Market Outlook & “The Decade Ahead”
May 2011
Jeremy Zirin, CFA Chief Equity Strategist
Wealth Management Research
This report has been prepared by UBS AG and UBS Financial Services, Inc.Please see important disclaimers and disclosures at the end of the document.
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Key economic and investment messages
Economics
Investment Strategy
Our base case: profits continue to drive stocks higher in 2011.
Overweight emerging markets and secular growth stocks.
Interest rates likely to rise from very low levels.
Sustainable economic recovery is on firm ground – but some soft spots are likely along the way.
Recovery has come with a pretty hefty price tag.
The Decade Ahead
Equities unlikely to suffer another “lost decade”.
Low valuation starting point bodes well for long-run returns.
Economic Outlook
A low growth, but sustainable expansion
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Near-term “soft patch” to be transitoryUS real GDP, quarter over quarter annualized
Source: DataStream, UBS WMR estimates
-8
-6
-4
-2
0
2
4
6
8
10
1Q00 1Q01 1Q02 1Q03 1Q04 1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 1Q12
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Home prices continue to “bounce along the bottom”S&P/Case-Shiller Home Price Index, 20 city composite
Source: Bloomberg, UBS WMR
50
75
100
125
150
175
200
225
250
2000 2002 2004 2006 2008 2010 2012
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Home prices certainly no longer “expensive”Median home price divided by median household income
Source: Bloomberg, UBS WMR
3.00
3.25
3.50
3.75
4.00
4.25
4.50
4.75
5.00
1975 1980 1985 1990 1995 2000 2005 2010 2015
Median home price divided by median household income Average
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Housing affordability at all-time highsUS Housing Affordability Index
Source: DataStream, UBS WMR
50
70
90
110
130
150
170
190
210
1971 1976 1981 1986 1991 1996 2001 2006 2011 2016
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Manufacturing rebound remains on solid footing ISM Manufacturing PMI Composite Index
Source: Bloomberg, UBS WMR
30
35
40
45
50
55
60
65
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
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Labor market recovery has significantly lagged past cycles…US non-farm payroll growth following recessions
95
100
105
110
0 4 8 12 16 20 24Postwar recessions (average) 2008/09 recession
US nonfarm private payrolls (recession trough = 100)
# of months (recession trough = 0)
Source: Bloomberg, UBS WMR
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…but is improving Initial jobless claims – 4 week moving average
Source: Bloomberg, UBS WMR
200
250
300
350
400
450
500
550
600
650
700
2000 2002 2004 2006 2008 2010 2012
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Small business sentiment is rebounding NFIB index of small business optimism
70
75
80
85
90
95
100
105
110
1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 2014
Source: Bloomberg, UBS WMR
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Improved lending standards highly correlated to job growthNonfarm payrolls and lending standards
Source: Bloomberg, UBS WMR
-3000
-2500
-2000
-1500
-1000
-500
0
500
1000
1500
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
-40%
-20%
0%
20%
40%
60%
80%
100%
Nonfarm payrolls (quarterly change in thousands, left scale)Lending standards (net % of banks tightening, right scale)
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Monetary policy to tighten but remain very accommodative Fed funds target rate, in %
Source: DataStream, UBS WMR
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
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In the early-to-middle innings of consumer deleveraging cycleRatio of US household financial liabilities to disposable income
Source: Thomson Reuters, UBS WMR
0%
20%
40%
60%
80%
100%
120%
140%
160%
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
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Deficit reduction tactics lie aheadUS federal budget breakout, in %
Source: Office of Management and Budget estimates, UBS WMR
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
Entitlements Mandatory Defense Discretionary Interest
2009 2019
Tactical Asset Allocation
Better relative value in stocks
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Stocks still poised to outperformCore asset allocation, Tactical deviations from benchmark
Tactical deviations from benchmark: Scale for charts - Symbol Description/Definition
+ moderate overweight vs. benchmark
-moderate underweight vs. benchmark
nNeutral, i.e. on benchmark
++ overweight vs. benchmark -- underweight vs. benchmark
+++strong overweight vs. benchmark
--- strong underweight vs. benchmark
Source: UBS WMR
Equity
Fixed Income
Cash
Commodities
+ ++ +++–– –– – – n
Underweight Overweight
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Equity valuations are undemandingS&P 500 P/E based on next 12 months consensus earnings estimates
Source: FactSet, S&P, UBS WMR
5
10
15
20
25
30
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015P/E Average
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30-year bull market in bonds is likely over10-year treasury bond yield
Source: Bloomberg and UBS WMR
0
2
4
6
8
10
12
14
16
18
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 201510-year treasury bond yield Average
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Corporate profits have rebounded sharplyS&P 500 earnings per share
Note: 2011-2012 UBS WMR earnings estimates. Source: FactSet, UBS WMR
$100
$108
$0
$20
$40
$60
$80
$100
$120
2000 2002 2004 2006 2008 2010 2012
S&P 500 EPS
16%
8%
-30%
-20%
-10%
0%
10%
20%
30%
40%
2000 2002 2004 2006 2008 2010 2012S&P 500 EPS y/y change
S&P 500 EPS, y/y percent change
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S&P 500 EPS is not US GDP
US GDP
* Other include: Technology, Healthcare, Telecom, Utilities, Financials. Source: FactSet, UBS WMR
S&P 500 EPS
Net Exports-3%Government
19%
Investment13%
Consumer71%
Other*55.4%
Industrial / Commodity
24.3%
Consumer-related 20.4%
21
S&P 500 (ex-financials) cash as a % of assets
Corporate cash continues to build
Note: Current constituents. Source: Bloomberg, UBS WMR
0%
2%
4%
6%
8%
10%
12%
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
22
S&P 500 dividends per share and earnings per share year-over-year percent change
Strong increases in dividends should follow surging profits
Source: FactSet and UBS WMR
-60%
-40%
-20%
0%
20%
40%
60%
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012-25%
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
S&P 500 EPS - 1 yr fwd, LHS S&P 500 DPS, RHS
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Shifting focus to mid-cycle, global beneficiariesSector allocation, tactical deviations from benchmark
Tactical deviations from benchmark: Scale for charts - Symbol Description/Definition
+ moderate overweight vs. benchmark
-moderate underweight vs. benchmark
nNeutral, i.e. on benchmark
++ overweight vs. benchmark -- underweight vs. benchmark
+++strong overweight vs. benchmark
--- strong underweight vs. benchmark
Source: UBS WMR
Tech
Industrials
Consumer Staples
Materials
HealthCare
Financials
Utilities
Telecom
Energy
Cons Discretionary
+ ++ +++–– –– – – n
underweight overweight
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Emerging markets best positioned regionally Regional asset allocation, tactical deviations from benchmark
Tactical deviations from benchmark: Scale for charts - Symbol Description/Definition
+ moderate overweight vs. benchmark
-moderate underweight vs. benchmark
nNeutral, i.e. on benchmark
++ overweight vs. benchmark -- underweight vs. benchmark
+++strong overweight vs. benchmark
--- strong underweight vs. benchmark
Source: UBS WMR
Emerging markets
UK
US
Other Developed
Japan
Eurozone
+ ++ +++–– –– – – n
Underweight Overweight
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Emerging markets the source for growth in the world economyContribution to global GDP growth, in %
Source: International Monetary Fund, UBS WMR
0
20
40
60
80
100
1981 1986 1991 1996 2001 2006 2011
Advanced economies Emerging and developing economies
Key investment debate #1
Have corporate profits only benefited from cost cutting?
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Decent revenue growthS&P 500 (ex-financials) revenues, year over year percent change
Source: FactSet, UBS WMR
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 1Q12
Key investment debate #2
Are profit margins are unsustainably high?
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Little evidence of margin collapse barring recession
Note: Profit margin proxy for this analysis was based on the Bureau of Economic Analysis ‘Corporate profits with inventory valuation and capital consumption adjustments’ account dividend by nominal GDP. Change in nominal GDP growth rate is equal to the last 12 months nominal GDP growth rate minus the prior 12 month nominal GDP growth rate. Source: Bureau of Economic Analysis, UBS WMR estimates
Average change in profit margins for a given change in nominal GDP growth
-1.5%
-1.0%
-0.5%
0.0%
0.5%
1.0%
1.5%
<5% -5% - 0% 0% - 5% 5%+
Key investment debate #3
Will end of QE2 dry up market liquidity?
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End of QE1 not a template for end of QE2 S&P 500 & Fed balance sheet
Source: Bloomberg, UBS WMR
S&P 500 & fed funds target rate
0
1
2
3
4
5
6
7
00 02 04 06 08 10 12700
800
900
1000
1100
1200
1300
1400
1500
1600
Fed Funds Target Rate, % (LHS)S&P 500 (RHS)
$1,400
$1,600
$1,800
$2,000
$2,200
$2,400
$2,600
2009 2010 2011 2012600
700
800
900
1000
1100
1200
1300
1400
1500
Fed Balance Sheet, $bil (LHS)S&P 500 (RHS)
Looser
Tighter
Key investment debate #4
Will rising oil prices derail equity market rally?
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Oil prices haven’t reached the “tipping point”Correlation between S&P 500 and change in oil prices
Source: Bloomberg, UBS WMR
-30%
-25%
-20%
-15%
-10%
-5%
0%
5%
10%
15%
< 40% -40% to -20%
-20% to0%
0% to 20% 20% to40%
40% to60%
60% to80%
> 80%
Oil at $110
Key investment debate #5
Won’t stocks suffer when leading economic indicators roll over?
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The “macro trade” has been all that has mattered recentlyISM Manufacturing Index and S&P 500 y/y percent change
Source: FactSet, UBS WMR
-60%
-40%
-20%
0%
20%
40%
60%
1955 1965 1975 1985 1995 2005 201530
40
50
60
70
S&P 500 y/y % chg (LHS) ISM Mfg Index (RHS)
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A maturing business cycle does not mean weak market returnsS&P 500 12-month performance after ISM peaks
Source: Bloomberg, UBS WMR
2.0%
-5.4%
7.1%
-10%
-5%
0%
5%
10%
All periods Recession follows No recession follows
Key investment debate #6
Are large-caps much cheaper than small-caps?
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Neutral between large- and small-capsRelative P/E valuation – large vs small
Note: earnings estimated growth are consensus. Source: FactSet, UBS WMR
16%13%
42%
34%
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
2011 2012S&P 500 EPS y/y Russell 2000 EPS y/y
Earnings growth rate - consensus
0.6
0.7
0.8
0.9
1.0
1.1
1.2
1.3
1.4
1978 1990 2002 2014Relative P/E valuation – large vs smallAverage
Large-caps cheap vs small-caps
Large-caps expensive vs small-caps
The Decade AheadStocks poised to outperform bonds
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GDP growth is not the only driver of stock returnsReal US GDP growth rate and S&P 500 total return, in %
Source: Bureau of Economic Analysis, Standard and Poor's, UBS WMR
0
1
2
3
4
5
6
1930s 1940s 1950s 1960s 1970s 1980s 1990s 2000s0
3
6
9
12
15
18
Real GDP growth (lhs) S&P 500 total return (rhs)
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Stocks were extremely expensive ten years agoPrice-to-earnings (P/E) ratio, earnings based on trailing 10-year adjusted real operating earnings per share
Source: Shiller (2011), Standard and Poor's, UBS WMR estimates
0
5
10
15
20
25
30
35
40
1900 1920 1940 1960 1980 2000
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Valuation negatively correlated with decade-ahead returnsP/E ratio versus annualized S&P 500 total return of next 10 years, in %
Source: Shiller (2011), Standard and Poor's, UBS WMR estimates
-5
0
5
10
15
20
25
0 5 10 15 20 25 30P/E ratio
Annu
alize
d S&
P 50
0 to
tal r
etur
n of
nex
t 10
year
s
1998-2000
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Higher sector concentration increases market riskDifference between first- and second-largest S&P 500 sector, as % of S&P 500
Source: FactSet, UBS WMR
0
5
10
15
20
25
1990 1995 2000 2005 2010
Tech bubble
Financial crisis
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Stocks likely to rebound after pronounced weakness10-year rolling compound annual return of stocks minus bonds, in %
Source: Shiller (2011), Standard and Poor's, UBS WMR estimates
-10
-5
0
5
10
15
20
1880 1900 1920 1940 1960 1980 2000
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Estimated 9% CAGR for S&P 500 total return for next 10 years2020 S&P 500 “target” or fair-value estimate for S&P 500: 2450
Source: UBS WMR estimates
•Trend S&P 500 earnings = $165 per share by the end of 2020
•Applying the average P/E multiple since 1940 of 14.7x
•2020 S&P 500 target: 2450
•6.5% annualized gain + 2.0% dividend yield = 8.5% annual return
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