Sector Strategy Report

Thu. May 28, 2009

Strategas Research Partners, LLC
Nicholas Bohnsack (212) 906-0132 nbohnsack@strategasrp.com
Chris Verrone (212) 906-0135 cverrone@strategasrp.com

Contrarians Note:
It’s Getting Awfully Consensus that Market Has Made Its Cycle Low
Consensus looks to be establishing the view that the equity rally from the March 9th
low is the start of a new bull market. A survey we took of our lunch guests yesterday
in Connecticut is the fifth investor survey over the last month to exhibit similar
sentiment to this point. While lack of institutional participation could help the market
melt higher from here, our contrarian instincts make us wary over the long-term
sustainability of this rally.

Despite a market that has stalled throughout much of

May (S&P 500 up +2%), our survey results have moved
increasingly bullish over the last month.

Strategas Institutional Has the S&P 500 made its final low at
Investor Survey 666.79 on March 6th, 2009?
Date Event Yes No

Apr. 28th New York Research Dinner 12 3

May. 7th Texas Investor Lunch 9 5
May. 20th Connecticut Research Lunch 16 2
May. 26th New York Policy Dinner 12 1
May. 27th Connecticut Research Lunch 10 1
SUM 59 12

Strategas Connecticut Research Lunch

Survey Results (Next 12 Months)
High Low Average
S&P 500 1,220 750 1,040
10-Year Yield 4.3% 3.3% 3.8%
Crude Oil $83 $45 $65
Gold $1,050 $800 $936
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 Don’t Buy the Headfake in Multiples,
Period of Secular Contraction Still in its Middle-Innings
We would be among the first to admit that earnings multiples are a poor timing tool – either
for a specific stock or the market as a whole – rather, they can help to frame the longer trend.
A look at the 12-month trailing multiple of the S&P 500 following World War II shows four
such clearly defined trends. Two periods of multiple expansion (1942-61 and 1979-99) –
broadly linear in orientation, generally characterized as periods of “financial asset”
outperformance and interesting to the extent that the quality of earnings declined; and, two
periods of multiple contraction (1961-79 and the current period beginning in 1999). Multiples
during the ’61-’79 period and this decade have been sideways in orientation, “real assets” have
outperformed, and the quality of earnings has improved. What’s interesting to us, if not the
order of magnitude of the ’61-’79 compression, is the trajectory. Aside from the triple
threat of rising budget deficits, higher inflation and the prospect of higher interest
rates – all defining elements of the ’70s – what stands out is the +74% increase in
earnings from ’75 to ’79. The takeaway for investors with longer-term time horizons is
that the macro headwinds seen three decades ago may be forming again and could
restrain the markets ability to further discount a recovery in profits.

S&P 500 Trailing P/E S&P 500 Trailing P/E

25x (1942 to 1961) 25x (1961 to 1979)
Interest Rates
Multiple Inflation
20x Expansion 20x Deficits
Taxes
1 5x 1 5x
Multiples

1 0x 1 0x

5x 5x
` '42 '45 '48 '51 '54 '57 '60 '61 '64 '67 '7 0 '7 3 '7 6 '7 9

S&P 500 Trailing P/E S&P 500 Trailing P/E

(1979 to 1999) (1999 to 2008)
30x 30x

25x Multiple 25x

Expansion
20x 20x

1 5x 1 5x

1 0x 1 0x

5x 5x
'7 9 '83 '87 '91 '95 '99 '99 '02 '05 '08 '1 1 '1 4 '1 7 '20
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 Don’t Buy the Headfake in Multiples,
Period of Secular Contraction Still in its Middle-Innings
In the post-World War II environment recession-related profit declines and recoveries
have been V-shaped in orientation – averaging 6 quarters from peak to trough and 6
quarters from trough to previous peak. The magnitude of decline has averaged -18%
from peak to trough, requiring a +36% increase in earnings to climb the “V.” This has
largely been possible due to two drivers: 1) productivity gains; and 2) financial leverage.
(We’ll leave the productivity argument aside for a moment. Our Chief Economist,
Don Rissmiller, has written about the long-term pressure on productivity gains.) On
the leverage front, companies that employ greater risk generally garner lower multiples.
To the extent they are replaced in the Index by companies employing less risk (and
garnering a higher P/E), the net effect is for aggregate multiples to increase – this along
with a absolute decline in “E” accounts for the sideways progression of valuations.
In this cycle, S&P profits peaked in 2Q ’07 – 8 quarters on, earnings are lower by nearly
-50%. We are of the view that earnings will decline through 3Q ’09, good for a 9
quarter retracement. In order for this profit cycle to “V” profits will need to double in
the ensuing 9 quarters. This could be tough to come by. Given that: 1) Financials now
represent a smaller portion of the Index (roughly 13%, down from 22% in ’06); 2) their
earnings power is impaired; and 3) their usage of leverage is curtailed (at least for the
moment), the recovery in Index profits will likely take far longer than many investors
would estimate – remember, it took over 4 years for earnings to increase +75% in the
late-’70s under similar macro conditions.

S&P 500 Earnings & Multiples

$45 $50 $55 $60 $65 $70
12x 540 600 660 720 780 840
13x 585 650 715 780 845 910
14x 630 700 770 840 910 980
15x 675 750 825 900 975 1050
16x 720 800 880 960 1040 1120
17x 765 850 935 1020 1105 1190
18x 810 900 990 1080 1170 1260

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 Industry Group Absolute Multiples

For trend watchers, we have broken the S&P 500 down into Industry Groups
benchmarking multiples at 5 and 1 year ago to today. For many groups, the sharp
contraction of earnings and the recent run in share prices have left things looking a little
expensive. The question to ask is, with the market rallying +35% in three months, will
investors continue to pay up for an uncertain profit picture.

S&P 500 Industry Group Forward P/E

5-Years 1-Year 10-Year
Present
Ago Ago Avg.
Diversified Financials 12.4 12.1 20.6 13.2
Materials 16.0 15.1 21.6 16.1
Banks 11.5 15.2 20.5 12.4
Energy 14.7 11.2 14.8 14.8
Retailing 18.2 15.1 17.9 19.3
Consumer Durables & Apparel 12.3 18.3 20.4 13.4
Real Estate 27.7 31.1 32.8 29.6
S&P 500 16.9 14.5 14.0 17.9
Commercial & Professional Svc. 18.2 13.5 13.0 17.5
Telecommunications Services 17.5 13.9 13.1 17.6
Consumer Services 19.4 16.5 14.9 18.0
Capital Goods 17.6 14.0 12.7 17.2
Technology Hardware & Equipment 22.9 16.9 14.9 25.8
Pharmaceuticals Biotech & Life Scn. 17.9 12.9 10.6 19.3
Food & Staples Retailing 21.0 16.0 12.8 18.0
Transportation 19.9 17.6 14.2 17.7
Household & Personal Products 21.4 16.9 13.4 19.8
Food Beverage & Tobacco 16.3 16.3 12.9 16.5
Software & Services 22.2 17.4 13.6 26.0
Insurance 11.9 9.6 7.4 12.6
Media 25.0 14.9 11.2 29.8
Health Care Equipment & Services 18.6 14.4 10.8 18.5
Utilities 13.3 15.5 10.7 13.7

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 Industry Group Relative Multiples

S&P 500 Industry Group Forward P/E Relative S&P 500 P/E
5-Years 1-Year 10-Year
Present
Ago Ago Avg.
Diversified Financials 0.73 0.83 1.47 0.75
Materials 0.95 1.05 1.54 0.92
Banks 0.68 1.05 1.46 0.73
Energy 0.87 0.77 1.06 0.82
Retailing 1.08 1.04 1.28 1.08
Consumer Durables & Apparel 0.73 1.27 1.45 0.80
Real Estate 1.64 2.15 2.34 1.91
Commercial & Professional Svc. 1.08 0.94 0.93 0.99
Telecommunications Services 1.04 0.96 0.93 0.97
Consumer Services 1.15 1.14 1.06 1.04
Capital Goods 1.05 0.97 0.90 0.96
Technology Hardware & Equipment 1.36 1.17 1.06 1.40
Pharmaceuticals Biotech & Life Scn. 1.06 0.89 0.75 1.06
Food & Staples Retailing 1.24 1.10 0.91 1.03
Transportation 1.18 1.22 1.01 1.03
Household & Personal Products 1.27 1.17 0.96 1.13
Food Beverage & Tobacco 0.96 1.13 0.92 0.95
Software & Services 1.32 1.20 0.97 1.40
Insurance 0.71 0.66 0.53 0.69
Media 1.48 1.03 0.80 1.55
Health Care Equipment & Services 1.10 1.00 0.77 1.04
Utilities 0.79 1.07 0.76 0.80
S&P 500 -- -- -- --

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 Looking Ahead to 2010, Risk to Our Profit Forecast
is Probably to the Upside
The relatively conservative economic inputs we’re using below suggest that the risk to
our 2010 profit forecast could actually be an upside earnings surprise along with some
modest margin improvement.

Productivity 2.00% Wages 2.00%

+Employment Growth 0.00% (Productivity) 2.00%
Real GDP 2.00% Unit Labor Costs 0.00%

Real Output 2.00%

Unit Labor Costs 0.00%
Total Costs 2.00%

2009 2010
Sales $100.00 $103.00 3.00% Revenue Gain*
(Costs) $95.90 $97.82 2.00% Cost Increase
Income $4.10 $5.18 26.3% Earnings Gain
Margin 4.1% 5.0%

A 26% increase off our 2009 estimate of $51.75 *Strategas 2010 nominal GDP forecast, 3.0%
would imply earnings of roughly $65 in 2010. We
are currently forecasting $59.25 for 2010.

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 Technical Tearsheet: Golden Cross Marks Significant
Inflection Point for Technology Sector

S&P 500 Technology Sector

with 50 & 200 Day Moving Averages
450
Downside
Golden Cross
400 Downside
Golden Cross

350

300
Upside
Golden Cross
250

Tech Sector On Verge of Upside Golden

200 Cross – 50 Day Avg. Breaking Through
200 Day Avg – Could Suggest Further
Upside Potential. Stay Tuned.
1 50
'06 '07 '08 '09

S&P 500 Technology Sector

Performance Through First 5 Months of Each Year
3 0% Tech is off to its best start in years,
and has resumed its leadership
20.1%
2 0% 17.5% status over the last several weeks. 16.4%

12.0%
1 0%
4.2%

0%
-2.6%
-4.3% -4.6% -4.6%
-1 0% -7.6%

-2 0% -17.7%
-22.1%
-3 0%
'9 8 '9 9 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09

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 Strategas Sector Scorecard

Index Strategas + or - Inception Absolute Relative

Weight Weight Diff Date Performance Performance

Materials 3% 6% 3% 1/26/09 18.1% 11.3%

Overweight

Energy 13% 15% 2% 1/26/09 -2.0% -8.7%

Staples 12% 13% 1% 7/10/08 -16.6% 12.1%

Market Weight

Industrials 11% 11% 0% 5/13/09 0.3% -0.7%

Financials 13% 13% 0% 1/26/09 31.8% 25.1%

Technology 17% 17% 0% 3/26/09 7.9% 0.7%

Telecom 4% 3% -1% 9/16/08 -17.0% 9.4%

Underweight

Discretionary 9% 8% -1% 7/10/08 -16.2% 12.6%

Health Care 14% 12% -2% 5/13/09 -1.1 -2.2%

Utilities 4% 2% -2% 7/23/08 -32.3% -1.9%

* Performance measured from Strategas position inception date.

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