US_EQUITY_STRATEGY：2013_AND_BEYOND-2013-01-04.ppt

,.,.,strategist,ab,global equity research,americas ubs investment research,us equity strategy,equity strategy,market comment 2013 and beyond 2 january 2013 /investmentresearch our sense is that many investors are feeling confident heading into 2013,following a year of strong equity market returns, and signs that congress is close to a deal that may avoid the most damaging aspects of the fiscal cliff. however, after looking at each of these items in greater detail, we are maintaining a cautious outlook for the year ahead. the s&p 500 rose 13.4% in 2012, bringing the markets advance to 110.8% since its 2009 lows (excluding dividends). at first glance, this could be viewed as a sign of robust economic and market health. however, a closer analysis reveals a disconnect between stock returns and underlying fundamentals. exhibit 1: s&p 500,jonathan golub, cfa +1-212-713 8673 chip miller, cfa strategist +1-203-719 3720 manish bangard, cfa strategist +1-212-713 3036,1600 1500 1400 1300 1200 1100 1000,log scale,4/23/10,+3%,12/31/11,12/31/12 +13%,mark carden associate strategist +1-212-713 3218,900 800 700,3/9/09,+80%,600 08,09,10,11,12,source: s&p, factset and ubs more specifically, we view last year as being defined by expanding multiples and falling risk aversion. this report has been prepared by ubs securities llc analyst certification and required disclosures begin on page 14. ubs does and seeks to do business with companies covered in its research reports. as a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. investors should consider this report as only a single factor in making their investment decision.,us equity strategy 2 january 2013 as illustrated in the table below, risk metrics fell across the board in 2012, with the vix declining substantially and high yield spreads collapsing. more than anything else, expanding risk appetites were evidenced by the sharp fall in european sovereign yields. normally, such periods are accompanied by improving growth. however, this was not the case last year, as global gdp slowed to just over 2% and earnings growth declined by almost two-thirds. exhibit 2: year-end comparison 2012 vs. 2011,2012,2011,growth global real gdp s&p 500 eps growth,2.2% 4.8%,2.9% 14.4%,while growth slowed in 2012, valuations are higher on declining risk aversion,valuation & volatility,forward p/e (bottom-up) vix credit u.s. 10-year treasury investment grade (baa) non-investment grade (b) italy 10-year sovereign commodities oil crb raw industrials,12.6x 18.0 1.76% 4.58 5.99 4.48 $91.82 530.40,11.7x 23.4 1.89% 5.35 8.46 7.10 $99.81 516.84,source: standard & poors, bloomberg, haver and ubs ecb propels u.s. equities a quick review of last years trading activity shows that ecb actions that led to a decline in european sovereign concerns were the most important factors driving above-average u.s. stock returns. as we entered 2012, the s&p 500 was in the midst of a strong rally up 14.4% from its autumn lows on the back of the ecbs ltro announcement. risk appetites continued to expand through early april, driving the market up an additional 12.8%. ubs 2,us equity strategy 2 january 2013 exhibit 3: s&p 500 returns,12.8%,14.3%,events in europe dominated the years,stock market movements -2.4% -9.9%,ltro rally 12/31 - 4/2,european crisis 4/2 - 6/1,whatever it takes 6/1 - 10/17,elections & fiscal cliff 10/17 - 12/31,source: standard & poors, factset and ubs the european crisis then re-emerged as sovereign concerns spread to spain and italy. in early-june, mario draghi promised to do whatever it takes to defend the euro, setting off a second ecb-driven rally that lasted through mid-october. in the final weeks of the year, the market provided flattish returns, as the focus shifted to election outcomes and the fiscal cliff. 2013 and beyond as we look to the future, its important to recognize that the economic and market environment is still shaped by the financial crisis. while in many ways life appears to have returned to normal, this is only the case due to trillion dollar deficits and extraordinary central bank actions.,going forward, we believe that the environment will be defined by the actions of four key economic actors: (1) policymakers committed to averting crises, but likely to push off the greatest long-term fiscal challenges; (2) corporations focused on cost controls; (3) consumers inclined to spend; and (4) investors,the actions of four economic actors define todays environment: policymakers, corporations, consumers and investors,wary of future outcomes and unwilling to “pay up” for earnings results. in total, we believe that these trends will result in an environment characterized by mid-single digit earnings growth, downward pressure on stock multiples, and disappointing equity market returns. policymakers throughout the recovery, policymakers have been largely successful in averting worst-case outcomes. however, they have shown much less of an ability to reinvigorate a slow economy, despite unprecedented deficit spending and central bank actions. on the fiscal front, the federal government has outspent tax revenues by more than $1 trillion in each of the past four years. this deficit represented 7.0% of gdp in 2012. according to the congressional budget office, avoiding the fiscal cliff would result in a continuation of this trend into the future. ubs 3,us equity strategy 2 january 2013 exhibit 4: federal budget deficit under existing cbo alternative scenario (us$ trillions),1.4,1.3 1.3,1.1,1.0,0.9,0.8,0.8 0.8 0.9,1.0,1.1,1.2,1.4,policymakers have run large deficits to avoid downside risks to the economy,09,10,11,12,13,14,15,16,17,18,19,20,21,22,source: cbo, choices for deficit reduction (nov. 2012), haver and ubs while cliff avoidance is the order of the day, its apparent that our system of transfer payments is at the heart of current imbalances. as dependence on these programs increases, it will become even more politically difficult to reconcile fiscal challenges in the future. as stated earlier, policymakers are committed to minimizing short-term pain, even at the expense of longer-term success. exhibit 5: % of us population on food stamps & social security disability benefits,16%,4%,12%, % on food stamps,3%,8% 2% 4% % on disability,0%,1%,70,75,80,85,90,95,00,05,10,source: social security administration, usda and ubs ubs 4,3.0,us equity strategy 2 january 2013 on the monetary front, we have seen a tripling of the feds balance sheet since mid-2008. the feds current quantitative easing programs are projected to send these balances significantly higher. exhibit 6: fed balance sheet assets ($t) the fed continues to take extraordinary,2.5 2.0 1.5 1.0 0.5 0.0,measures,90,92,94,96,98,00,02,04,06,08,10,12,source: federal reserve, bloomberg and ubs according to ubs economists drew matus and sam coffin, “monetary policy,will continue to operate as a poor substitute for responsible fiscal policy. the possibility of policy errors remains a key risk for the foreseeable future. we believe that the fed will find it far more difficult to exit than they have found it,policy uncertainty may be offsetting some of the benefit provided by low interest rates,to enter qe.” from an investment perspective, easy money policies create significant ambiguity around the future direction of inflation, interest rates, currency values, and commodity prices, offsetting some of the benefits provided to the economy through lower rates. this, in turn, is negatively impacting business confidence and capital investment. in the long-run, large deficits and ballooning central bank balance sheets will likely result in some combination of austerity, tax increases, and sub-par growth. corporations the same environment that has resulted in extraordinary policy responses is also having an outsized impact on corporate behavior. more specifically, an array of uncertainties has resulted in conservative spending policies, especially around longer-term capital commitments. the result is clearly visible on company financial statements, where margins and cash balances are high, and capex spending remains near record lows. ubs 5,30,20,us equity strategy 2 january 2013 this behavior is evident in capital goods orders, where the trend remains weak, despite a recent uptick. while underinvestment is likely to lead to stronger cash flows and profitability in the near term, it is also likely to retard longer-term growth. exhibit 7: capital goods new orders ex-defense & aircrafts corporate spending remains constrained due to macro uncertainties 10 0 -10 -20 -30,94,97,00,03,06,09,12,source: bea, bloomberg and ubs this same pattern is also reflected on corporate income statements. by way of example, twelve quarters into the current recovery, we find sg&a and r&d spending at trough levels and falling. exhibit 8: sg&a and r&d as a % of sales 20.0%,8.8%,operating expenses and r&d continue,19.0% 18.0%,r&d / sales, sg&a/ sales (rolling 12m),8.3% 7.8%,to shrink as a percent of sales,(rolling 12m) ,17.0% 16.0%,16.9% 6.9%,7.3% 6.8%,00,01,02,03,04,05,06,07,08,09,10,11,12,source: standard & poors, compustat, thomson financial, factset and ubs ubs 6,us equity strategy 2 january 2013 on the cash flow front, while most investors predicted that companies would release their war chests through increased buybacks, dividends and m&a this has clearly not been the case. exhibit 9: s&p 500 cash % of assets,12%,10.8%,cash remains near peak levels 3,years into the recovery 10% 8% 6% 4%,99,01,03,05,07,09,11,source: s&p, compustat, factset and ubs,note: universe excludes financials,its also interesting to see buybacks stall out at mid-cycle levels. a similar pattern can be seen in the level of m&a activity which is far below trend. exhibit 10: total payout ratio,110% 90% 70% 50% 30%,108.0 dividends + buybacks,58.1,71.7 30.2,buyback activity has stalled out mid- cycle, dividends 10%,00,01,02,03,04,05,06,07,08,09,10,11,12,source: s&p, compustat, factset and ubs,note: universe excludes financials,we expect these trends to persist. in addition to the ongoing macro uncertainties discussed above, earnings growth is decelerating. as illustrated below, s&p 500 companies delivered outsized results from 4q09 to 3q11 as profits rebounded from recessionary levels. however, a slowing economy and flat-to- down commodity prices have impaired this pace in 2012. our $108 estimate for 2013 earnings is consistent with roughly 4% eps growth in the year ahead. ubs 7,us equity strategy 2 january 2013 exhibit 11: s&p 500 operating eps growth (yoy),40 41,earnings growth should be rather tepid,16,25,18 20 18 17,in 2013,-30 -21,7,4,-2 -3,4,-4,1,3,4,2q09,4q09,2q10,4q10,2q11,4q11,2q12 4q12e 2q13e 4q13e,source: standard & poors, thomson financial, compustat, factset and ubs note: year-over-year growth actuals are shaded in black. estimates beginning in 3q12 are shaded in grey consumers while companies are responding to macro and growth uncertainties through cautious behavior, the same cannot be said of the consumer. over the past three years, retail sales grew in line with the long-term average and nominal gdp. exhibit 12: retail & food services sales yoy 12%,8% 4% 0% -4% -8% -12%,avg. 3.8%,3.8%,retail sales remains roughly inline with nominal gdp,00,02,04,06,08,10,12,source: us census bureau, haver and ubs moreover, consumers are showing a willingness to commit their capital toward longer-term purchases. as shown below, auto sales continue to improve from 2009 levels. the same can be said for housing activity. ubs 8,17,16,us equity strategy 2 january 2013 exhibit 13: u.s. light vehicle sales,18 15 14 13 12 11 10,mn,14.1,auto sales and housing activity are up sharply,95,97,99,01,03,05,07,09,11,source: wards, haver and ubs,note: rolling 12-month basis,clearly, consumers have benefitted from the actions taken by policymakers, who have run large deficits and provided ultra-aggressive monetary policy. although the level of unemployment remains uncomfortably high, consumers are reaping significant benefits from reduced debt burdens and increased asset values. for example, over 3% of disposable income has been freed up as homeowners have refinanced at lower rates. exhibit 14: household debt service to disposable income,140 120,%,%,14,household debt service has fallen dramatically supporting spending,13,100 80 60, household debt/ disposable income,household debt service ,12 11 10,80,85,90,95,00,05,10,source: federal reserve, haver and ubs throughout the recovery, the savings rate has fallen from 6.0% to 3.6% of disposable income, providing another tailwind for spending. while many are concerned that higher taxes resulting from the fiscal cliff will drive a contraction in demand, we believe that this will be partially mitigated as consumers take the savings rate even lower. ubs 9,200,us equity strategy 2 january 2013 exhibit 15: savings rate & total household net worth,12 % 10 8, savings rate,total household net worth,$t 3.6%,0 20,a lower savings rate provides an additional tailwind for consumer spending,6 4 2,$64.8,40 60,65,70,75,80,85,90,95,00,05,10,80,source: federal reserve, bea, factset and ubs,note: savings displayed on a rolling 12 month basis,in the short run, spending is critical to economic growth. however, current savings are woefully inadequate running one-half to one-third of the levels experienced in the 60s, 70s and 80s. at some point in the not-so-distant future, consumption will have to fall as retirees find themselves with insufficient assets. investors generally speaking, investors remain cautious nearly four years after the markets 2009 bottom. this is evident in the direction of equity mutual fund flows. as the exhibit below highlights, the shift away from stocks began well before the 2008 crisis. exhibit 16: 12 month flows to u.s. equity mutual funds (in $ billions),150 100 50 0 -50 -100, period of inflows,period of outflows ,u.s. equity fund flows have been negative since 2004,92,96,00,04,08,source: amg lipper and ubs,note: excludes etfs,we believe that investor sentiment is even better captured by stock multiples what investors are willing to pay for a dollar of earnings. throughout the recovery, investors have espoused reversion toward some mean multiple, with 14.5x cited as normal. we do not endorse this line of reasoning, as the range of valuations over time has been extremely wide, and average levels tend to be quite specific to the time period measured. ubs 10,30,15,16,14,4,us equity strategy 2 january 2013 exhibit 17: forward p/e multiples the average multiple depends largely,25 20 10 5,avg = 11.1x,avg = 16.5x,on the period measured,70,75,80,85,90,95,00,05,10,source: standard & poors, dept. of labor, thomson financial, factset and ubs while stock multiples move in an extremely wide band over time, over shorter periods they tend to anchor on a specific market metric which captures the general level of interest rates/inflation, growth expectations, and attitudes towards risk. this behavior is most visible in the relationship between earnings yields and 10-year bond yields from 1981 to 1999. exhibit 18: fed model (1981-1999), earnings yield,stocks anchor on a single valuation,metric for prolonged periods of time 12 10 8 6 10-year yield ,82,84,86,88,90,92,94,96,98,source: federal reserve, s&p, thomson financial, factset and ubs history shows us, however, that these relationships often come to an abrupt end. as shown below, the 18-year fed model period broke down in the latter days of the tmt bubble. in the years that followed, investors and market pundits predicted a reversion to the mean, which never occurred. ubs 11,8,11,10,6,us equity strategy 2 january 2013 exhibit 19: fed model (1999-present) 10 when these relationships break down,6 4 2,earnings yield 10-year yield ,they tend not to quickly mean revert,00,02,04,06,08,10,12,source: federal reserve, s&p, thomson financial, factset and ubs from 2004-2010, stock multiples and investment grade (baa) bond yields became closely tethered. this reflected a higher level of investor caution than the simple 10-year risk-free treasury yield would imply. this relationship appeared to be reasonably short lived (roughly five years), breaking down with the onset of the european debt crisis. valuations are currently more closely aligned with non-investment grade yields. exhibit 20: s&p 500 earnings yield vs. corporate yields,9 8 7 5,p/e anchored to baa yields earnings yield baa yield,p/e pegged to b yields b yield ,multiples re-anchored on non- investment grade yields in 2010,04,05,06,07,08,09,10,11,12,source: standard & poors, moodys, bloomberg and ubs if history teaches us one lesson with respect to valuations, its that mean reversion is a less powerful force than often perceived. we agree that stocks look extraordinarily cheap versus fixed income alternatives by almost any measure. however, given the events of the past 12 years, plus the substantial uncertainties that exist around u.s. and global fiscal imbalances and growth outlooks, we see no reason that these valuation gaps will close in the near future. ubs 12,us equity strategy 2 january 2013,conclusions,as we write this note, policymakers in washington are in the process of finalizing a patch to higher taxes under the fiscal cliff. unfortunately, necessary long-term tax and entitlement reforms will most likely be absent from this agreement. also unaddressed is the debt ceiling, which is on target to be hit in late-february or early-march. we believe this only sets us up for another bare knuckled fight in the near future.,in january 2010 roughly three