105.00 $110.00 $117.09 5% 5% 6% 12.0x 13.5x 19.8x 12%

Cyclicals $45.55 $48.30 $51.94 7% 6% 8% 12.0x 13.6x 18.6x 13%

Near-Cyclicals $31.40 $32.80 $35.20 8% 4% 7% 10.1x 11.6x 14.0x 15%

Defensives $28.05 $28.90 $29.96 0% 3% 4% 14.3x 15.5x 16.5x 9%


Cyclicals Still Valued More Attractively

Last year, Cyclicals outperformed the S&P 500 while Defensives lagged (see

Figure 10), and Cyclicals have outperformed Defensives in three of the last four

years (2011 was the exception). We continue to see Cyclicals as attractive:

Foremost, Cyclicals are projected to deliver EPS growth 700bp above the 10%

EPS growth forecasted for the S&P 500 (using bottom-up consensus). This is a

meaningful acceleration from Cyclicals EPS growth of 5% growth in 2012.

Leading this forecast growth are Basic Materials (up 28%), Discretionary (up

15%) and Technology (up 13%). Energy EPS growth is also expected to reverse

from a decline of 8% in 2012 to an increase of 2% (1,000bp swing).

US Year Ahead 2013

16


December 2012

As for valuations, note that Cyclicals still trade at a sizable discount to

Defensives, although both trade at a premium to the S&P 500. Historically,

Defensives have traded at a 15-20% discount to Cyclicals, but the opposite is

the case currently, with Cyclicals trading at a discount of approximately 17% to

Defensives.

Lastly, as noted in Figure 14, Cyclicals typically have outperformed by 700bp in

the fifth year of a bull market, with a win ratio of 75%. In fact, the two best-

performing sectors in the fifth year of a bull market have been Basic Materials

and Energy (1,600bp and 1,500bp outperformance, respectively).

Figure 10: Sector Performance Since 2009

Since Start of 2009 Bull Market; P/E Multiples as of the Start of the Year for 2009, 2010, 2011 and 2012

Annual Return YoY EPS Growth Premium/Discount: P/E relative to SPX (NTM)

Forecast Forecast

2009 2010 2011 2009 2010 2011 2012 2013E 2014E 2009 2010 2011 2012 2013E 2014E

S&P500 23% 13% 0% 12% 0% 38% 14% 5% 10% 11% 13.2x 20.3x 20.3x 16.5x 16.5x 14.4x

Cyclicals 40% 20% -2% 12% -4% 55% 21% 5% 17% 11% 108% 103% 110% 94% 102% 101%

Near Cyclicals 13% 14% -8% 11% -115% 111% 22% 8% 7% 13% 128% 91% 100% 78% 86% 88%

Defensives 9% 6% 9% 9% -3% 1% 2% 0% 8% 12% 100% 105% 111% 115% 119% 120%

Materials 45% 20% -12% 7% -49% 92% 32% -1% 28% 9% 132% 110% 113% 86% 97% 95%

Industrials 17% 24% -3% 9% -32% 24% 22% 7% 10% 10% 109% 105% 112% 98% 101% 101%

Discretionary 39% 26% 4% 21% 63% 62% 11% 7% 15% 16% 99% 98% 118% 106% 116% 116%

Technology 60% 9% 1% 13% 2% 44% 17% 8% 13% 11% 90% 98% 98% 86% 93% 92%

Energy 11% 18% 3% 1% -58% 50% 36% -8% 2% 16% 126% 92% 85% 82% 89% 91%

Financials 15% 11% -18% 20% -172% 171% 7% 24% 12% 10% 130% 90% 115% 73% 83% 85%

Staples 11% 11% 11% 10% 3% 2% 6% 2% 9% 9% 102% 106% 114% 118% 121% 125%

HealthCare 17% 1% 10% 15% 1% 3% 7% 0% 6% 7% 85% 90% 89% 93% 103% 107%

Telecom 3% 12% 1% 14% -23% -8% -4% 0% 17% 25% 122% 130% 145% 133% 137% 129%

Utilities 7% 1% 15% -3% 6% 6% -2% -4% 0% 7% 89% 93% 97% 115% 113% 119%

2012

(YTD)

Source: J.P. Morgan and Datastream.

Focus on Basic Materials

Basic Materials has been a notable laggard. Over the past two years, this group has

lagged the S&P 500 by 2,300bp, the worst relative performance, followed closely by

Energy (underperformed by 700bp). The fundamentals have lagged (look at EPS

discussion above) given the downshift of global growth over the last two years, but

price performance, we believe, has been worse than the fundamentals.

Figure 11, below, shows two-year trailing returns; note that the current level of

underperformance has been seen four times since 1975.

In three of the four instances, Basic Materials outperformed by about 2,000bp

over the following yearthat is, a forecast return of 10% for the S&P 500 would

imply a gain of 30% for Basic Materials. The only exception was the in the late

90s when underperformance continued for multiple years.

We believe the prospect for outperformance in 2013 (mean reversion) has

fundamental support, in light of our views for US durable goods (rising), China

stabilization (good) and Europe exiting recession (good). In other words, given

Cycli

cals

Near-

Cycli

cals

Defe

nsiv

es

US Year Ahead 2013

17


December 2012

the reduced expectations, and P/E of 9.4x 2013E (Energy only sector that is

cheaper), we see the potential for outperformance.

Figure 11: Basic Materials Two-Year Trailing Return vs. S&P 500

Since 1975; Two-Year Rolling Relative Return


Aluminum, Coal, Mining and Steel Have Lagged Most (If

One Is Thinking of Low Expectations)

As shown in Figure 12, several groups have suffered historic underperformance.

We sorted these industries based on worst overall one- and two-year relative returns

(percentiles vs. their history).

For instance, Aluminum stocks have seen the worst two-year performance since

1973. We also note Steels underperformance of 4,500bp is nearly as bad. While

deceleration in China and Europe has pressured pricing, an improvement in

pricing could follow upside surprises to growth.

Mining and Gold stocks are not far behind (9th/25th percentile, respectively).

Clearly fundamentals are challenged and exports weak. But, again, with 3,000-

4,000bp of underperformance over two years, expectations are likely to be

extremely low, in our view.

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

1/75 7/77 1/80 7/82 1/85 7/87 1/90 7/92 1/95 7/97 1/00 7/02 1/05 7/07 1/10 7/12

1-yr forward return (relative) Basic Materials Current

Outperforms OutperformsOutperformsSecular

issues

We are here

today

US Year Ahead 2013

18


December 2012

Figure 12: Basic Materials Industry-Level Performance

S&P 500; Rank Since 1973


J.P. Morgan Analyst Coverage of Basic Materials: CRS, GG,

MWV, SLW and LYB Are Top Ideas

We have compiled J.P.Morgan analyst coverage of the Basic Materials sector in

Figure 13. The largest sub-group (GICS level 4) is Specialty Chemicals ($122B).

And the names in most of the sub-industries tend to be mid-cap.

J.P. Morgan Analyst 2013 top picks are shown as well. The tickers are CRS, GG,

MWV, SLW and LYB.

Figure 13: J.P. Morgan Analyst Coverage of Basic Materials

S&P 1500; $ millions


2-year returns 1-year returns Avg (1 & 2-yr)

Relative

%

%-tile rank

(100=highes

t)

Relative

%

%-tile rank

(100=highes

t) %-tile

Aluminum -56% 1 -30% 8 5

General Mining -40% 5 -37% 10 8

Steels -45% 12 -34% 8 10

Gold Mining -30% 25 -40% 8 17

Non-ferrous Metals -38% 5 -7% 39 22

Commodity Chemicals -11% 29 -5% 40 35

Forestry 42% 46 19% 62 54

Specialty Chemicals 6% 48 7% 65 57

Paper & Forest Products 12% 79 11% 82 81

GICS 4 Industry

# Stocks

(S&P

1500)

Market

Cap (S&P

1500)

JPM Analyst

Coverage

Top

Pick Other Stocks Covered

1 Specialty Chemicals 23 $122,038 Jeffrey J. Zekauskas LYB ALB, ASH, CE, ECL, FOE, FUL, IFF, MTX,

ROC, RPM, SHW, VAL

Tycho W. Peterson SIAL

2 Diversified Chemicals 7 $114,432 Jeffrey J. Zekauskas DOW, DD, EMN, HUN, PPG

3 Fertilizers & Agri Chem 6 $82,835 Jeffrey J. Zekauskas AGU, CF, MON, POT, SMG, MOS

4 Industrial Gases 3 $56,670 Jeffrey J. Zekauskas APD, PX

5 Diversified Metals &

Mining

8 $39,819 Michael F. Gambardella FCX, GSM, IMN.TO, MCP, RTI, TCKb.TO, TC,

TIE

Jeffrey J. Zekauskas CMP

6 Steel 13 $37,609 Michael F. Gambardella CRS AKS, ATI, CLF, CMC, HAYN, MUSA, NUE,

RS, STLD, X, WOR

7 Paper Products 10 $29,531 Phil Gresh, CFA MWV UFS, IP

8 Gold 2 $27,001 John Bridges, CFA, ACS GG AEM, ABX, BVN, GRZ, JAG, KGC, NEM, NG

9 Metal & Glass Containers 6 $17,826 Phil Gresh, CFA ATR, BLL, CCK, GEF, OI, SLGN

10 Paper Packaging 5 $17,816 Phil Gresh, CFA BMS, BZ, GPK, PKG, RKT, SEE, SON

11 Construction Materials 5 $15,274 Scott Levine EXP, MLM, VMC

Michael Rehaut, CFA CSTE

12 Aluminum 3 $10,970 Michael F. Gambardella AA, CENX

13 Commodity Chemicals 5 $4,947 Jeffrey J. Zekauskas CBT, GGC, WLK

14 Precious Metals &Minerals John Bridges, CFA, ACS SLW CDE, HL, PAAS, SWC

US Year Ahead 2013

19


December 2012

Cyclicals Outperformed in Year 5 of Each Bull Since 1974

History strongly argues for investors to stay Cyclical. Figure 14, below, shows the

returns by Sector in the fifth year of bull markets (we have data since 1974).

The best-performing groups have bee Basic Materials and Energy, with

outperformance of 1,500-1,600bp. Overall, Cyclicals (Industrials, Materials,

Technology and Discretionary) outperformed in each bull market, with average

outperformance of 700bp. Near-Cyclicals (Energy and Financials) also

outperformed in each bull market, with an average outperformance of 500bp.

In the 2013 context, outperformance of Cyclicals is logical, in our view. After all,

given the improving global economic picture (China and Europe) and the upturn

in US economic growth in 2H, we can see early cycle names outperforming.

These would be Materials and Energy. However, these names are not likely to be

without risk.

Figure 14: Relative Sector Performance in Year 5 of Bull Market

Year 5 of the 1974, 1982, 1987 and 2002 Bull Markets

1978 1986 1991 2006 Avg

Win

Ratio

S&P500 (Abs) 6% 38% 13% 16% 18% 100%

Cyclicals -3% 11% 9% 11% 7% 75%

Near Cyclicals 12% -1% 0% 8% 5% 75%

Defensives -13% -20% -2% 3% -8% 25%

Materials 4% 22% 7% 31% 16% 100%

Energy 21% 24% -14% 28% 15% 75%

Technology -3% 10% 10% 10% 7% 75%

Industrials -3% 5% 3% 8% 3% 75%

Discretionary -11% 7% 16% -5% 2% 50%

Staples -12% -9% 4% 3% -3% 50%

Financials 2% -27% 15% -12% -5% 50%

HealthCare -8% -6% -4% -6% -6% 0%

Telecom -17% -22% 2% 9% -7% 50%

Utilities -14% -43% -11% 6% -15% 25%


US Year Ahead 2013

20


December 2012

15 Best and Worst Industries in Year 5 of Bull Markets

We decided to drill down another layer and highlight the best and worst industries in

the fifth year of bull markets. These groups (of roughly 115) are shown in Figure 15

and Figure 16 below. There are no major surprises here (compared to Sectors).

But, notice how many groups have outperformed in the fifth year of each bull

market. These include Metals, Semis, Telco Equipment and Marine

Transportation. Not far behind (from a win-ratio perspective) have been the

Steel stocks (these have been laggards for three years running). And the

magnitude of outperformance is notable, ranging from 2,200bp to 5,900bp.

As for the laggards, it is interesting to note that only a handful have

underperformed in the fifth year of each bull market (0% win ratio), with the only

two being Airlines and Food Products.

Figure 15: Top 15 Industries Relative

Performance in Year 5 of Bull Market

Year 5 of the 1974, 1982, 1987 and 2002 Bull

1978 1986 1991 2006 Avg

Win

Ratio

Software 155% 23% -2% 59% 75%

Nonferrous Met 16% 58% 7% 128% 52% 100%

Consumer Eltro 43% 66% 55% 100%

Tires -19% 96% 32% 94% 51% 75%

Travl & Toursm 40% 37% 57% 45% 100%

Home Con 125% 8% 69% -55% 37% 75%

Iron & Steel 70% -5% 37% 44% 36% 75%

Heavy Con 41% -19% 7% 105% 34% 75%

Semiconductors 23% 48% 56% 3% 32% 100%

Marine Transpt 2% 42% 39% 36% 30% 100%

Footwear 21% 20% 26% 23% 100%

Telecom Eq 6% 19% 73% 6% 26% 100%

Gold Mining 26% 106% -28% -5% 25% 50%

Oil Eq & Svs 23% 48% -17% 44% 24% 75%

Fd Rtl & W 10% -10% 12% 77% 22% 75%

Average 37% 85%


Figure 16: Bottom 15 Industries Relative

Performance in Year 5 of Bull Market

Year 5 of the 1974, 1982, 1987 and 2002 Bull

1978 1986 1991 2006 Avg

Lose

Ratio

Apparel Rtl -42% 21% -22% -21% -16% 75%

Biotechnology -19% -2% -12% -11% 100%

Airlines -20% -5% -1% -15% -10% 100%

Speciality Fin 3% -20% 8% -29% -9% 50%

Pipelines -5% -24% -9% 1% -9% 75%

Mobile T/Cm -7% -29% 3% -3% -9% 75%

Asset Managers-15% -15% -11% 6% -9% 75%

Mortgage Fin -6% -23% 16% -21% -9% 75%

Eqt Ivst Ins -8% -8% 100%

Investment Cos. -8% -8% 100%

Pharm 2% -6% -17% -11% -8% 75%

Water 5% -41% -7% 11% -8% 50%

Investment Svs -8% -26% 9% -5% -7% 75%

Food Products -7% -12% -1% -8% -7% 100%

Brewers -16% -5% -7% 0% -7% 75%


US Year Ahead 2013

21


December 2012

Year 5 in Bull Markets Has Been Strong

This is the twelfth bull market since 1935 (see Figure 18 below) and eight have

lasted for at least four years (that carries us into today). We have modeled the

composite returns in the fifth year of bull markets in Figure 17 below.

Of the eight that lasted at least four years, five continued into the fifth year (green

line) with an average gain of 19%.

The other three turned into bear markets (red dashed line) with a significant

correction taking place.

Notice also that performance in 1H of the fifth year has tended to be flat. We

believe this also is likely to be the case in 2013 (see prior section).

Bottom line, we are constructive on 2013, but see 2H13 as the upside story. In other

words, we recommend investors buy the dips in 1H.

Figure 17: Bull Markets that Have Reached Year 4 Have Tended to Do Well in Year 5

100=Start of Bull

1942, 1949, 1957, 1962, 1974, 1982, 1987, 2002 and 2009 Bull Markets

Current

196.8

Remained Bull in Yr 5

217.6

Turned Bear in Yr 5

166.8

140.0

150.0

160.0

170.0

180.0

190.0

200.0

210.0

220.0

230.0

Yr 3 Yr 4 Yr 5 Yr 6

Current Remained Bull in Yr 5 Turned Bear in Yr 5


Avg. return in

5th year of bull

was up 19%

Notice that the market

has tended to be

flattish in 1H of the

5th year of bull

US Year Ahead 2013

22


December 2012

Recession or Big Downshift in GDP for Three Bull

Markets Ending in Fifth Year

The natural question is what has caused bull markets to end by the fifth year.

Figure 18, below, shows returns in each year of the 11 bull markets since 1932.

There have been three that ended during the fifth year:

1942-1946, with a recession starting in February 1945;

1957-1961, with a recession starting in April 1960); and

1962-1966, after GDP growth of 10% annually for several years downshifted to

2% beginning in 1966in addition, the Vietnam War was starting.

In the five that lasted through the fifth year, the average gain in year 5 was 19%,

even stronger that in year 4. As we do not expect a recession in 2013, we do not

expect the current bull market to end.

Figure 18: Bull Markets Annual Equity Market Returns

% Change; Since 1932 (Based on S&P 500 Returns)

SPX

Bull Markets Annual % change

Start Date End Date

Length

(months) Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 Yr 11 Yr 12

3/14/1935 3/10/1937 24 77 29

4/28/1942 5/29/1946 49 54 3 24 26

6/13/1949 8/2/1956 86 42 12 13 (2) 20 37 16 5

10/22/1957 12/12/1961 50 31 10 (5) 28

6/26/1962 2/9/1966 44 33 17 2 4

10/7/1966 11/29/1968 26 33 7

5/26/1970 1/11/1973 32 44 11

10/3/1974 11/28/1980 74 38 21 (7) 7 6 16

8/12/1982 8/25/1987 60 58 2 14 28 38

12/4/1987 3/24/2000 148 21 29 (8) 18 13 8 (2) 34 25 29 21 19

10/9/2002 10/9/2007 60 34 8 7 13 15

Average return ALL years 59 42 13 5 15 19 20 7 19 25 29 21 19

3/9/2009 12/3/2012 45 69 16 3 4


recession 2/45

recession 4/60

US GDP downshifts from 10% saar to 2% plus Vietnam war

US Year Ahead 2013

23


December 2012

P/E Ratios in Those Three Markets Also Considerably

Higher than Current Level

In Figure 19, below, we illustrate the NTM P/E multiples at the beginning of each

year in the 11 bull markets since 1932, and highlight the higher P/E multiples for

those bull markets that ended by the fifth year.

The P/Es ranged from 16x to 22x, well above the current 14x.

In contrast, the P/Es for the bull markets that extended into the fifth year have

been lower at 9-16x although 1992 was an exception (P/E of around 20x).

Figure 19: Bull Markets P/E Ratio

NTM P/E; Since 1932

Bull Markets P/E ratio

Start Date End Date

Length

(months) Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 Yr 11 Yr 12

3/14/1935 3/10/1937 24 19.1x 17.8x

4/28/1942 5/29/1946 49 10.7x 12.8x 14.9x 20.7x

6/13/1949 8/2/1956 86 8.4x 7.7x 9.9x 9.9x 11.3x 12.7x 12.6x 13.8x

10/22/1957 12/12/1961 50 17.7x 16.6x 16.4x 22.3x

6/26/1962 2/9/1966 44 18.9x 19.2x 18.2x 16.1x

10/7/1966 11/29/1968 26 18.0x 18.3x

5/26/1970 1/11/1973 32 19.5x 18.5x

10/3/1974 11/28/1980 74 11.4x 10.7x 8.8x 8.7x 7.1x 8.9x

8/12/1982 8/25/1987 60 13.3x 10.2x 12.3x 16.3x 19.4x

12/4/1987 3/24/2000 148 11.9x 14.4x 14.5x 20.7x 20.4x 18.0x 15.2x 16.4x 18.4x 21.3x 25.6x 28.6x

10/9/2002 10/9/2007 60 19.8x 17.4x 16.2x 15.9x 17.1x

Average return ALL years 59 15.3x 14.9x 13.9x 16.3x 15.1x 13.2x 13.9x 15.1x 18.4x 21.3x 25.6x 28.6x

3/9/2009 12/3/2012 45 18.4x 15.4x 14.0x 13.6x


1982 Bull Market Still Good Analog: 2H13 Story?

We have written in the past that we see the 1982-1987 period as the most analogous

for the current bull market. Please see US Equity Strategy FLASH dated 9/19 for a

full discussion. In both cases, investors have been still skeptical several years into a

bull market.

This is very much the case today with the public still skeptical of this bull market.

In 1985-1986, the turning point arguably occurred when inflation finally broke

(breaking stagflation fears).

In 2012-2013, we believe this is likely to be more about proving the US recovery

has escape velocity beyond support provided by QE (previously this recovery has

been supported by stimulus) and is therefore highly dependent on a sustained

recovery in US housing and auto sales.

US Year Ahead 2013

24


December 2012

This market is tracking 1982-1987 closely both on price and P/E

We have plotted price and P/E for both markets (1982-1987 and 2009-2014) below

in Figure 20 and Figure 21. Thus far, this market is tracking 1982-1987 closely.

On price, if this market follows the prior markets trend, we see 1H13 as flattish.

On P/E, note how the P/E multiple really began to re-rate as the prior market

(1985-1986 period) moved forward.

Figure 20: Comparative Price 2009 Bull Market vs. 1982 Bull Market

S&P 500 in 2009-2014 vs. 1982-1987


Figure 21: Comparative P/E 2009 Bull Market vs. 1982 Bull Market

S&P 500 P/E in 2009-2014 vs. 1982-1987


Flattish

US Year Ahead 2013

25


December 2012

P/E to Re-Rate on Durable Goods Boom

Beyond Housing, Durable Goods Lowest Since 1951

This year has been a story about recovery in demand for US housing. We see this

extending into a broader story about durable goods. Figure 22, below, shows durable

goods spending (as % of GDP) since World War II. As this series shows, US durable

goods spending (as % of GDP) of 21% is the lowest since 1951. We define durable

goods spending as capex plus construction (both residential and non-residential) plus

consumer purchases of durable goods.

The line in Figure 22 represents the five-year average (to reduce noise); as shown

below, the latest level of 21% is the lowest reading since World War II.

We do not believe this stems from the US shifting manufacturing overseas. The

long-term average has been around 24%, a level seen as recently as 2008.

Rather, we attribute this collapse to the credit crisis, which has resulted in a

multiyear contraction in durable goods spending.

Figure 22: U.S. Fixed Investment & Consumption of Durable Goods as % of GDP (Five-Year

Trailing Avg.)

Since 1951

9/12

21%

LT Avg (Since 1951),

24%

18%

20%

22%

24%

26%

28%

3/51 3/56 3/61 3/66 3/71 3/76 3/81 3/86 3/91 3/96 3/01 3/06 3/11

U.S

. P

riv

ate

Fix

ed

In

ve

stm

en

t &

Pe

rso

nal

Co

ns

um

pti

on

of D

ura

ble

Go

od

s a

s %

of

GD

P

Recession 5-yr trailing avg

Source: J.P. Morgan and BEA. Note: Data from 1951 to the present reflects quarterly data.

Rising Durable Goods Spending Has Driven P/E Expansion

In Figure 23, below, we highlight the behavior of the S&P 500 P/E multiple during

the eight precedent periods of rising durable goods spending since 1950.

On average, the S&P 500 P/E ratio has expanded by 1.8 turns from 15.3x to

17.1x. This implies potential for upside to the current P/E ratio and the main

reason we expect upside to equity performance in a period of rising durable

goods spending.

GDP growth typically has been higher as well during periods of rising durable

goods spending. As shown, real GDP growth has been around 5%, above the 3%

considered trend, during periods of rising durable goods spending.

The next closest period was

the early 90swhich was

followed by a period of above-

trend growth

US Year Ahead 2013

26


December 2012

This is logical to us, since credit generally is required to fund durable goods

purchases, and the related cycle leads to above-trend growth.

Figure 23: P/E Ratios Have Expanded During Periods of Rising Durable Goods Spending

GDP CAGR

Start date End date Start End Change Start End Change

9/30/1958 9/30/1959 21.90% 24.00% 2.10% 13.7 16.4 2.6 6.9%

6/30/1961 3/31/1966 21.80% 24.70% 2.90% 17.9 17.8 (0.1) 6.2%

3/31/1967 3/31/1969 22.60% 24.40% 1.80% 16.2 17.6 1.4 4.1%

12/31/1970 3/30/1973 22.80% 26.50% 3.70% 15.9 18.6 2.7 6.2%

6/30/1975 3/30/1979 22.90% 27.60% 4.70% 10.7 8.8 (1.8) 5.1%

9/30/1982 9/30/1986 23.70% 26.40% 2.70% 8.3 13.2 4.9 5.0%

12/31/1991 3/31/2000 21.00% 26.70% 5.70% 17.4 27.0 9.6 3.9%

3/31/2003 3/31/2006 24.10% 26.00% 1.90% 22.2 17.6 (4.6) 3.5%

Average 22.60% 25.79% 3.20% 15.3 17.1 1.8 5.1%

S&P PE, trailing 8Q averageDurable goods and fixed investment spending

Periods of rising durable goods spending

Source: J.P. Morgan and BEA. Note: Data from 1929 to 1946 reflects annual data. Data from 1947 to the present reflects quarterly

data.

P/E re-rates

US Year Ahead 2013

27


December 2012

Positive Effect on S&P 500 EPS

Figure 24 below plots durable goods spending (as % of US GDP) with the peaks and

troughs of S&P 500 EPS marked.

What stands out, in our view, is that S&P 500 EPS has never peaked when

durable goods spending has been this low. In fact, the current level of US durable

goods spending typically has been seen at S&P 500 EPS troughs.

The data in Figure 25 essentially bears this out: S&P 500 EPS typically has

peaked when durable goods spending has reached around 25% of GDP. As

highlighted below, given durable goods spending nearly 500bp below that level,

we estimate there is another $1.5T in top line or nearly $50 in EPS before peak.

Figure 24: S&P 500 EPS Peak and Troughs Notated

vs. Durable Goods Spending

Since 1951

9/12

20%

LT Avg (Since

1951), 24%

18%

20%

22%

24%

26%

28%

3/51 3/56 3/61 3/66 3/71 3/76 3/81 3/86 3/91 3/96 3/01 3/06 3/11

U.S

. P

riv

ate

Fix

ed

In

ve

stm

en

t &

Pe

rso

nal C

on

su

mp

tio

n o

f D

ura

ble

Go

od

s a

s %

of G

DP

Recession

Durable goods spending as % of GDP

SPX Trough

SPX Peak

Source: J.P. Morgan, Bloomberg and BEA. Note: Data from 1947 to

the present reflects quarterly data.

Figure 25: S&P 500 EPS Has Peaked When Durable Goods Spending Peaked

% of GDP and $ per share

Source: J.P. Morgan and BEA. Note: Data from 1929 to 1946 reflects annual data. Data from 1947 to the present

reflects quarterly data.

S&P 500 Peak EPS % GDP

Dates EPS

Durable Goods

Capex + Construction

+ Consumer durables)

Construction

(Private Fixed

Investment in

Auto Sales

(Nominal consumption of

motor vehicles and parts)

1 3/51 $2.83 26.5% 4.3%

2 12/55 $3.62 25.4% 4.2%

3 12/66 $5.55 23.4% 3.5% 3.7%

4 9/69 $5.89 24.2% 4.2% 3.8%

5 9/74 $9.11 24.9% 4.3% 3.4%

6 3/80 $15.29 26.7% 4.8% 3.4%

7 12/84 $16.64 26.0% 4.4% 3.8%

8 6/89 $25.22 24.5% 4.3% 3.8%

9 9/00 $57.37 26.4% 4.4% 3.6%

10 6/07 $92.15 24.8% 4.6% 2.9%

Avg 25.3% 4.3% 3.7%

Current $101.64 20.5% 2.3% 2.5%

Current vs Avg (Delta) -4.8% -2.0% -1.1%

Current vs Avg (%)

below

prior

peaks...

$748b in

incremental

GDP, or $1.5T

in top-line

(using

multiplier)

US Year Ahead 2013

28


December 2012

Global Perspective: Shift Back to US?

To put some global context around this, we have compared US durable goods

spending (using data from the CIA World Factbook) to that in other major countries.

This is summarized in Figure 26, in which we compare GDP per capita and a

countrys fixed investment (as a percentage of GDP).

The US is an outlier: its GDP per capita is one of the highest yet its durable goods

spending as a percentage of GDP is one of the lowest (#144 globally). And note

that countries with similar GDP per capita spend substantially more for durable

goods.

Similarly, China is also an outlier: its durable goods spending at 46% of GDP is

more than twice the typical level globally and well above the 27% for Emerging

Markets countries like Korea, India and Brazil.

Figure 26: GDP per Capita vs. Gross Fixed Investment as a % of GDP

Underinvestment in the US

Estimates for 2011; Rank of Gross Fixed Investment as % of GDP in

parentheses

India (# 19)

Korea* (# 28)

Canada (# 59)Hong Kong (# 68)

Turkey (# 71)

Spain (# 80)Russia (# 76)Mexico (# 82) Switzerland (# 91)

Japan (# 87)

Italy (# 97)

France (# 94)

Brazil (# 100) EU (# 112) Sweden (# 115)Germany (# 116)

Greece (# 141) UK (# 139)

US (# 144)

Singapore (# 53)

Norway (# 92)

United Arab Emirates

(# 30)

Netherlands (# 119)

Kuwait (# 134)

Austria (# 77)

Ireland (# 149)

Australia (# 33)

Iceland (# 140)

Zimbabwe (# 70)Burundi (# 61)

Indonesia (# 13)

Belgium (# 86)

Egypt (# 136)

Saudi Arabia (# 81)

China (# 3) ($8,500;

46.2%)

Qatar (#21; $98,900;

28.6%)

Luxembourg (# 104;

$80,600; 19.0%)

10%

15%

20%

25%

30%

35%

0 10,000 20,000 30,000 40,000 50,000 60,000

Gro

ss

Fix

ed

Inve

stm

en

t a

s %

of G

DP

(2

011

es

t.)

GDP Per Capita ($) (PPP) (2011 est.)

Source: J.P. Morgan and CIA World Factbook. Note: The gross fixed investment entry (shown

above) "records total business spending on fixed assets, such as factories, machinery,

equipment, dwellings, and inventories of raw materials, which provide the basis for future

production. It is measured gross of the depreciation of the assets, i.e., it includes investment

that merely replaces worn-out or scrapped capital." Data reflects 2011 estimates for 228

countries. Korea* reflects South Korea. The top 10 countries listed are, in order of rank:

Equatorial Guinea, Sao Tome and Principe, China, Cape Verde, Republic of the Congo,

Belarus, Armenia, Kosovo. Lesotho and Seychelles. GDP per capita (PPP) is defined as GDP

on a purchasing power parity (PPP) basis divided by population as of 1 July for the same year.

The top 10 countries listed for GDP per capita, in order of rank: Qatar, Liechtenstein,

Luxembourg, Bermuda, Singapore, Jersey, Falkland Islands (Islas Malvinas), Norway, Brunei,

Hong Kong and United States.

Figure 27: Gross Fixed Capital Formation as a % of GDP US vs. China

% of GDP

2011E

12.1%

2011E

46.2%

10%

15%

20%

25%

30%

35%

40%

45%

50%

19

65

19

67

19

69

19

71

19

73

19

75

19

77

19

79

19

81

19

83

19

85

19

87

19

89

19

91

19

93

19

95

19

97

19

99

20

01

20

03

20

05

20

07

20

09

201

1E

Gro

ss

fix

ed

ca

pital f

orm

atio

n a

s %

of G

DP

US Gross fixed capital formation as % of GDP

China Gross fixed capital formation as % of GDP

Source: J.P. Morgan, CIA World Factbook and World Bank. Note: 2011E US reflect estimates from the CIA

World Factbook. Data from 1965 through 2011 reflects World Bank estimates. Gross fixed capital formation

(formerly called gross domestic fixed investment) is defined by the World Bank as "includes land improvements

(fences, ditches, drains, and so on); plant, machinery, and equipment purchases; and the construction of roads,

railways, and the like, including schools, offices, hospitals, private residential dwellings, and commercial and

industrial buildings. According to the 1993 SNA, net acquisitions of valuables are also considered capital

formation."

We provide a time series of this metric for the United States and China since 1965 in

Figure 27 above. Notice that from 1975 to 2000 spending levels in both the US and

China generally were range-bound. It was not until 2005 that the trajectories of

spending for each country diverged meaningfully.

Chinas spending surged to 46% of GDP from a prior range of 25-35%. Over the

next decade, in our view, this is likely to revert to the prior range of 25-35%.

Conversely, US spending has collapsed since 2007 from its long-time range

during 1975 to 2003. We similarly expect this spending to recover as the US

cannot defer spending indefinitely.

Range-bound

Lift-off

Lift-off

Range-bound

Revert

to prior

range

US Year Ahead 2013

29


December 2012

Where Has There Been Underinvestment in US?

The US underinvestment in durable goods is summarized in Figure 28 below. We

include for each category the number of standard deviations the current level is from

long-term trend and shaded those more than 1.0 standard deviations from trend.

To the downside, these include Motor Vehicles (-1.9), Furniture (-1.6), Non-

Residential Structures (-1.1) and Housing (-2.3).

Within structures (see right side), these include Office Space (-1.6), Malls (-1.8),

Restaurants (-1.9) and Electric (-0.6).

Figure 28: GDP Components Components as a % of GDP

As of 3Q2012

GDP Components Components as a % of GDP (excl. chg private inventories, net exports

and govt expenditures)

Line Item (from BEA)

% of GDP

(3Q12) LT Avg

Delta vs.

LT Avg

# of std dev

from LT avg

Personal consumption expenditures 70.6% 65.0% 5.6% 1.8

Goods 24.0% 29.2% -5.2% (1.1)

Durable goods 7.7% 8.8% -1.1% (1.7)

Motor vehicles and parts 2.6% 3.5% -0.9% (1.9)

Furnishing and durable household equipment1.7% 2.3% -0.6% (1.6)

Recreational goods and vehicles 2.2% 1.9% 0.4% 1.0

Other durable goods 1.2% 1.0% 0.2% 1.7

Nondurable goods 16.3% 20.4% -4.1% (0.9)

Services 46.6% 35.8% 10.8% 1.5

Gross private domestic investment 13.2% 15.9% -2.7% (1.6)

Fixed Investment 12.6% 15.3% -2.7% (1.9)

Nonresidential 10.2% 10.7% -0.5% (0.4)

Structures 2.9% 3.6% -0.7% (1.1)

Equipment and software 7.3% 7.1% 0.2% 0.2

Residential 2.5% 4.6% -2.2% (2.3)

Structures 2.4% 4.5% -2.1% (2.3)

Equipment 0.1% 0.1% 0.0% (2.0)

GDP Components, Private Fixed Investment: Nonresidential Structures as a % of GDP


% of GDP

(3Q12) LT Avg

Delta vs.

LT Avg

# of std dev

from LT avg

Structures 2.9% 3.6% -0.7% (1.1)

Commercial and health care 0.6% 1.2% -0.6% (1.9)

Office 0.2% 0.4% -0.3% (1.6)

Health care 0.2% 0.3% 0.0% (0.8)

Hospitals and special care 0.2% 0.2% 0.0% (0.8)

Hospitals 0.1% 0.2% 0.0% (0.5)

Special care 0.0% 0.0% 0.0% (1.3)

Medical buildings 0.0% 0.1% 0.0% (0.5)

Multimerchandise shopping 0.1% 0.2% -0.1% (1.8)

Food and beverage establishments0.0% 0.1% -0.1% (1.9)

Warehouses 0.0% 0.1% -0.1% (1.9)

Other commercial 0.1% 0.1% -0.1% (2.4)

Manufacturing 0.3% 0.5% -0.2% (1.1)

Power and communication 0.6% 0.7% -0.1% (0.5)

Power 0.5% 0.5% 0.0% (0.1)

Electric 0.3% 0.3% -0.1% (0.6)

Other power 0.2% 0.1% 0.1% 1.1

Communication 0.1% 0.2% -0.1% (1.8)

Mining exploration, shafts, and wells1.0% 0.5% 0.5% 1.6

Petroleum and natural gas 0.9% 0.5% 0.5% 1.6

Mining 0.0% 0.0% 0.0% 0.5

Other structures 0.4% 0.7% -0.3% (1.9)

GDP Components, Private Fixed Investment: Residential Structures as a % of GDP


% of GDP

(3Q12) LT Avg

Delta vs.

LT Avg

# of std dev

from LT avg

Structures 2.4% 4.5% -2.1% (2.3)

Permanent site 1.0% 2.8% -1.8% (2.3)

Single-family structures 0.8% 2.2% -1.4% (2.3)

Multifamily structures 0.1% 0.5% -0.4% (1.3)

Other structures 1.4% 1.6% -0.2% (0.8)

Manufactured homes 0.0% 0.1% -0.1% (1.6)

Dormitories 0.0% 0.0% 0.0% (0.1)

Improvements 1.0% 1.1% -0.1% (0.6)

Brokers' commissions on sale of structures0.4% 0.4% 0.0% (0.1)

Net purchases of used structures 0.0% 0.0% 0.0% 0.7

Source: J.P. Morgan and BEA. Note: BEA tables 1.1.5; 2.4.5U; 5.3.5; 5.5.5U and 5.4.5U.

US Year Ahead 2013

30


December 2012

Housing Is a Big Factor

It remains our view that US housing is in a three- to five-year upcycle that ultimately

will lead to starts reaching 2.0M sometime by 2015 or so (see Positive on Housing

Food Chain IV dated 8/29). The key is a favorable supply/demand mix in US

housing markets over the next five years: we estimate housing starts are set to rise to

1.3-1.8M annually (see Figure 29), after languishing at 450-550k for three years

(2009-2011).

It simply comes down to short supply (low supply plus scrappage).

And demand driven by the Echo boom and basement dwellers (pent-up

formation). The adult population is projected to increase by 12.2M over the next

five years and pent-up household formation is estimated to total another 2.4M.

And each 250,000 increase in US housing starts adds about 1M jobs.

Figure 29: Implied Annual Housing Starts, 2012-2017E

Housing in Actual Units

Supply

(a) Excess homes/rentals/other 678,000

(b) Scrappage '12-'17 (250k x 5 years) -1,250,000

(c ) = (a) + (b) Total starting supply -572,000

Demand

(d) Adult population change '12-'17 12,244,000

(e) Ratio pop/ shelter 2.04

(f) = (d) / (e) Incremental housing units demand 6,008,000

(g)=(f) - (c ) Net required housing units to be built 6,580,000

/ 5 years 5

Base case: 12-'17 annual housing starts BASE case 1,316,000

(h) Plus: pent-up household formation 2,356,000

(i)=(g) + (h) - (c ) Net required housing units to be built 8,936,000

/ 5 years 5

Upside case: 12-'17 annual housing starts HIGH case 1,787,200

Source: J.P. Morgan and U.S. Census Bureau. Note: Census data as of 2Q12.

Figure 30: Rising Births and Adults Behind This Rise...

Newborns: Births 5-Yr Avg.; Adults: Becoming 20-Yr Old 5-Yr Avg.

2,000

2,500

3,000

3,500

4,000

4,500

2025202020152010200520001995199019851980197519701965

00

0s

5-yr avg : entering age 20 5-yr avg births

1950s-1960s 1970s-1980s 1990s-2000s 2010s...

Rising births Rising adults Rising births

Rising birthsRising adults

Fewer adults Fewer births Fewer adults

Source: J.P. Morgan, Census Bureau and CDC.

Capex to Sales Highlights Underinvestment as Well

Another area of accelerating spending should be capex. Figure 31 shows the capex-

to-sales ratio for S&P 500 companies. The current figure is 6.2% of sales, in the

lower end of the 16-year range of 5.1% to 8.1%.

There are multiple reasons for this but we ultimately attribute this to corporate

caution stemming from policy overhangs (globally) and generally poor

confidence in the global recovery.

This level of spending is low for both Cyclicals and Defensives, as seen below.

This is indicative of overall caution by businesses, both those selling staples (less

cyclical) and those with leverage to the economy.

Over the cycle, this figure should rise to 8% of GDP. This implies capex could

rise from the current level of $550 billion annually towards $800 billion. Again,

this would represent a substantial increase of around $250 billion in the run rate.

US Year Ahead 2013

31


December 2012

Figure 31: Capex to Sales of S&P 500 Companies

% of Sales

Source: J.P. Morgan and FactSet. Note: LTM reflects estimates. Near-Cyclicals reflects an average of energy and financials.

Automobile Demand Recovering: 15.2M SAAR in Nov 12

Automobile demand is recovering and recently reached a SAAR of 15.2M in

November. We believe there is room for automobile demand to recover further.

J.P. Morgans Auto & Auto Parts analyst has written extensively on this but we

present some simple charts below in Figure 32 to Figure 34. Basically, even with the

recent recovery in auto sales, sales per adult is still quite low.

As Figure 33 shows, the average vehicle life has extended significantly since

1996, rising from 8.7 years to 10.8 years.

The current level of auto sales works out to about 49.7 cars per 1,000 adults, as

shown in Figure 34 below, a level that is still quite low. Historically such a level

of sales has been associated with troughs in auto demandthis is analogous to

the situation in housing as well. Basically, we believe the SAAR of auto sales can

recover towards 16M, aided by an easing of credit standards.

CAPEX / Sales (%)

Current Low High Decile

LTM % Date % Date Low High

S&P 500 6.2% 5.1% 2009 8.1% 1998

Cyclicals 5.0% 4.1% 2009 7.7% 1996

Materials 6.8% 4.4% 2004 9.7% 1996

Industrials 5.1% 4.1% 2010 10.4% 1996

Discretionary 4.5% 3.9% 2009 8.1% 1997

Technology 5.0% 3.7% 2009 8.0% 1995

Near-Cyclicals 7.7% 4.2% 2000 8.1% 1997

Energy 12.4% 5.8% 2000 14.0% 1997

Financials 2.9% 2.2% 2004 3.8% 2009

Defensives 5.5% 5.5% 2006 15.2% 2001

Staples 2.7% 2.7% 2010 4.4% 1997

HealthCare 1.9% 1.7% 2010 6.1% 1995

Telecom 14.0% 13.6% 2009 27.6% 2001

Utilities 24.1% 15.2% 2006 41.2% 2002

US Year Ahead 2013

32


December 2012

Figure 32: Scrappage Rate

From 1996

Source: J.P. Morgan, NADA and Wards Auto.

Figure 33: Average Vehicle Life

From 1996

Source: J.P. Morgan and Polk.

Figure 34: Auto Sales per 1,000 People

From 1950

Source: J.P. Morgan and Bureau of Economic Analysis.

6.3%

5.8%5.7%

6.8%

6.6%

6.1%

5.5%

4.9%

4.3%

5.0%

5.2%

5.6%

4.2%

5.1%

5.1%

5.3%

2008

4.2%

2011

5.3%

4.0%

4.5%

5.0%

5.5%

6.0%

6.5%

7.0%

1996 1998 2000 2002 2004 2006 2008 2010

Scrappage % of Vehicles

8.68.6

8.88.88.98.9

9.09.1

9.49.5

9.79.8

10.0

10.3

10.6

10.8

8.50

9.00

9.50

10.00

10.50

11.00

1996 1998 2000 2002 2004 2006 2008 2010

Recessions Average Vehicle Life

12/09

33.9

11/12

49.7

25.0

30.0

35.0

40.0

45.0

50.0

55.0

60.0

65.0

70.0

12/50 3/62 6/73 9/84 12/95 3/07

Recessions Auto Sales per 1,000 People

US Year Ahead 2013

33


December 2012

Credit Easing Should Be Visible in 2014

In Last Three Housing Cycles, Bank Lending Eased 16-37

Months AFTER Trough in Housing

There appears to be a misconception that bank lending has eased to start a housing

upcycle. In fact, it seems the opposite has occurred. As shown in Figure 35, an ease

in bank lending has never preceded or coincided with an upturn in US housing.

The earliest that bank lending has eased was 16 months after the start of an

upcycle (1992) and in 2000 it took 37 months (more than three years).

This makes sense from a banks perspective. Loan losses need to contract and an

improvement in housing activity and prices is needed prior to a banks gaining

confidence to increase lending. Thus, we would not expect these conditions to

precede an upturn in starts.

As we have argued in our past pieces, US housing recoveries are a result of an

improvement in pent-up demand vs. supply balance. And, thus, that is the driver

of an upturn in housing.

Figure 35: Bank Mortgage Loan Standards

% of Respondents Tightening Standards; Federal Reserve Senior Loan Officer Opinion Survey

Source: J.P. Morgan and Bloomberg. Note: Latest survey released for October 2012.

While US Private Sector Has High Liquidity

Corporate cash (as % of assets) near all-time highs

One way to measure corporate cash balances is to look at these balances as a

percentage of assets. As shown in Figure 36 below, the current level is 11%, well

above the long-term average of 8% and basically the highest since the 1950s.

Consider the favorable position of the private sector at the moment. At a time

when durable goods spending is the lowest in 50 years corporate liquidity is

nearly the highest in 50 years.

This contrasts with the early 90s (the last time durable goods spending rose)

when corporate liquidity was not nearly as strong.

-20.0%

0.0%

20.0%

40.0%

60.0%

80.0%

9/90 9/92 9/94 9/96 9/98 9/00 9/02 9/04 9/06 9/08 9/10 9/12 9/14

Net

% o

f R

esp

on

den

ts T

igh

ten

ing

Sta

nd

ard

s

Mortgage Loan Standards Prime Mortgage Loans Non-Traditional Mortgage Loans

3/91 6/95 12/00 9/11

Start of Housing Upcycle

7/92 4/97

Start of easing (% < 0%)

1/04

16 mos 22 mos 37 mos

US Year Ahead 2013

34


December 2012

Figure 36: Corporate Cash as % of Assets

Since 1952

Source: J.P. Morgan and Federal Reserve Flow of Funds.

US debt service ratios back to best levels in 30 years

Leading up to the recession, the household debt service ratio climbed to 20-year

highs as households increased mortgage borrowings. Since the 2007 peak, the

household debt service ratio has declined significantly, falling below the long-term

average, to 1993 levels.

About one-third of that decline has been due to lower borrowings and the balance

to lower interest costs.

As shown in Figure 37 below, the debt service ratio has only been as low as the

most recent 10.7% (per the Federal Reserve) in the early 80s and early 90s.

Figure 37: Debt Service Ratio for Households

Since 1980; Ratio of Household Service to Disposable Personal Income; Seasonally Adjusted (SA, %)

LT Avg, 11.96%

1 st dev

1 st dev2Q2012, 10.7%4Q1993

3Q2007, 14.1%

10.0%

10.5%

11.0%

11.5%

12.0%

12.5%

13.0%

13.5%

14.0%

14.5%

1Q

19

80

1Q

19

81

1Q

19

82

1Q

19

83

1Q

19

84

1Q

19

85

1Q

19

86

1Q

19

87

1Q

19

88

1Q

19

89

1Q

19

90

1Q

19

91

1Q

19

92

1Q

19

93

1Q

19

94

1Q

19

95

1Q

19

96

1Q

19

97

1Q

19

98

1Q

19

99

1Q

20

00

1Q

20

01

1Q

20

02

1Q

20

03

1Q

20

04

1Q

20

05

1Q

20

06

1Q

20

07

1Q

20

08

1Q

20

09

1Q

20

10

1Q

20

11

1Q

20

12

1Q

20

13

1Q

20

14

Ho

use

ho

ld d

eb

t s

erv

ice

ra

tio

(S

A)

(%)

Household Debt Service Ratio (SA, %) LT Avg 1 st dev

Source: J.P. Morgan and Federal Reserve Flow of Funds. Note: Household debt service ratio defined by the Federal Reserve Board

as an estimate of the ratio of debt service payments (consistent of the estimated required payments on outstanding mortgage and

consumer debt) to disposable personal income.

12/55

11%

12/59

9%12/63

9%

12/76

6%

12/86

7%

9/12

11%

4%

5%

6%

7%

8%

9%

10%

11%

12%

3/52 3/56 3/60 3/64 3/68 3/72 3/76 3/80 3/84 3/88 3/92 3/96 3/00 3/04 3/08 3/12

Cas

h a

s %

of

To

tal

Ass

ets

Recession Cash as % of Total Assets (ex-Financials)

US Year Ahead 2013

35


December 2012

STYLES: Favor High FCF, Low Div Yield

High FCF and Low Dividend Yield Are Two Best Styles

We also looked at the historical performance of styles in the fifth year of bull

markets since 1973. This was based on the attributes of the roughly 118 industry

groups with trading history, rather than the individual S&P 500 constituents, as the

fundamental data from our sources at the company level only went back to 1980. As

a result, we examined industry groups based on quintiles of attributes:

We list the best- and worst-performing attributes in Figure 38 and Figure 39.

Note the substantial outperformance of high FCF yield. The highest-quintile

groups typically outperformed by 2,100bp with a win ratio of 79%.

After high FCF yield, low dividend yield performed the best, with average

outperformance of 1,800bp and a win ratio of 67%. Interestingly, this would

mark a reversal for dividend strategies, as high dividend yield stocks have

performed so well.

In the 2013 context, we can see this as logical. After all, if we are looking for a

P/E re-rating as durable goods spending ramps up, this would favor companies

with potential to re-rate higher.

These would encompass companies with higher FCF, rather than dividend payers.

Recall that not every company with a high FCF yield pays a high dividend.

Figure 38: Average Relative Annual Return in Year 5 of a Bull Market

Since 1973; Sorted from Best to Worst

21%

14%

11%

10%

9%

4%

18%

14%

12%

10%

8%

4%

FCF Yield - Highest Quartile

Div Yield - Lowest Quartile

ROE - Lowest Quartile

P/E - Highest Quartile

Interest Charge Coverage - Lowest Quartile

P/E (Percentile) - Highest Quartile

P/E (Percentile) - Lowest Quartile

ROE - Highest Quartile

Interest Charge Coverage - Highest Quartile

P/E - Lowest Quartile

Div Yield - Highest Quartile

FCF Yield - Lowest Quartile

Source: J.P. Morgan and Datastream. Note: ROE, Interest Charge Coverage and FCF Yield

calculations exclude the 1974 Bull Market due to unavailable data.

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