EFTA01123502.pdf

North America Equity Research IP Morgan 07 November 2012 US Equity Strategy FLASH Sell-Off Post Election Shows More Hoped for a Romney Win; Reasons for Selling Improves Equity Risk/Reward; 30 Ideas Equity markets sold off sharply today (S&P 500 down 34 pts), more than reversing the Portfolio Strategy 1 I -pt gain yesterday. We spent a lot of time on the phone with PMs and found most Thomas J Lee. CFA AC investors trying to understand the catalyst behind such a large sell-off and it seems there is disappointment, owing to a combination of: (i) an election outcome without a mandate (poor voter turnout, Obama and Romney garnered fewer votes than in 2008); (ii) shift to focus on the fiscal cliff; (iii) concerns about higher taxes, particularly capital gains taxes, with an Obama regime; (iv) some hoped for a Romney surprise. We see the sell-off more due to disappointment with outcome (more Romney M. Morgan Securities LLC hopefuls than we realized) vs. fiscal cliff. Why? Investment Grade and High Yield markets should be selling off if this is a "fiscal cliff" issue, similar to 2011's weakness. The fiscal cliff (fiscal drag) is large enough to potentially push —semetraisi — opscals.relsi the US into a recession, which would have negative consequences for both IG and ----- oseumsonal HY bonds. But notice the contrast in those markets. In 2011, HY and HG spreads .5 100 crook In learn. widened sharply as investors worried about the fiscal cliff. In 2012, HY and HG ,?M; 1.450 I 15 spreads have rallied since October. And liquidity (issuance) remains strong. These SW* .. markets do not seem as concerned with the fiscal cliff as the US equity markets. SI.S) I.400 ii761810 1.315 Where do we go from here? So let's say this weakness is indeed due to a knee-jerk Onvent 'Co reaction to an Obama win (Romney disappointment). One might argue there are (RMSI 1.100 11112 'Co some reasons the market can recover from here. I0? 1.290 $ • #1) Since September, US gasoline prices have fallen $0.38 from $3.84 to $3.46, 12,1I 2.12 4112 6112 012 10,I2 1191 resulting in $50 billion in annualized savings for households, or 0.40% lift to 1012 2012 301207D YID GDP. The US consumes 134 billion gallons annually, so the $0.38 drop in price per SaP500 12% 3% 6% -3% 11% CO (Mat IT. Dec. Ind) 14% -5% 5% -3% 12% gallon is worth $51 billion, or 0.4% annualized lift to GDP. As shown in Figure 2 N666 Cyel(Ener. Fin) 12% -7% 8% 2% 11% and Figure 3, the S&P 500 has historically rallied following a drop in gasoline Del (SµIC. Tel. Ull) 3% 5% 3% -4% 7% prices. In other words, this is a potential upside driver in the next few months. • #2) Potential that, with the election over, compromise on the fiscal cliff could be Valuation: less political. One element of uncertainty around the fiscal cliff has been reduced, as 2012E 2013E we now know three of the key players in negotiating the fiscal cliff: (a) President S8P500 Level 1395 Obama; (b) Senate Majority Leader (Reid); and (c) Speaker of the House (Boehner). EPS $105 $110 And unlike 2011, when 2012 election political calculus interfered with negotiations, PIE (current) 13.3x 12.7x there is a possibility of reaching an agreement, or at least deferring the difficult Div Yield 2.3% 2.5% decisions (punting). Our economists' base case remains a portion of the fiscal cliff is avoided in 2013 (1.6% fiscal drag is the result). #3) US housing continues its recovery regardless of the White House. One of the Year-End Target upside stories in 2012 has been the better-than-expected improvement in US home S8P503 1430 prices and housing demand (absorption and starts). The latest data point is 3Q12 US PIE 13.0x household formation (Census Vacancy Report) exceeded 1.1 mm for the first time Source: M. Morgan. FertSet. since 2Q06 as the recovery in labor markets and pent-up demand drive a surge in household formation. And, as we noted in the past, the recovery in home prices has delivered already in 2012 wealth effect of $1.7T (see "S&P 500 3Q EPS..." dated 10/11/12). And, as we noted in the past, each 250k increase in starts is worth I mm jobs and an estimated S4 in S&P 500 EPS. See page 7 for analyst certification and important disclosures. M. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Mn 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. EFTA01123502  North America Equity Research 07 November 2012 J.P.Morgan • #4) US corporates still have record cash balances. As we noted a few weeks ago, US corporates which have enjoyed unusual liquidity in this expansion now boast the largest cash balances in history with $1.5T in cash (up 7% y/y vs. 0.8% EPS growth), in part due to inventory liquidation in the quarter. Shareholders will eventually pressure corporates to deploy this cash either via buybacks, dividends or (the latter more likely if there had been a Romney victory). But this remains a positive for US equities. • #5) Equity markets traded cheap relative to credit prior to this weakness, and discount is wider today—HY remains the "harbinger" to equity valuations and it remains strong. The lag of equities to corporate credit has been discussed by our fixed income team for some time and in past episodes this has led to equities outperforming. Take HY markets, for instance. HY YTW is now 6.59%, down 38bp from 6.97% on 9/1, lifting the implied P/E (inverse of yield) to I5.2X from 14.3X. The S&P 500 has fallen 30 points since to 1390-ish and now trades at 12.7X. Since 1980, the S&P 500 P/E has EXCEEDED the HY P/E by at least 3 turns (i.e., should be 18X now), meaning the risk/reward in equities is substantially greater. And corporate credit is NOT IMMUNE to a fiscal cliff. Thus, those markets should be converging. • #6) Investors are still underperforming, thus unlikely to write off the beta chase. Investors are still badly lagging their benchmarks. Thus, the weakness, in our view, is coming at a time when active managers (mutual funds) are underperforming. Thus, we see pressure for funds to improve returns during what is seasonally a strong quarter for stocks. Thus, the beta chase should continue, while tempered by concerns of the US fiscal cliff. • What could go wrong? We have a fiscal cliff. The biggest risk to our view in the short term is the US fiscal cliff becomes unavoidable. That could justify further downside from here pushing the S&P 500 into the I 350-ish level from the 1400s today. However, as we noted above, there are some reasons to expect the US to avoid this (see reason #2 and also reason #1). MARKET STRATEGY: Focus on Global Cyclicals and High-Dividend stocks, among others. We believe once the initial selling exhausts itself, investors will reconsider the positive risk/reward in equities. One notion is that the current White House policies are less pro-growth (than Republican ones), and thus growth outside the US becomes more attractive. As a consequence, investors are likely to favor global cyclicals (see Figure 4) which include Technology (semis, hardware, software) and Industrials (multinationals, machinery, etc.). We also maintain our 2012 YE target of 1430. We have identified 30 Global Cyclicals using the following criteria: (a) % revenue from outside the US > 50%; (b) positive FCF yield; (c) belongs to a Cyclical sector; and (d) rated OW by E. Morgan. The tickers are: DELL, PAY, KBR, FLR, AA, AAPL, NLSN, TRW, ORCL, BWA, MA, GOOG, SNPS, CCK, MCD, PCLN, QCOM, EBAY, MOS, DHR, XLNX, TXN, IBM, ETN, ALB, CREE, PPG, TRMB, YUM, and ADI. 2 EFTA01123503  North America Equity Research 07 November 2012 J.P.Morgan Exhibits Figure 1: Investment Grade and High Yield Sold Off in 2011 During the Debt Ceiling Debacle... bp on spreads CSSWHYI 586 F= If 11/06/12 Basis Points JPhorgan High Yield Bond Index STW Global CSS . Fia Index 99 Save As 90 Actions - 91) Edit - 9S Table Line Chan 04106/2011 11/06/2012 11 Ci === 1D 3D 1M 6M ITD 1•( F! Daly • m Event O 900 •CS5WHYI Index - Hid Price 586.00 I-800 0-700 Sell-off 4 0 900 MU'S Index - Last Price 115.5 '250 Rally 0-200 • t • • Jun Sep Dec Mar Jun Sep 2011 2012 Australia 61 2 9777 8600 Brazil $511 3048 4500 Europe 44 20 7330 7500 Germany 49 69 9204 1210 Haig Kong 852 2977 6000 Jopan 81 3 3201 8900 Singapore 65 6212 1000 U.S. 1 212 318 2000 Copyright 2012 Bloomberg Finonce L.P. SN 644008 EST GMT-5t00 H343-8%-0 07-Nov-2012 1521:40 Sarre. • Nova, a4 BNcrnaerg EFTA01123504  North America Equity Research 07 November 2012 J.P.Morgan Figure 2: Gasoline Prices MA daily gasoline price - 3AGSREG Index GP MA Daily National Avgof Gasdine Prices — — — 200d mavg in $4.00 $3.90 $3.87 a. $3.80 -a 4 $3.70 • 13 $3.60 • • 5. 5 x$3.50 ... .2 $3.40 .. - $3.46 e 4' 41 $3.30 e 4' e A $3.20 e $3.10 t < 4• < $3.00 3/11 4/11 5/11 6/11 7111 8/11 9/11 10/11 11/11 12111 1112 2/12 3/12 4112 5/12 6112 7(12 8112 9/12 10/12 11112 Source: . Now and Bloomberg. Figure 3: Declines in Gasoline Prices and S&P 500 MA gasoline prices o% Discount of MA gasoline from 2C0d mavg —S&P5C0 Price 1500 ee 1450 35% Er 1400 25% 1350 2 a 1300 15% 0. g 1250 a 1200 5% a 1150 -5% *6 1100 -15% I 1050 1000 -25% 0 3/11 7(11 11/11 3/12 7/12 11112 Source Morgan an! Bloomberg 4 EFTA01123505 Thomas J Lee. CFA North America Equity Research 07 November 2012 J.P.Morgan Figure 4: Comparative Market Implications of Obama vs. Romney Victory Romney Obama Policy Implications ... Impact on Groups ... Policy Implications ... Impact on Groups... Romney seen as pro- Long Small-Caps (M) and Affordable Care Act Long Hospitals business—incentives for capital Domestic Cyclicals maintained spending, boosting activity, including Tax repatriation holiday Long Health Care and Maintain QE and Fed policy Long High-Dividend Technology and Industrials stocks and Defensives I. and avoid Financials Expand energy exploration and Long Energy stocks and Less pro-business climate, Long Global Cyclicals and coal Coal names higher taxes, so global growth China plays is more important Affordable Care Act repealed Long most Healthcare stocks Subsidies to alternative Long Solar energy China labeled currency AVOID Global Cyclicals Higher income taxes Reduce Luxury Consumer manipulator (China) LONG Domestic Cyclicals (Homebuilders, Consumers) and Small-Caps Pressure to end OE/change Long Banks and Financials Expanded government Regulatory impact across Fed, leading to steepening yield regulation sectors curve Simplify tax code (lower rates Long Domestic Cyclicals but offset by removing deductions). This should aid small-business formation. Source:IS Move. EFTA01123506 Thomas J Lee, CFA North America Equity Research 07 November 2012 J.P.Morgan MARKET STRATEGY We believe that once the initial selling exhausts itself, investors will reconsider the positive risk/reward in equities. One notion is that the current White House policies are less pro-growth (than the Republican ones), and thus growth outside the US becomes more attractive. The companies in Figure 5 are cyclical stocks that have high revenue exposure to international markets. We used the following criteria: • Percentage of Revenue from Outside the US >50%; • Positive FCF Yield; • In a Cyclical Sector (Materials, Industrials, Discretionary or Technology); and • Rated Overweight rated by Morgan. These 30 companies have an average upside of 22% to M. Morgan target prices, an average 2013E P/E of 14.0; and an average NB of 2.9x. Figure 5: Global Cyclicals - 30 Stock Ideas Priced as of 114/12 PM Coverage Screen Metrics EPS aid Valuation Carat Merkel PM Tagel Milled %Rev from Positive 2013E NE Nene SLO-Incurry Mer Price Cap fbg JPM Meyer Price Upside Outside the US FCF Yield EPS (13E) P/B 1 Dell Inc. Ccrnpuvr Flatware DELL 5953 $16.531 OW MS* MCCAW& $16.50 73% 51% 152.E $1.79 5.3c 1.7te 2 Verfone Sysems Ma Dam Frecesang & Cu:muted SPAY $32.31 $3.483 OW MoanHue)).I $5400 67% EC% 429E $323 9.9x 226c 3 KBR Inc. Contrumon &Engneenng KBR $2541 k102 OW Scot Lenre $44.50 57% 78% 55% $3.07 Oh 1.61x 4 Fluor Cap. Conoucton &Engneenng FLR $5149 19.073 OW Scot Levine $78.03 43% 53% 33% $4.40 124x 247k 5 Acme Inc. Nurninum AA $8.74 $9.327 OW MiMael F. Gamb $1250 43% 51% 2.4% 129t 0Att 6 Apple Inc. Cravat Hantware AAPL $92225 $6482/2 OW MS( MOSkOMIZ $770.00 32% Ed% 72% $5327 10.6t 4.63c 7 Wien Holdings. Research &C coaling Sent cmRLS4 DM 114724 OW AnIew C. Still 54900 32% 51% 5.4% $216 144x 2.1Etc 1RWAthomotIve HolIngs Aum Pan & &sprat TRW $4a KM OW RyaiBrinlman 93103 27% 77% 4.1% $634 7Bc 1.76‘ 9 Ora Cap Sysems Sol/ware ORCL $31.63 $152.427 OW Jae) OFtice $40.03 26% 54% in $2.91 10.44 331 10 BorgWaner Inc. Atom Pats & Empnet BVIA $63.10 17.970 OW RyaiBrinlman 93503 29% 76% 4.6% $5.83 11.7k 2_62c 11 lAasteCard Mc. CIA Oars Processing & (loomed 5 MA $471.78 $56.272 OW TerganHieng.11575.03 22% 50% 4.5% $25.65 18.4x Mc 12 Google Inc. CI A I nava Solmare & Services GOOG 01.72 $180.536 OW Doug Anmuth $802.03 18% 54% 5.6% $49.76 13.7k a 13 Syncpsys Inc Acetate,Sotwrre SNPS 54.42 1(635 OW Swing Auty. CF 53800 17% 54% 8.4% $228 11.2c 2.02c 14 Crown Wirings Inc. Metal& Glass Containers CCK $18.79 $5.588 OW FM Gresh. CFA $45.03 16% 73% 0.99E $3.37 1131 15 McDcnerfs Cap. Ressurants MCD $37.97 $88.333 JoMlvankce $101.00 15% 68% 12% $596 1St 6.31c 16 Inc. I Mod 12,321 PCLN $61410 $32.158 OW Doug Anmuth $740.00 15% 50% 4.6% $3631 17.2c 8.9$4 17 OLIALCOMM irc Ccmmuncetcre Equernant 0001,1 $60.37 5102.631 OW Rod Hall. CFA $9103 14% 91% as $4.13 tax 3.1h 18 dlay Inc. Marra Sobare & Services EBAY $49.49 564.030 OW Doug Anmutli $56.03 13% 53% 3.4% $272 182‘ 32bc 19 Nominee. Ferelzers 8 Apncubsal Cherie MOS $53.64 $15.925 OW Jae% J Maus: 93603 12% 63% 2.6% $526 102‘ 1.22c 20 De.naner Cop. I alusrnal Cmganetales DHR $223 $36.574 OW C. StaxoRea $5903 12% 58% in $3.62 1461 1.44x 21 )om Inc. Senconductces VAX 23416 $8287 OW Chmooner Dam $3600 12% Ea% 529E $2.15 159t 322a 22 Texas InsrAments Scapa Senconductors TAN $3144 $33.557 OW CMsepher Dans $3100 10% 89% 5.6% $2.01 1414 214x 23 imermocna Business lAacITConsultng & Omer Sere kes IBM $195.07 ODA'S OW Mgt lAoskomtz $215.00 10% 58% 5.6% $16.74 11.7k 1021c 24 Edo, Cory. Indusma lAachrery $5042 $17.037 OW Am Dulran $5500 50% 2984 $4.75 1011c 2_07k 25 AteverlaCcrp. SPeckaly Chancels ALB $57.02 $5.660 OW Maw J. Zdeol 93200 61% 3.1% $527 10.5tc 181x 26 Cree Ma Sentconductors CREE $3157 $3.671 OW CfrislcceeriNam $3403 8% ER% 589E $123 252c 1.4h 27 PPG inflame Inc. Wrath:4 Clwricals PPG $123.19 116501 OW Jeltey J. Zekausl$133.03 6% 51% 5.0% $7.79 152c 4.89x 28 TriodeNergeoonlm. ElececnicMadacrung SeviaMMB $53.61 $6.742 OW Paul Coster. CF/ $5650 5% 55% 4.1% $3.03 17.7k 3,73c 29 YIN Brands Inc. Resstrans `NM $73.15 131091 OW JanIvanloe $75.03 3% 70% 2.0% $174 Hit 15.0fe 30 Arekg Deuces Inc. Senconductors ADI $1133 $12354 OW Cfrebpber Dare $4200 2% 77% $230 16.5c 3.07k Average 22% 63% 48% 14ax 294:4 Source:` Morgan and FactSel. 6 EFTA01123507 Themes J Lee CFA North America Equity Research 07 November 2012 J.P.Morgan Analyst Certification: The research analyst(s) denoted by an "AC— on the cover of this report certifies (or, where multiple research analysts are primarily responsible for this report, the research analyst denoted by an "AC' on the cover or within the document individually certifies, with respect to each security or issuer that the research analyst covers in this research) that (1) all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analyst's compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst(s) in this report. 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