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ab Global Equity Research Americas UBS Investment Research Equity Strategy US Equity Strategy Investment Strategy 1,425 on Improving Fundamentals 7 February 2011 Raising Year-End 2011 S&P 500 Price Target to 1,425 www.ubs.com/investmentresearch We are raising our year-end 2011 S&P 500 price target to 1,425 from 1,325 on the back of an improving outlook for the economy and earnings. Our new target is based on a 13.7x forward P/E applied to a 2012 EPS estimate of $104. This represents an 8.7% increase from current levels — 10.7% including dividends. Jonathan Golub, CFA Strategist Earnings — An Improving Outlook email@example.com +1-212-713 8673 Our upgrade is primarily driven by a reacceleration in economic data, which should support stronger top- and bottom-line growth. Despite rising commodity Chip Miller, CFA prices, margins should expand on the back of higher capacity utilization, cost Strategist vigilance, and a more favorable sector mix. Cautious management guidance firstname.lastname@example.org should lead to further upside surprises. +1-203-719 3720 Manish Bangard, CFA Multiples — To Drift Higher Strategist At 13.5x forward EPS, multiples look cheap compared to historical averages and email@example.com bond alternatives. Increasing dividends, buybacks, and M&A activity should be +1 212 713 3036 supportive of higher stocks prices. A more pro-business tone in Washington Thomas M. Doerflinger, Ph.D. should also support higher valuations. Strategist firstname.lastname@example.org Risks to Our Upgrade +1-212-713 2540 Given the 25% run in stocks over the past five months, we would not be surprised Natalie Garner, CFA if the market pulls back for technical reasons. Should this occur, we would Strategist recommend more aggressive buying. Further, we continue to expect episodic email@example.com spikes in macro-driven volatility. In the absence of macro disruptions, we believe +1-212-713 4915 there is upside risk to both our earnings and valuation forecasts. Exhibit 1: Sector Recommendations Overweight Technology Industrials Financials Market Weight Consumer Discretionary Health Care Energy Materials Underweight Consumer Staples Telecom Svcs. Utilities Source: UBS This report has been prepared by UBS Securities LLC ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 10. 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 7 February 2011 1,425 on Improving Fundamentals Summary of Price Target & Forecasts We remain constructive on the outlook for U.S. equities, and are raising our year-end 2011 S&P 500 price target to 1,425 from 1,325. Our new target is based on a forward P/E of 13.7x applied to our 2012 EPS estimate of $104. This implies an 8.7% price return and 10.7% total return from current levels. Exhibit 2: S&P 500 Price Target S&P 500 Price Level Price % Change Our target is based on a 13.7x multiple applied to our $104 2012 EPS target Current (as of 2/4/11) 1,311 2011 Year-End Target Price 1,425 8.7% Source: Standard and Poor’s and UBS Following a sharp recovery in 2010, we expect EPS growth rates to remain above average in 2011, before returning to a more normal 8-9% pace in 2012. Exhibit 3: UBS S&P 500 Earnings Forecast Operating Earnings EPS Y/Y Growth 2009 Actual 62.25 2010 Estimate 86.00 38.2% 2011 Estimate 96.00 11.6% 2012 Estimate 104.00 8.3% Source: Standard and Poor’s and UBS Valuations are currently below historical levels and should expand modestly. We note that multiples could move within a wide band as sovereign, geopolitical, or other macro risks enter and exit the headlines. We believe that P/Es could also end the year significantly higher if macro risks remain in check. Exhibit 4: S&P 500 P/E Forecast P/E Multiple Current 2011 Target on NTM EPS 13.5x 14.8x on 2012 EPS 12.6x 13.7x Source: Standard and Poor’s and UBS Good with a Chance of Great On December 1, 2010 we published our 2011 outlook, Good with a Chance of Great. In that piece, we stated that risks were weighted to the upside for both our earnings and valuation forecasts. Over the past two months, several upside risks have, in fact, materialized. More Conditions have improved substantially specifically, consensus GDP forecasts have risen steadily on the back of better- over the last several months than-expected economic data, S&P 500 revenue and earnings surprises have reaccelerated, and many investors believe Washington has taken a more pro- growth, pro-business tone. In the remainder of the piece, we discuss our updated outlooks for (1) the economy; (2) earnings; (3) valuations; (4) risks; and (5) sector positioning. UBS 2 US Equity Strategy 7 February 2011 #1 Economic Acceleration As the UBS Economic Surprise Index below illustrates, economic data has consistently surpassed expectations over the past five months. Exhibit 5: Economic Surprise Index 3 > 0 represents Positive Surprise Economic data has crushed 2 expectations over the past five months 1 0 -1 -2 -3 < 0 represents Negative Surprise -4 06 07 08 09 10 11 Source: Bloomberg and UBS Global Economics Team This, in combination with the passage of a favorable tax package, has resulted in a steep increase in consensus 2011 GDP estimates from under 2.5% to over 3.0%. Chief U.S. Economist Maury Harris recently raised his forecast to 3.3%. Exhibit 6: Consensus 2011 GDP Forecast 3.5 UBS Forecast = 3.3% We expect 3.3% GDP growth in 2011 3.3 3.1 2.9 2.7 2.5 2.3 02/09 06/09 10/09 02/10 06/10 10/10 Source: Bloomberg and UBS Further, UBS’s 1Q GDP forecast calls for 4.2% growth, a 1% improvement from 4Q results. A Solid Outlook We believe that recent data indicate that risks remain weighted to the upside. For example, the recent GDP report included a 7.1% quarterly (annualized) increase in final demand, the highest level in over 20 years. UBS 3 US Equity Strategy 7 February 2011 Exhibit 7: Final Demand 8 7.1 6 At 7.1%, 4Q final demand was the highest it’s been in over 20 years 4 2 0 -2 -4 -6 90 92 94 96 98 00 02 04 06 08 10 Source: BEA, FactSet and UBS Moreover, according to ISM’s January Manufacturing report, a 60.8 reading “corresponds to a 6.4% increase in real gross domestic product on an annual basis”. New Orders — the most forward looking component of the report — accelerated to 67.8, suggesting strong manufacturing activity in the months ahead. Exhibit 8: ISM New Orders 67.8 70 New Orders index suggests solid manufacturing activity is likely to 60 continue 50 40 30 90 92 94 96 98 00 02 04 06 08 10 Source: ISM, FactSet and UBS #2 Earnings Outlook Improving On January 10, we raised our S&P 500 EPS estimates to $96 for 2011, and $104 for 2012, from $93 and $101, respectively. In addition to better economic data, recent surprises and further margin upside are quite supportive of higher earnings. Revenue Surprises Reaccelerate Investors tend to focus on EPS, not revenues, during reporting season because top-line surprises tend to be quite small after the initial phases of a recovery. However, in 4Q10, revenue surprises reaccelerated to 2.7% — higher than the level achieved during the market’s rebound in 4Q09. UBS 4 US Equity Strategy 7 February 2011 Exhibit 9: S&P 500 (ex-Finls) Revenue Surprise 2.7 2.3 Top-line surprises reaccelerated in 4Q10 0.4 0.5 0.4 -0.9 -0.1 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10E Source: Standard and Poor’s, Compustat, FactSet and UBS Margin Expansion Opportunities While input costs are rising and margins appear close to prior cyclical peaks, we expect margins to expand further in 2011. Operating Leverage Typically, margins rise as fixed costs are spread over greater volumes. While strong cost controls accelerated the rebound in profitability, still-low utilization rates should accommodate higher volumes without the need for a big pickup in overhead costs. Exhibit 10: Operating Margins vs. Capacity Utilization 15% 14.3% 82 14.8% Low capacity utilization means companies still have significant Capacity 78 operating leverage 13% Utilization ► 13.3%, ex-Tech74 70 11% ◄ S&P 500 (ex-Finl.) 66 Operating Margins 9.8% 9% 62 00 01 02 03 04 05 06 07 08 09 10 Source: Federal Reserve, Standard & Poor’s, Compustat, FactSet and UBS Mix Shift During the last downturn, margins contracted across the board. As the economy recovers, each sector’s profitability is improving in sync. As the table below illustrates, the S&P 500 operating margin is approximately 3% below its most recent cyclical peak, 14.3 versus 14.8. By contrast, industry group margins stand at 20% below peak levels. The reason for the discrepancy is a change in mix between sectors toward higher margin stocks. We believe this will lead to higher highs in the current cycle. UBS 5 US Equity Strategy 7 February 2011 Exhibit 11: Operating Margins Now vs. Peak 3Q10A Peak Margin Cyclicals Technology 22.0% 4Q09 22.6% Industry group margins are 20% below Software 27.4 4Q09 31.9 peak levels on average Hardware 16.0 4Q09 17.6 Semis & Equipment 29.1 1Q00 34.9 Industrials 14.0 2Q07 16.8 Capital Goods 13.8 2Q07 17.0 Commercial Svcs 14.5 3Q00 17.7 Transportation 15.2 2Q06 16.5 Cons Discretionary 11.4 2Q10 11.7 Autos 10.0 2Q09 11.6 Durables & Apparel 11.1 4Q05 13.7 Consumer Svcs 21.2 3Q10 21.2 Media 18.6 2Q03 22.3 Retailing 6.7 4Q03 9.5 Materials 13.4 2Q06 15.9 Energy 14.1 3Q08 22.1 Non-Cyclicals Health Care 13.8 2Q00 18.6 Healthcare Svcs 7.0 3Q07 7.8 Phama & Biotech 29.7 2Q03 34.1 Consumer Staples 10.3 2Q05 11.8 Food Retailing 4.7 2Q05 7.3 Food, Bev & Tob 18.4 2Q01 19.8 Household Prod 20.0 4Q03 26.8 Telecom Svcs 17.1 3Q00 27.8 Utilities 22.2 3Q09 23.7 S&P 500 S&P 500 (ex-Finl.) 14.3 3Q06 14.8 Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS UBS 6 US Equity Strategy 7 February 2011 Surprises on the Rise While typically earnings surprises decline as a recovery matures, current quarter results appear to show a reacceleration. Exhibit 12: Earnings Surprises 11.5 Earnings surprises reaccelerated in 9.9 4Q10, defying the pattern of smaller 8.9 surprises as the cycle matures 8.0 7.0 6.4 5.2 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10E Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS Note: S&P 500 ex-Financials More to Come Despite strong earnings results, consensus expectations have not meaningfully increased. As illustrated below, outside of Energy and Materials — where rising commodity prices have driven revisions — there hasn’t been much change to 2011 EPS estimates. This suggests to us that analysts’ forecasts remain overly conservative, setting the market up for future beats. Exhibit 13: 2011 EPS Revisions 7.0 6.0 Analysts’ revisions remain subdued, setting the market up for future beats 3.9 1.4 -0.9 -1.1 -1.2 Matr Energy Tech Indls Non- C. Disc. Finls Cycls Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS UBS 7 US Equity Strategy 7 February 2011 #3 Multiples to Drift Higher At 13.5x, today’s P/E is approximately 10% below the 20 year average of 15.0x. The market appears even more undervalued relative to bond yields, which imply a 16.4x multiple. Shareholder-Friendly Behavior Over the last several quarters we have seen an increase in dividends, buybacks, and M&A. Each of these shareholder-friendly activities should support higher stock prices. Buybacks Historically, dividends drift higher in a relatively consistent manner. By contrast, share repurchases have increased materially over the past several quarters. We expect this pattern to continue throughout 2011 and beyond. Exhibit 14: Dividends vs. Buybacks 150 $B Buybacks ► Robust buyback activity should help 120 support the market 90 60 30 ▲ Dividends 0 99 00 01 02 03 04 05 06 07 08 09 10 Source: Standard & Poor’s, Compustat, FactSet and UBS Note: S&P 500 ex-Financials M&A Rising In addition, we expect M&A activity to continue to pickup as it has over the past year. Large cash balances, growing business confidence, still-low valuations, and a large gap between large- and small-cap margins, all support this trend. Exhibit 15: M&A 255 268 244 A large gap between large- and small- 233 cap profitability suggests that deal 195 180 synergies should be meaningful 157 165 151 143 120 96 98 101 87 90 67 36 94 96 98 00 02 04 06 08 10 Source: MergerStat, FactSet and UBS UBS 8 US Equity Strategy 7 February 2011 Washington Moves Toward the Center Following a drubbing in the mid-term elections, we have seen a shift in sentiment emanating from within the Beltway. We see this as an important development which should also support higher valuations. We believe that the December tax compromise, and recent shift in tone, contributed significantly to the rise in consensus GDP forecasts. #4 Risks Trees Don’t Grow to the Sky Since the end of August, the market has risen for five straight months and is now 25% higher. Given the strength of this run, we wouldn’t be surprised if the We would view a short-term pullback in market pulled back for technical reasons alone. If this were to occur, we would the market as a buying opportunity view it as a buying opportunity. Headwinds to Valuation We expect episodic spikes in macro-driven volatility. Further, rising inflation and concerns over monetary policy are likely to rise as the year progresses. These headwinds are most acute in emerging markets. Great Not Good Should macro risks remain in check, we believe there is substantial upside to our earnings and valuation forecasts. While investors might not see this as a risk in On balance, we think the risks to our the traditional sense, under-investing in a powerful recovery could prove to be a outlook remain to the upside negative. #5 Sector Positioning Consistent with our constructive call on the market, we have a pro-cyclical bias toward sector positioning. We remain overweight Technology, Industrials and Financials, and underweight Staples, Telecom and Utilities. Overweight Sectors Technology. The sector remains attractive on valuation and has the best prospective long-term revenue growth among cyclical sectors. Industrials. Given the group’s later stage nature, it has significant margin upside from current levels. Financials. There are a number of tailwinds supporting Financials including (1) improving loss trends; (2) a turn in C&I and consumer loan volumes; (3) a steeper yield curve; (4) a more favorable backdrop for investment banking activity; and (5) attractive valuations. Underweight Sectors Consumer Staples. We expect Staples to underperform as the broader market is driven higher by earnings upside. We are least optimistic on companies exposed to low-end consumer spending, which should lag if employment remains soft and credit remains constrained. UBS 9 US Equity Strategy 7 February 2011 Telecom. Rising interest rates are a headwind for the sector. Telecom also remains expensive and faces a challenging long-term competitive environment. Utilities. Like Telecom, interest rates could hold back the group and the risk from increasing environmental regulation is high. 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UBS Investment Research: Global Equity Rating Allocations 1 2 UBS 12-Month Rating Rating Category Coverage IB Services Buy Buy 49% 40% Neutral Hold/Neutral 42% 35% Sell Sell 8% 21% 3 4 UBS Short-Term Rating Rating Category Coverage IB Services Buy Buy less than 1% 14% Sell Sell less than 1% 0% 1:Percentage of companies under coverage globally within the 12-month rating category. 2:Percentage of companies within the 12-month rating category for which investment banking (IB) services were provided within the past 12 months. 3:Percentage of companies under coverage globally within the Short-Term rating category. 4:Percentage of companies within the Short-Term rating category for which investment banking (IB) services were provided within the past 12 months. Source: UBS. Rating allocations are as of 31 December 2010. UBS Investment Research: Global Equity Rating Definitions UBS 12-Month Rating Definition Buy FSR is > 6% above the MRA. Neutral FSR is between -6% and 6% of the MRA. 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