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2014: Debunking the bear case

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US Equity Strategy Year Ahead
Equity and Quant Strategy | United States
26 November 2013
2014: Debunking the bear case
the bull market while it lasts
 Enjoy
Where we sit today has generally been the sweet spot for equities: low but rising
rates, low inflation, and a pickup in economic growth. For those worried about
everything that could go wrong, we address the various arguments we hear against
equities, including sentiment, peak margins, valuations, China, the Fed liquidity
bubble, DC dysfunction, and the list goes on…see page 5 inside.
SPX @ 2000: less upside than ‘13 but highest on the Street
Our 2014 year-end target on the S&P 500 is 2000, implying a price return of about
11%. This is lower than the lofty gains of the last two years as the risk premium for
equities (ERP) has fallen by a third. We expect earnings growth of 7%, and a bit more
multiple expansion as we see further room for the ERP to normalize lower. But the
wall of worry on Wall Street persists: the consensus 2014 S&P 500 target implies only
4% annualized return from current levels, and the recommended equity allocation
remains well below the benchmark. The Great Rotation may have more to go.
Savita Subramanian
+1 646 855 3878
Dan Suzuki, CFA
+1 646 855 2827
Alex Makedon
+1 646 855 5982
Jill Carey
+1 646 855 3327
Equity & Quant Strategist
MLPF&S
savita.subramanian@baml.com
Equity Strategist
MLPF&S
dan.suzuki@baml.com
Quantitative Strategist
MLPF&S
alex.makedon@baml.com
Equity Strategist
MLPF&S
jill.carey@baml.com
Fade the tails, buy the middle
As interest rates rise and the economy accelerates, investors should shed the
extremes of high yield or high growth and move to the middle – we recommend
buying the hybrid half-growth/half-yield stocks. Yield still matters, but we expect
investors to move down the yield spectrum into less expensive, less rate-sensitive
stocks, while a pickup in GDP growth should drive investors out of expensive
secular growth into more attractively valued cyclical growth. This dovetails with our
continued preference for high quality multinationals as Europe exits its recession.
Note that while European equities have run, US stocks with global exposure are still
at record cheap levels – and this entry point may be fleeting.
Still plenty of do-it-yourself value creation potential
With valuations having reached more normal levels as macro risks have abated, the
onus may have shifted to company management to drive continued shareholder
returns. 2013 saw the beginnings of this, as significant returns within the S&P 500
were driven by operational turnarounds or capital structure re-engineering.
Shareholder activism and corporate re-tooling should remain a strong theme in
2014, as companies remain under-levered and cash-rich, and still fighting against a
lower growth backdrop – they thus may be more likely to unlock value through
divestitures, strategic M&A or other such avenues.
Click the image above to watch the video.
Table of Contents:
2014: On the road to normal….…..……4
Debunking the bear case……………….5
S&P 500 Target………..……………….18
EPS Outlook…………………………….23
Short Term Themes………………...….24
Long Term Themes……………….……30
Sector Preferences……………….…….33
Appendix/Methodology…….…………..44
For the long-term: do the opposite of the last 30 years
The last 30 years saw falling rates and easy money, culminating in an unprecedented
wave of stimulus over the last decade; credit-sensitive areas generally prospered. As
we embark on fiscal and monetary tightening, we recommend that investors do the
opposite of what worked over the last cycle. Bonds could suffer, whereas stocks
(especially rising rate beneficiaries) might fare better. Large or cash-rich companies
could outperform small or more levered companies that thrive on access to cheap
capital. And high quality companies (stable growth, not low beta) that have seen no
multiple expansion during the era of hyper-stimulus could re-rate higher.
BofA Merrill Lynch 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.
Refer to important disclosures on page 48 to 50. Link to Definitions on page 47.
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U S Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
Contents
2
2014: On the road to normal
4
Debunking the bear case
5
“The 5-year bull market is long in the tooth”
5
“Valuations are too high”
6
“Everyone is bullish — it’s time to sell”
8
“Margins are peaked and poised to collapse”
9
“Higher rates are bad for equities”
11
“The Fed is about to take the punch bowl away”
13
“Europe continues to ail”
14
“China is a disaster waiting to happen”
14
“Dysfunction in DC is spiraling out of control”
16
“Geopolitical tensions are running high”
17
S&P 500 outlook: 2014 target = 2000
18
#1: BofAML Fair Value Model
18
#2: Sell Side Indicator
20
#3: Estimate Revisions Model
20
#4: Long-term valuation model
21
#5: 12-month Price Momentum Model
21
EPS Outlook: modest acceleration in 2014
23
Short-term themes
24
1) Fade the tails, buy the middle
24
2) Self-help stories
26
3) Buy GDP-sensitive stocks
28
U S Equity Stra tegy Yea r Ahead
2 6 Nov embe r 201 3
4) Buy multinationals, sell US-centric stocks
28
5) Sell low beta stocks
29
Long-term themes
30
1) Stocks over bonds
30
2) Large caps over small caps
31
3) High quality, cash-rich companies
31
Sector preferences
33
Overweight Technology, Industrials, Energy
33
Underweight Discretionary, Utilities & Telecom
37
Marketweight Health Care
39
Marketweight Consumer Staples
40
Marketweight Financials
40
Marketweight Materials
42
Sector Snapshot
43
Appendix/Methodology
44
Performance of mentioned quantitative strategies
45
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2014: On the road to normal
Five years after the financial crisis, the markets have begun to normalize.
Earnings volatility has dropped from record levels, and in tandem, the equity risk
premium has fallen from extreme highs to only slightly elevated levels. Wall Street
sentiment, while far from euphoric, has improved from the rock-bottom pessimism
we witnessed in 2012. In 2013, equity volatility subsided (possibly at the expense
of bond volatility rising) and fundamentals started to matter again, with factors like
valuation and earnings surprises driving returns more than risk attributes.
Two extremes of the market have grown
expensive: high yield/no growth and high
growth/no yield.
What’s still extreme?
Against the backdrop of low yield and weak global growth, valuations have grown
expensive for the tails – either high yield, no growth stocks (e.g., Utilities) or high
growth, no yield stocks (e.g., biotech, social media.) They have begun to derate
but there is more to go. Another bubble in the process of deflating can be found in
low beta stocks, where investors are paying big premiums for perceived safety.
S&P 500 at 2000 for 2014: less upside than last year…
Our 2014 year-end target on the S&P 500 is 2000, implying a price return of
about 11%. While this is above average (7%) it is a significant drop from the
loftier gains we have enjoyed in the last two years, as the risk premium for
equities has dropped significantly. We expect earnings growth of about 7%
(driven by a slight pickup in sales as well as continued buybacks) and a bit more
multiple expansion, as the equity risk premium is still elevated.
…but more upside than Wall Street is expecting
The wall of worry persists: the consensus 2014 S&P 500 target implies just 4%
upside from current levels, well below average. And our Sell Side Indicator remains
in BUY territory: the average allocation to equities, at 53%, is well below benchmark
~65% levels. The Great Rotation may still be in the early innings.
For 2014, we like the middle – hybrid
half-growth/half-yield stocks.
I.e.,cyclicals with reasonable, but not
stretched, dividends.
And for the very long-term, do the
opposite. Sell what worked over the last
few decades of easy money, and play the
anti-credit bubble. Buy large, cash rich,
high quality companies.
For the near term, fade the tails, buy the middle
As interest rates pick up and the economy accelerates, investors should shed the
extremes of high yield or high growth and move to the middle–hybrid halfgrowth/half-yield stocks. It may be too early in the rising rates cycle to ignore equity
yield, but we expect investors to move down the yield spectrum into less expensive,
less rate-sensitive stocks, while a pickup in GDP growth should drive investors out
of expensive secular growth into more attractively valued cyclical growth. This
dovetails with our continued preference for high quality multinationals as Europe
exits its recession. While European equities have run, US stocks with global
exposure are still at record cheap levels – and this entry point may be fleeting.
For the long-term: do the opposite of the last 30 years
The last 30 years saw falling rates and easy money, culminating in an
unprecedented wave of stimulus over the last decade; credit-sensitive areas
generally prospered. As we embark on fiscal and monetary tightening, we
recommend that investors do the opposite of what worked over the last cycle.
Bonds could suffer, whereas stocks (especially rising rate beneficiaries) might fare
better. Large or cash-rich companies could outperform small or more levered
companies that thrive on access to cheap capital. And high quality companies
(stable growth, not low beta) that have seen no multiple expansion during the last
10-20 years of hyper-stimulus could re-rate higher.
Finally, enjoy the bull market while it lasts
We suggest investors enjoy where we sit today, which has generally been the
sweet spot for equities – low but rising rates, low inflation, and a pickup in the
economy. For those worried about everything that could go wrong, please turn
the page and read our next section, Debunking the Bear Case, where we address
the various arguments we hear against equities.
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Debunking the bear case
We hear a lot of bearish arguments against equities, some of which are listed
below. With most of our market indicators flashing green, we address the bear
cases below to either debunk them or provide evidence that the risks are priced
into stocks.
1.
“The 5-year bull market is long in the tooth”
2.
“Everybody’s bullish - it’s time to sell”
3.
“Valuations are too high”
4.
”Margins are peaked and poised to collapse”
5.
“Higher rates are bad for equities”
6.
“The Fed is about to take the punch bowl away”
7.
“Europe continues to ail”
8.
“China is a disaster waiting to happen”
9.
“Dysfunction in Washington DC is spiraling out of control”
10. “Geopolitical tensions are running high”
“The 5-year bull market is long in the tooth”
One common refrain we hear from skeptical investors is that bull markets typically
last for no more than five years, and, with equities having posted gains for almost
half a decade, the market is poised for a correction.
Bull markets vary in duration
The length of bull markets has varied over time – from two to nine years, and the
dispersion of duration is quite high – a 2-year standard deviation (Table 1). The
duration and returns during a bull market vary, and are better determined by the
interest rate and growth backdrop, the magnitude of the downturn prior to the bull
market and valuations, rather than by arbitrary time periods.
Table 1: Historical equity bull markets
Start Date
End Date
Start Price
Apr-42
Jun-49
Oct-57
Jun-62
Oct-66
May-70
Oct-74
Aug-82
Dec-87
Oct-90
Oct-02
Mar-09
May-46
Aug-56
Dec-61
Feb-66
Nov-68
Jan-73
Nov-80
Aug-87
Jul-90
Mar-00
Oct-07
Nov-13
7.47
13.55
38.98
52.32
73.2
69.29
62.28
102.42
223.92
295.46
776.76
676.53
End Price
19.25
49.64
72.64
94.06
108.37
120.24
140.52
336.77
368.95
1527.46
1565.15
1802.48
Average
Median
St Dev
Years
4.1
7.1
4.1
3.6
2.1
2.6
6.2
5.0
2.6
9.5
5.0
4.7
4.7
4.7
2.1
S&P 500 Change
158%
266%
86%
80%
48%
74%
126%
229%
65%
417%
101%
166%
165%
126%
107%
Source: S&P, BofAML US Equity & Quant Strategy
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Chart 1: What relationship? 5-yr return vs.
subsequent 12-month S&P 500 returns ('29-'13)
Subs 1-yr SP500 PR
60%
R² = 0.0002
40%
20%
0%
-20%
-40%
No relationship between 5-yr returns & what happens next
This cycle’s returns hardly make a case for a correction. The S&P 500 has gained
roughly 80% over the last five years. In the year following a similar run, S&P 500
returns have been positive two-thirds of the time, and have averaged about 8%,
slightly above trend. There is literally no relationship between historical five-year
returns and subsequent 12-month returns — the R-square is essentially 0 (Chart
1). Skeptics may be extrapolating from the fact that coming out of sustained bear
markets, there is a higher probability that returns will be positive in the
subsequent year. But strong five-year equity runs tell you little to nothing about
the future.
Early cycle has lasted longer than usual …
60%
70%
80%
90%
5yr S&P 500 Price Return
Source: BofA ML US Equity Strategy
100%
We have been in a five year cycle of aggressive Fed easing, and leadership has
come from early cycle sectors like consumption and housing plays. The last
several easing cycles have been shorter in duration, leading some to believe that
we have enjoyed too much equity upside for too long.
…But mid-cycle returns tend to be strong
But we have found that the transition from early to mid-cycle leadership that we
believe is about to occur is generally accompanied by the withdrawal of liquidity,
which some argue is a negative, but has been a good environment for equities –
over the last two cycles we’ve enjoyed mid- to high-double digit returns (Chart 2).
Chart 2:Early-cycle to mid-cycle rotation accompanied by positive equity returns
1.6x
1.5x
S&P 500 returned 18% p.a.
S&P 500 returned 15% p.a.
1.4x
1.3x
1.4x
1.2x
1.3x
1.1x
1.2x
1.1x
1.0x
1.0x
0.9x
0.9x
0.8x
1990
1991
1992
1993
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2008
2009
2010
2011
2012
2013
2014
0.8x
Early cycle: Cons Disc vs. SP500
Mid-cycle: Industrials vs SP500
BofA ML US Equity & Quantitative Strategy
“Valuations are too high”
With the S&P 500 hitting record highs, and with most of 2013’s gains having
come from multiple expansion rather than earnings growth, we hear that stocks
are now expensive. We disagree. The S&P 500 is trading near 15x forward
earnings, a demonstrable rise from its cycle lows, but is only now approaching its
historical multiple, even excluding the frothy Tech Bubble years. Moreover, even
if interest rates rise for the next few years, they are likely to remain near the lower
end of the historical 2-15% range for a while; real rates, along with low levels of
inflation, have typically coincided with elevated multiples on earnings.
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Of the 15 valuation metrics we track,
only the Shiller P/E suggests equities are
very stretched vs. history.
But rather than rely on one valuation metric, we looked at 15. Of those 15
measures, 12 of them indicate that the market is trading below historical norms,
both relative to their own history and relative to other asset classes (Table 2). This
suggests that multiples have simply come back from very depressed levels.
Two—the trailing P/E and P/OCF—are just trading slightly above historical
averages. Only the Shiller P/E, which bases normalized earnings on inflationadjusted earnings over the past decade, suggests stocks are very expensive. This
metric assumes normalized EPS of ~$70, and incorporates the worst profits
recession in history which was largely driven by excessive leverage—a scenario we
think is too pessimistic to assume recurs for perpetuity, especially given the
significant deleveraging of the corporate sector.
Table 2: S&P 500 Valuation Metrics (as of 10/31/13)
Trailing PE
Forward Consensus PE
Trailing Normalized PE
Shiller PE
P/BV
EV/EBTIDA
Trailing PEG
Forward PEG
P/OCF
P/FCF
EV/Sales
ERP (Market-Based)
Normalized ERP
S&P 500 in WTI terms
S&P 500 in Gold terms
Current
Average
16.5
14.6
17.8
23.9
2.6
9.7
1.4
1.2
11.1
21.2
1.9
662
480
17.5
1.3
16.0
16.4
19.1
16.5
2.9
9.9
1.5
1.3
10.4
28.7
2.2
439
264
22.4
1.5
Avg. ex. Tech
Bubble
15.2
14.7
17.3
15.8
2.5
9.4
1.6
1.3
9.4
24.9
2.1
452
312
19.4
1.2
Min
Max
6.7
10.5
9.2
4.8
1.7
6.3
1.1
1.0
5.5
12.9
1.2
136
-96
2.7
0.2
30.5
25.1
33.9
44.2
5.9
15.0
2.4
1.8
19.7
65.9
3.5
880
947
109.0
5.5
% Above (below)
avg.
3%
-11%
-7%
45%
-8%
-2%
-12%
-8%
7%
-26%
-16%
51%*
82%*
-22%
-12%
*ERP above average implies equities are attractively valued relative to bonds
Note: Trailing PE based on GAAP EPS from 1960-1977, Operating EPS from 1978-1996 and Pro forma EPS from 1996-present. Market-based ERP based
on DDM-implied return for S&P 500 less AAA corp bond yield. Normalized ERP based on normalized EPS yield less normalized real risk-free rate.
Normalized EPS is based on a log-linear regression of S&P 500 operating EPS and the normalized risk-free rate is the difference between 1) the avg. of the
30-yr Treasury yield and the 5-year rolling avg. of the 10 year-Treasury yield, and 2) the 10yr TIPS spread and the 5-year rolling average CPI inflation rate.
Source: S&P, Compustat, Bloomberg,Shiller, FactSet/First Call, BofA Merrill Lynch US Equity & US Quant Strategy
Moreover, multiple expansion by sector has not been broad based, but has been
concentrated in certain, mostly defensive sectors: Health Care, Utilities, Staples
and Materials saw P/E expansion as the primary driver of performance. But
returns for Energy, Industrials, and Telecom have been entirely driven by forward
earnings growth (Telecom’s multiple has actually been contracting since this past
spring). We expect multiples for Energy, Industrials and Tech will expand as
global growth reaccelerates in the quarters to come.
Chart 3: Sector performance breakdown since 12/31/10: Change in Forward P/E vs. EPS
80%
Chg in P/E
60%
40%
20%
Utilities
Telecom
Tech
Financials
Health Care
Staples
Cons Disc
Industrials
Materials
-20%
Energy
0%
S&P 500
Multiple expansion over the last three
years has not been broad-based: only
Health Care, Utilities, Staples and
Materials saw their performance driven
chiefly by P/E expansion.
Chg in EPS
Source: Factset/I/B/E/S, BofA Merrill Lynch US Equity & US Quant Strategy
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2 6 Nov embe r 201 3
“Everyone is bullish — it’s time to sell”
While skeptics argue that everyone is bullish, we find a tremendous amount of
evidence to the contrary. In fact, our work suggests that both the buy side and the
sell side maintain far more cautious outlooks than they have historically.
Sell side: far from euphoric
The Sell Side Indicator—our measure of Wall Street’s bullishness on stocks—is
currently at 52.8, and remains in “Buy” territory. Wall Street is more bearish on
equities than it was at the March 2009 market lows. Strategists are still
recommending that investors significantly underweight equities at 53% vs. a
traditional long-term average benchmark weighting of 60-65%.
Chart 4: Sell Side Consensus Indicator (as of 31 October 2013)
The sell side is still recommending that
investors significantly underweight
equities at 53% vs. a traditional
benchmark weight of 60-65%.
71
69
67
65
63
61
59
57
55
53
51
49
47
45
43
Current Statistics:
Latest = 52.8%
15-Year Average = 60.4%
Sell Threshold = 66.2%
Buy Threshold = 54.5%
EXTREME BULLISHNESS
BEARISH FOR STOCKS
EXTREME BEARISHNESS
BULLISH FOR STOCKS
'85
'87
'89
'91
'93
'95
'97
'99
'01
'03
'05
'07
'09
'11
'13
Source: BofA Merrill Lynch US Equity & Quant Strategy
Note: Buy and Sell signals are based on rolling 15-year +/- 1 standard deviations from the rolling 15-year mean. A reading above the blue line
indicates a Sell signal and a reading below the red line indicates a Buy signal.
Additionally the average 2014 year-end target S&P 500 forecast currently sits at
1880, implying annualized returns of less than 4%. This is below historical average
S&P 500 returns (+7% since 1929), well below the average gains forecast by
strategists at the beginning of the year (+11%), and almost as bearish as the sell
side was at the all-time low, an expected +2.7ppt return in 2012 (Chart 5).
Chart 5:Implied upside from consensus strategist S&P 500 target (January of each year)
30%
20%
10%
0%
-10%
-20%
-30%
-40%
-50%
30%
25%
20%
15%
10%
5%
Implied return from consensus forecast
Source: Bloomberg, BofA ML US Equity & Quantitative Strategy
8
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
0%
Actual S&P 500 Price Return
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
Buy side is in the bunkers
In our active fund positioning work, mutual fund managers’ exposure to defensive
versus cyclical sectors is the highest we have seen since the credit crisis (Chart
6). This positioning is far more suggestive of a weak equity market outlook than a
bullish stance.
Chart 6:Mutual fund exposure to cyclical vs. defensive sectors suggests a defensive bias
1.25
1.20
1.15
1.10
Cyclicals: Cons Discretionary,
Energy, Tech, Industrials & Materials
Defensives: Cons Staples & Health Care
1.05
1.00
06/13
03/13
12/12
09/12
06/12
03/12
12/11
09/11
06/11
03/11
12/10
09/10
06/10
03/10
12/09
09/09
0.95
06/09
Relative weight (1.0 = equal
weight)
Fund manager positioning is more
suggestive of a weak market outlook than
a bullish stance.
Source: Lionshares, BofAML US Equity & Quantitative Strategy
In the latest BofAML Global Fund Manager Survey, our Global Investment
Strategy team points out that cash balances remain very high at 4.6%, in "buy"
territory by their trading rule (Exhibit 1).
Exhibit 1: BofA-ML Global FMS Cash Indicator
Source: BofAML Global Research
“Margins are peaked and poised to collapse”
One of the most common bearish arguments that we hear from clients is that
margins are mean-reverting. With net margins near record levels, a reversion to
the mean would result in a 15-20% hit to earnings. Margins are cyclical and tend
to collapse during recessions, but we argue that there is a difference between
mean-reversion and cyclicality. A look at the history of margins suggests that
secular shifts in underlying margin trends can last for decades (Chart 7). The
argument for the mean reversion of margins assumes that there is some natural
equilibrium of margins, and ignores the structural changes in the economy, policy
and mix that can have real and long-lasting impacts on profitability.
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Net Income Margin (%)
Chart 7: S&P 500 and S&P Industrials Composite Net Margins (1967-2012)
10%
9%
8%
7%
6%
5%
4%
3%
2%
25 years
21 years
'67'69'71'73'75'77'79'81'83'85'87'89'91'93'95'97'99'01'03'05'07'09'11
S&P Industrials Composite
S&P 500 Non-Financials
Source: BofA Merrill Lynch US Equity & Quant Strategy, S&P, Compustat
50%
80%
45%
77%
40%
74%
35%
71%
2009
2005
2001
25%
1997
65%
1993
30%
1989
68%
Effective Tax Rate (%)
83%
1985
Domestic Sales (%)
Chart 8: Tax rate vs. foreign exposure
Domestic Sales (%)
Effective Tax Rate (%)
Source: BofA Merrill Lynch US Equity & Quant Strategy, S&P, Worldscope
Margins are higher mostly due to interest expense and taxes
There are several reasons why margins should remain structurally higher than the
historical average. Importantly, roughly two-thirds of the improvement in net
margins can be attributed to changes below the operating line, specifically interest
expense and taxes (Chart 9). The S&P 500’s effective tax rate has fallen as an
increasing share of profits is being generated from overseas where tax rates are
lower (Chart 8). We do not expect any meaningful decline in the share of foreign
profits, and if we eventually see US corporate tax reform, most of the proposals
actually call for corporate tax rates to be lowered, not raised. Meanwhile, lower
leverage levels and interest rates have reduced the interest expense burden of
companies, and although we are likely to continue to see interest rates rise from
current depressed levels, we would still expect them to remain well below history.
We also do not see any rush for corporations to meaningfully re-lever their balance
sheets for the foreseeable future. Every 10bp of margin expansion translates into
roughly 1ppt faster EPS growth relative to sales growth.
Chart 9: Contribution to increase in S&P 500 Non-Financial net margin
10%
+0.7%
9%
8%
+0.3%
+0.2%
-0.3%
Energy
Other sectors
9.5%
+0.9%
7.6%
7%
6%
Lower Interest
1995-2004
Lower
Net Margin Effective Tax Expense
Rate
Note: Based on current constituents of the S&P 500
Source: BofA Merrill Lynch US Equity & Quant Strategy
10
Tech
2012 Net
Margin
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
Chart 10: Operating margin ex Fins & Tech
14.0%
13.5%
13.0%
12.5%
12.0%
11.5%
11.0%
10.5%
10.0%
2013
2010
2007
2004
2001
1998
1995
1992
1989
1986
Avg =
12.1%
Note: Based on current constituents of the S&P 500
Source: BofA Merrill Lynch US Equity & Quant Strategy, S&P, Compustat
Chart 11:Tradeoff between the risk-free rate and
the equity risk premium
1000
Risk free rate (x-axis)
vs.
BofA ML market-based
Equity Risk Premium (y-axis)
800
600
400
200
0
300
700
Source: BofA ML US Equity Strategy
1100
1500
Higher operating margins are due to Tech
S&P 500 Non-Financial operating margins are currently about 13.0%, which is in
line with their historical average of 12.9%. Half of the ten GICS sectors have
operating margins above their historical average, while the other half are below
average. The biggest standout sector is Tech, for which some of the improvement
in profitability could be sustainable. The sector’s margins have benefitted from the
maturation of certain industries, such as Internet services, as well as a shift
towards more software and services. Every 100bp decline in Tech operating
margins would have roughly a 10bp impact on overall S&P 500 margins.
Excluding Tech, Non-Financial operating margins are running at 11.8%, which is
below the long-term average of 12.1% (Chart 10).
“Higher rates are bad for equities”
Rates have been rising for over a year (they bottomed in July 2012) and stocks
have returned 30% since then. But many cite that rising rates are bad for equities.
The logic is simple: if a stock price is simply the present value of future cash
flows, then an increase in the 10-year treasury yield is tantamount to an increase
in the discount rate for equities. That should depress equity prices.
A pickup in rates generally means a pickup in growth
One cannot model the discount rate in a vacuum, as higher interest rates are
generally accompanied by stronger economic growth. The interplay between
growth and rates could actually bode well for equities in 2014, as we have seen in
prior cycles, especially for equities with medium to long duration. In a discounted
cash flow analysis, a higher denominator from a rising rates could be offset by a
higher numerator from stronger growth and the resulting increase in cash flows.
Trade-off between ERP and risk-free rate keeps Ke stable
Moreover, there exists a strong negative relationship between the risk-free rate
and the equity risk premium. The discount rate for equities, or Ke, is the sum of
the risk-free rate plus the equity risk premium. This discount rate has remained
remarkably stable over the last two decades despite tremendous changes in
interest rates over the same period.
QE has distorted the relationship between rates and stocks
Whereas the relationship between equity returns and interest rates has shifted
post-crisis, we think it may revert back to its pre-crisis relationship. Stocks and
real rates were positively correlated as growth improved, but the five-year
correlation of stocks with real rates has been negative since the crisis, amid the
liquidity bubble and fears of an end to QE. But if the Fed begins to taper next year
against the backdrop of a self-sustaining economy, equities—especially more
cyclical equities—and rates could move higher in tandem. We have already
begun to see evidence of a tick-up in the correlation between S&P 500 returns
and the 10yr Treasury over the last few months since the Fed first began
discussing tapering—see Chart 12.
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2 6 Nov embe r 201 3
Chart 12: Rolling 5-yr correlation: S&P 500 returns vs. change in real 10-yr Treasury yield
40%
30%
20%
10%
0%
-10%
-20%
-30%
-40%
-50%
95
97
99
01
03
05
07
09
11
13
Note: Real 10yr Treasury based on TIPS 2003 on, constant maturity real 10yr Tsy yield 1998-2003, and 10yr Tsy yield less Livingston Survey inflation
expectations 1990-1998
Source: FRB/Livingston Survey, Bloomberg, BofAML US Equity & US Quant Strategy
Table 3: CPI vs. S&P 500 Returns (1928-now)
Inflation S&P 500 S&P 500 Probability of
(CPI)
Average Median
Negative
Range
Return
Return
Returns
-11% to 1%
1% to 2%
2% to 3%
3% to 5%
5% to 20%
3.4%
13.5%
10.2%
8.3%
1.3%
5.3%
13.7%
9.8%
8.0%
-1.5%
46%
23%
19%
26%
52%
Source: BLS, Bloomberg, BofA Merrill Lynch US Equity & US Quant Strategy
Nominal vs. real rates matter
Distinguishing between nominal and real rates is also important: most periods of
rising rates have coincided with rising inflation expectations. However, this time
might be different, as our economists expect very muted inflation (1.4% CPI
growth) in 2014. This level of inflation is a sweet spot for equities—the stock
market enjoys the strongest returns (as well as the lowest probability of negative
returns) when inflation ranges between 1-3%.
Early cycle tightening is not late cycle tightening
In a scenario more akin to what we may be facing, namely, short-rates remaining
low and flat but long rates rising, the tightening of liquidity typically has not stemmed
growth nor does it stem equity market returns. A steepening yield curve during
environments in which the 3-month Treasury yield remained stable but the 10-year
Treasury yield was rising was generally positive for equities: annualized S&P 500
returns ranged between 23% and 31% in these periods.
Chart 13: Rising 10-yr yield with flat front-end bodes well for equities
18
S&P 500:
+24%
16
14
S&P 500: +23
+23%
S&P 500: +31%
2.0
10
1.0
8
0.0
6
-1.0
4
-2.0
2
89
91
93
95
97
3-mth Tsy yield, %
99
01
03
05
10-yr Tsy yield, %
Source: Federal Reserve, BofA Merrill Lynch US Equity & US Quant Strategy
12
4.0
3.0
S&P 500: +25%
12
0
5.0
07
09
11
3m/10y Curve, % (rhs)
-3.0
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
“The Fed is about to take the punch bowl away”
Unprecedented Fed easing over the last several years has some worried about
the unwinding of this easing cycle. Some worry that if the economy gathers
momentum and the Fed begins to taper its asset purchase program, equities
could come under pressure and ultimately be pushed into bear territory. Our
economics team expects the US economy to grow at a 2.6% clip in 2014, and
expects inflation to remain benign at the same low level we saw this year (CPI
inflation at 1.4%). In our economists’ view, this warrants a more dovish Fed, and
suggests only a very gradual tapering beginning in March and lasting through
December of next year. Our economics team expects that the first rate hike might
be pushed out to early 2016.
With seven FOMC meetings between March and December 2014, the current
$85bn per month in purchases would need to be reduced by a moderate amount,
~$12bn each meeting, to wind down the program. Our rates team expects these
actions would gradually drive the yield on 10-yr US treasury to 3.75% by 2014 yearend.
While differences between asset purchases and fed funds rate hiking exist, both
amount to tightening of monetary conditions. Equity performance during the last
two market cycles may provide a rough guide. Both instances actually turned out
to be great buying opportunities for stocks. In 1990s, the first rates hike occurred
in February 1994 when the fed funds rate increased by 25bp from 3% to 3.25%
(Chart 14). The move began a series of rate hikes that ended in February 1995,
driving the fed funds rate to 6%. The initial market reaction was negative, with a 2
month correction of 8.9% (2/2/94 to 4/4/94). However, the market subsequently
rebounded to end the year roughly flat. The tightening cycle that began in June
2004 lasted for two years. Similarly, we saw a two-month 7.1% correction
(6/23/04 to 8/12/04) followed by a subsequent rebound, moving the market into
positive territory for the year (Chart 15).
Chart 14: The bull market continued throughout 1990s tightening
cycle
Chart 15: After initial correction, equities kept advancing as the Fed
tightened
6.5
540
6.0
520
5.5
500
5.0
480
4.5
1300
4.0
1250
3.5
3.0
1200
2.5
4.5
460
4.0
440
3.5
420
3.0
400
12/92 03/93 06/93 09/93 12/93 03/94 06/94 09/94 12/94 03/95
2.5
S&P 500
Fed Funds rate,% (rhs)
Source: BofA Merrill Lynch US Equity & US Quant Strategy
1150
2.0
1.5
1100
1050
12/03
1.0
03/04
06/04
09/04
12/04
S&P 500
03/05
06/05
09/05
0.5
Fed Funds, % (rhs)
Source: BofA Merrill Lynch US Equity & US Quant Strategy
Today, some of the initial response around tapering may already be priced into
the market, as we saw a significant consolidation last summer when taper talk
began with 10-yr Treasury bond yields rising about 120bp and equities
experiencing some volatility. Our models assume that the market is already
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US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
pricing in normalized interest rates that are about 50bp higher than current levels,
and our forecast assumes that the market will be pricing in another 50bp by the
end of next year. Therefore, our expectations are for a more muted market
reaction once the Fed begins to actually scale back its asset purchases. A
moderate correction is possible, but strong fundamentals, underallocation to
equities, and an improving economic backdrop should trump the negative effects
of tapering, in our view. Should a correction occur, as in the previous cycles, we
would view it as a buying opportunity and add to our preferred areas of the
market — cyclically and globally exposed Tech, Industrials and Energy.
“Europe continues to ail”
Table 4: S&P 500 sectors’ correlation with
Europe & China equity performance since 1990
Correlation with Correlation with
Europe (Euro
China (MSCI
Sector
Stoxx)
China)
Cons. Disc.
Cons. Staples
Energy
Financials
Health Care
Industrials
Technology
Materials
Telecom
Utilities
0.71
0.41
0.64
0.73
0.61
0.76
0.70
0.50
0.66
0.61
0.28
0.15
0.55
0.26
-0.01
0.45
0.32
0.65
0.25
0.26
Source: MSCI, ECB, S&P, BofA Merrill Lynch US Equity & US Quant Strategy
While softness in Europe had been one of the most-cited reasons for weak results
by S&P 500 companies over the past few years, the region appears to be in the
early stages of recovery. European economist Laurence Boone acknowledges the
recovery has been and will continue to be fragmented, with accelerating growth in
Germany, Spain and the Netherlands while Italy remains in recession. Credit
conditions also remain tight. However, she expects that the ECB’s accommodative
monetary policy will provide stability for a continued recovery in the region, and
forecasts muted but accelerating GDP growth from 0.5% (QoQ SAAR) in 4Q13 to
0.6% in the first three quarters of 2014 and 1.1% by 4Q14. She expects the drag
from fiscal austerity will decline to 1.1ppt in 2013 from 1.6ppt this year. Additionally,
the Eurozone Manufacturing PMI has climbed to 51.5—in expansion territory and at
its highest level since mid-2011—from its trough of 44 in July 2012.
Thus, for the first time in many quarters, most S&P 500 companies cited stabilizing
or improving trends in Europe during 3Q13 earnings season. In our view, the fact
that Europe is coming out of a recession and transitioning from negative to positive
growth is significant; Industrials—which has the highest correlation with Europe of
all ten sectors (Table 4)—has been the third-best performing sector this year, and
the best-performing sector since the end of April. We additionally believe that risks
associated with Europe are already priced in to US stocks, as the most foreignexposed stocks in the S&P 500—most of which have Europe as their largest
regional exposure—are trading at the biggest discount to pure domestic stocks we
have seen in at least a decade (see Chart 39.)
“China is a disaster waiting to happen”
With China having been a major contributor to global economic growth over the
last decade, investors are understandably concerned about what might happen if
the slowdown in Chinese growth is more sudden or severe than the market
expects. The main risk that investors point to is the rapid credit growth over the
last several years, but our Chinese economist Ting Lu makes the case for why a
crisis is not imminent.
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2 6 Nov embe r 201 3
Chart 16: China debt to GDP by type
How big is China’s debt burden?
Since 2012, China’s ratio of total non-financial debt to GDP has risen from 155%
to 185% (central government: 21%; local governments: 32%; corporates: 111%;
households: 22%). See Chart 16. Compared to other economies, China’s 185%
debt-to-GDP ratio is neither exceptionally high nor low (Chart 17), and its
government and household debt levels are modest, particularly relative to
developed economies. The area that sticks out as high relative to other countries
is the 111% non-financial corporate debt to GDP ratio (Chart 18). And although
China’s government debt is low, it is dominated by local government debt with
significant duration mismatches between short duration financing from
commercial banks and trusts used to fund long-term infrastructure projects with
diminishing returns.
Source: CEIC, NBS and BofA Merrill Lynch Global Research
% of GDP
160
140
120
100
80
60
40
20
0
Source: CEIC, NBS and BofA Merrill Lynch Global Research
Indonesia
India
Thailand
Germany
US
Italy
Taiwan
Japan
Indonesia
Australia
Korea
Taiwan
China
Thailand
China
Malaysia
India
Spain
Germany
US
UK
France
Italy
Japan
0
Malaysia
50
China
100
China
150
Non-financial Corporate
UK
Gov ernment
200
Korea
% of GDP
250
Chart 18: Non-financial debt to GDP ratios (end-2012)
Australia
Chart 17: Government debt to GDP ratios (end-2012)
France
2012
1H13
2011
2010
Local gov ernment
Household
Spain
Central gov ernment
Nonfinancial corporations
2009
2008
2007
2006
2005
2004
2003
2002
% of GDP
200
175
150
125
100
75
50
25
0
Source: CEIC, NBS and BofA Merrill Lynch Global Research
Why isn’t a financial/debt crisis imminent?
1. The central government has a very low debt-to-GDP ratio at 21%, and it has
cash savings at the PBoC equivalent to 6% of GDP.
2.
Almost all government debt is denominated in RMB and owned by domestic
entities, meaning that the PBoC can prevent a government debt crisis with its
unlimited capability in liquidity supply.
3.
China has huge national savings with US$3.5tn FX reserves, 20% reserve
requirement ratio, and only 65% loan-to-deposit ratio, implying that the room
for the central bank to support the government in an emergency is quite big.
4.
The government, both central and local, owns significant assets.
5.
Despite the slowdown, China still has a relatively high economic growth
(7.6% YoY in real terms in1H13) and fiscal revenue growth (7.9% YoY in
nominal terms in 1H13).
What steps can China take to address the issues?
Based on its unique debt structure, we believe the country should deleverage its
local governments while leveraging up the central government, and should try to
replace local governments’ short-term bank and trust loans with longer-duration
bonds. On corporate leveraging, high debt levels are partly a function of the
country’s underdeveloped capital markets, resulting in most of the corporate
15
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
sector’s financing coming from bank loans instead of equity capital. Rather than
simplistically limiting the credit supply to corporates, the government should
encourage equity financing by reinvigorating its stock markets via serious
reforms. Helping more companies to raise equity capital on the stock exchanges
will also stimulate equity funding in the private equity market.
“Dysfunction in DC is spiraling out of control”
Chart 19: Average Ideological Positions of
House Party Coalitions, 80th-112th Congresses,
1947-2012
1.0
0.8
0.6
0.4
0.2
0.0
-0.2
-0.4
-0.6
-0.8
-1.0
Conservative
Republicans
Democrats
Liberal
1947 1954 1961 1968 1975 1982 1989 1996 2003 2010
Source: BofA Merrill Lynch Global Resaerch
Brinksmanship in Washington DC has grown more pronounced, and ideological
positions of the House suggests that politicians are more polarized then ever,
according to our Economics team (Chart 19). Politicians have failed to reach a
comprehensive agreement on the budget and debt ceiling, resulting in
downgrades to the US sovereign credit rating and a prolonged government
shutdown. Even issues with general bipartisan support, such as corporate tax
reform, the two parties have failed to come together and achieve results. In
assessing the impact of brinkmanship in Washington on equities, focusing on the
sustained impact on confidence, the economy, interest rates and currency may
be most relevant. And while the headlines may weigh on consumer and corporate
confidence, the long-term impact on the economy and rates is less certain.
The silver lining of dysfunction
Given an increasing focus on government debt and deficits (government debt
levels are now approaching 100% of US GDP), Congress could become
incrementally tighter with future budgets than it might have been. We have seen
some evidence of this in 2013. Still, the biggest long-term driver of government
debt is entitlements, an issue that has not yet drawn the focus of negotiations in
Washington. Increasing public dissatisfaction and scrutiny on policymakers may
force a higher likelihood for results here. And although government debt levels
are high, they are less egregious than levels in Japan (>200% of GDP) and many
European countries (see Chart 17, page 15.)
DC drama can create opportunities
Since the debt downgrade, the S&P 500
has rallied 60%.
Most recently, many investors feared that a government shutdown in October
would put pressure on equities and possibly drive the US economy into a
recession. However, we highlighted that sell-offs were not in fact necessary to
force policy resolution, as the S&P 500 actually rose during the last government
shutdown in 1995, and has been flat to up on average during prior shutdowns
since 1981. Indeed, investors shrugged off the October shutdown, and the S&P
500 ended the month up 4.5%. The most notable impact to markets was the US
debt downgrade in August 2011, which saw the S&P 500 drop 7% the following
trading day, compounding a sell-off that was already underway as a result of the
European crisis that summer. But since the debt downgrade, the S&P 500 has
rallied 60%.
While the shutdown in October ultimately resulted in a more can-kicking, markets
have also become somewhat desensitized to the continued disagreement in DC.
If a sell-off were to occur around political dysfunction, we would view this as a
buying opportunity.
The hedge? High quality
In the period immediately following the 2011 downgrade, high quality stocks
outperformed low quality stocks. Thus overweighting high quality stocks—which
16
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
are one of our preferred themes—could provide a good hedge if dysfunction in
DC rears up again.
“Geopolitical tensions are running high”
While the risk of a geopolitical shock is a real one, it has been a consistent risk
throughout history. It thus seems somewhat arbitrary to assign a higher
probability today relative to any other time over the last several decades. Outside
of an event on US soil, the main transmission mechanisms for the long term
impact on the financial markets are likely to be commodity prices and perhaps
increased defense spending. Although the US is likely to remain a net importer of
oil for the foreseeable future, one of the benefits of booming energy production in
the US is that its dependence on foreign oil has been greatly diminished. And
although it may be too early to call for an all-clear signal, Iran’s recent interim deal
to limit its nuclear program in exchange for relief from economic sanctions is at
least encouraging.
The recent crisis in Syria brought about renewed fears of geopolitical risk and oil
price spikes, which are generally negative for equities. However, history has
shown that negative returns during past oil conflicts have been modest and shortlived, with stocks typically declining just 2% and then rebounding once the crisis
subsides (Table 5). Additionally, as our Global Commodities team notes, Brent oil
prices averaged $109 this year, almost exactly in-line with both 2011 and 2012
levels despite many instances of geopolitical instability and macro uncertainty.
Similarly, we do not expect oil prices to collapse, and our commodities team
forecasts Brent will average $105 in 2014.
Table 5: Asset returns during oil price spikes
Oil spike episodes
% increase
Brent Crude
Arab Oil Embargo (1973)
237%
Iranian Revolution (1978)
59%
Iran-Iraq War (1980)
22%
Iraqi- Kuwait (1990)
154%
Venezuela unrest (2002)
44%
Libya Crisis (2011)
40%
Median
52%
Absolute Performance % (Total Return)
Duration of
increase
12w
22w
8w
14w
16w
8w
T-bill
AAA Corp
10yr UST
US equities
1.90%
4.00%
2.30%
1.80%
0.40%
0.00%
-0.70%
1.20%
-3.90%
0.20%
6.10%
1.10%
-1.80%
0.60%
-2.90%
0.20%
4.50%
1.40%
-2.80%
9.80%
12.90%
-15.50%
-8.40%
-1.50%
13w
1.90%
0.70%
0.40%
-2.10%
Source: BofA Merrill Lynch Global Investment Strategy, Bloomberg, Global Financial Data
17
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
S&P 500 outlook: 2014 target = 2000
Our target framework incorporates diverse signals
Our S&P 500 targets of 1750 for 2013 year-end and 2000 for 2014 are principally
based on our fair value model, but if the last fifteen years have taught us
anything, it is that fundamentals sometimes take a backseat to sentiment,
technicals and macro. As such, we have explicitly incorporated tactical, technical
and sentiment signals into our market forecast.
Table 6: S&P 500 2014 Target Models
Table 7: BofAML Fair Value Model (2014)
Normalized 2014 EPS
Normalized EPS Growth (Nominal Ke - Div Yld)
Normalized 2015 EPS
Nominal Long-Term Risk-Free Rate
- Assumed Long-Term Inflation
= Normalized Real Risk-Free Rate
+ Equity Risk Premium
= Fair Real Cost of Equity Capital (Ke)
Fair Forward PE (1 ÷ Fair Ke)
2014 Target (Fair PE × Normalized 2015 EPS)
$107.50
5.74%
$114
3.50%
2.00%
1.75%
400bp
5.75%
17.4x
1,977
Source: BofAML US Eqtuiy & Quant Strategy
Expected
Current
Return
Weight in
Model
Category
Time Horizon 2014 Target (Annualized) Forecast
BofAML Fair Value Model Fundamental/Valuation Medium Term
1,977
+9.2%
40%
Sell Side Indicator
Sentiment
Medium Term
2,146
+16.7%
20%
Estimate Revisions
Fundamental/Sentiment
Short-term
2,019
+10.7%
20%
Long-term Valuation Model
Valuation
Long-term
1,995
+9.6%
10%
12-Month Price Momentum
Technical
Medium Term
1,949
+7.5%
10%
Official S&P 500 Target
2,000
We maintain our target based on increments of 50pts on the S&P 500.
Short-term can be interpreted as one to three months, medium-term as one year, and long-term as five or more years.
Source: BofA Merrill Lynch US Equity & US Quant Strategy
#1: BofAML Fair Value Model
Chart 20: Normalized EPS yield & risk-free rate

A 17.4x multiple on normalized 2015E EPS of $114 suggests a 2014 yearend fair value of 1977.

The fair forward normalized PE multiple of 17.4x is based on a 60bp decline
in the ERP from current levels to 400bp (Chart 21), partially offset by a 40bp
higher normalized risk-free rate. This would imply a 0.5pt multiple increase
on normalized earnings. This compares to the historical average forward
normalized PE ratio of 18.2x, and we note that normalized real interest rates
are still less than half the historical average of the past 35 years.
12%
10%
8%
6%
4%
Falling equity risk premium offsetting rising risk-free rates
2%
0%
'87 '90 '93 '96 '99 '02 '05 '08 '11 '14
Normalized Earnings Yield
Real Normalized Risk-Free Rate
Source: BofAML US Equity & Quant Strategy, FRB, S&P, BLS
In economics, things take longer than
you think they will, and then they
happen faster than you thought they
could.
– Rüdiger Dornbusch
18
The equity rally this year has been primarily driven by multiple expansion, with the
forward PE multiple on the S&P 500 expanding from 12.6x to 14.9x (18%). In our
fair value model, we focus on the normalized forward PE multiple, which has also
risen from 14.3x to 16.9x (18%). This multiple expansion has predominantly been
a function of the 180bp decline in the equity risk premium (ERP), partially offset
by the 70bp rise in real normalized interest rates. This rapid ERP compression
reflects the reality that many of the major uncertainties overhanging the market
have been removed or significantly diminished (US election, fiscal cliff,
sequestration, Eurozone collapse, China hard landing).
But at 460bp, the ERP is currently still well above the sub-400bp levels preceding
the Financial Crisis, and we think it should continue to decline over the next
several years as the memory of the Financial Crisis fades and corporate profits
continue to make new highs. We expect the “wall of worry” to persist as new
concerns emerge, but visibility is clearly improving and we still expect global
growth to pick up over the next several quarters.
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
Chart 21: Normalized equity risk premium
1,000
Financial Crisis
Euro Crisis, Fiscal
Cliff/Election
800
600
Average (ex-Tech
Bubble) = 340bp
400
200
Equity Fear
Equity Optimism
0
-200
Tech Bubble
'87 '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14
Source: BofAML US Equity & Quant Strategy, Federal Reserve Board, Standard & Poor’s, BLS
Note: Normalized ERP is calculated as the spread between the normalized EPS yield and normalized real risk-free rate, where normalized EPS is
based on a log linear regression of S&P 500 operating EPS and the normalized risk-free rate is the difference between (1) the average of the 30-yr
Treasury yield and the 5-yr rolling average 10-yr Treasury yield and (2) the 10-yr TIPS spread and the 5-yr rolling average CPI inflation rate.
Falling EPS volatility is bullish for long-term equity returns
The rise in the equity risk premium over the last cycle was partially justified by the
rise in earnings volatility to unprecedented levels (Chart 22). This caused asset
allocators to reduce exposure to equities. But as growth reverts to trend, as it
already has, the decline in earnings volatility should cause the equity risk
premium to re-rate lower.
Chart 22: Rolling 3-Yr Std Deviation of SP500 12-Mth Rep EPS Gth (2Q40-2Q13)
350%
Rolling 3-Yr Std Deviation of
Y/Y EPS Growth for SP 500
300%
250%
200%
150%
100%
50%
0%
40 44 48 52 56 60 64 68 72 76 80 84 88 92 96 00 04 08 12
Source: BofAML US Equity & Quant Strategy
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US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
#2: Sell Side Indicator
Table 8: S&P 500 total return post-SSI troughs
1989
1990
1995
1997
2004
2009
2012
Avg
Min
Max
3m
12.8%
14.2%
10.1%
2.9%
9.2%
13.8%
3.0%
9.4%
2.9%
14.2%
6m
11.9%
25.6%
21.0%
17.2%
6.9%
20.0%
9.9%
16.1%
6.9%
25.6%
12m
10.5%
33.4%
38.6%
9.0%
12.2%
38.8%
25.0%
24.0%
9.0%
38.8%
24m
29.9%
46.7%
75.1%
39.3%
24.3%
62.7%
?
46.3%
24.3%
75.1%
Wall Street Sentiment: don’t follow the crowd

Wall Street’s consensus equity allocation has been a reliable contrary
indicator over time. In other words, it has been a bullish signal when Wall
Street strategists were extremely bearish, and vice versa.

Despite the rebound since hitting an all-time low of 43.9 in July 2012 (based
on data since 1985), strategists’ bearishness on equities remains depressed
relative to history. At 52.8, the indicator remains in “Buy” territory.

Even though the S&P 500 has already risen 31% since sentiment bottomed,
historical returns have also been very robust in the subsequent 12 and 24
months after the indicator troughed, averaging 24% and 46%, respectively
(Table 8).

Historically, when our indicator has been this low or lower, total returns over
the subsequent 12 months have been positive more than 95% of the time,
with median 12-month returns of +27%. Current bearish sentiment suggests
+17% 12-month price returns.
Source: BofAML US Equity & Quant Strategy, S&P, Bloomberg
Table 9: Predictive power of selected indicators
forecasting 12-month S&P 500 returns
Indicator
R2
Sell Side Indicator
S&P 500 Dividend Yield
Proforma PE
Adj. Fed Model (EPS Yld - Real 10-Yr Tsy Yld)
10-Yr Treasury Yield
M2 Growth
3-Mo T-Bill Rate
Yield Curve (10-Yr - 3-Yr)
Fed Model (EPS Yield - 10-Yr Treasury)
BBB to Treasury Spread
GAAP PE
M1 Growth
28%
13%
12%
4%
3%
2%
1%
0%
0%
0%
0%
0%
Source: BofA Merrill Lynch US Equity and US Quant Strategy, Bloomberg,
Haver, Citigroup, Federal Reserve Board, Standard & Poor's
For further details, please see our most recent monthly Sell Side Indicator report.
Chart 23: Sell Side Consensus Indicator (as of 31 October 2013)
71
69
67
65
63
61
59
57
55
53
51
49
47
45
43
Current Statistics:
EXTREME BULLISHNESS
BEARISH FOR STOCKS
Latest = 52.8%
15-Year Average = 60.4%
Sell Threshold = 66.2%
Buy Threshold = 54.5%
EXTREME BEARISHNESS
BULLISH FOR STOCKS
'85
'87
'89
'91
'93
'95
'97
'99
'01
'03
'05
'07
'09
'11
'13
Source: BofA Merrill Lynch US Equity & Quant Strategy
Note: Buy and Sell signals are based on rolling 15-year +/- 1 standard deviations from the rolling 15-year mean. A reading above the blue line
indicates a Sell signal and a reading below the red line indicates a Buy signal.
#3: Estimate Revisions Model
Estimate revisions: Rising
20

We track the ratio of upward to downward changes to consensus earnings
and revenue estimates, and for management, we track the ratio of upward to
downward guidance relative to consensus expectations.

Market returns have displayed predictable patterns based on whether analyst
estimates are rising or falling.

At 1.0, the 3-month estimate revision ratio (ERR) is currently above its
historical average (Strong).

Historically, when the indicator has been above its historical average, the
S&P 500 has risen 1.7% over the next two months (10.7% annualized).
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
Chart 24: ERR vs. annualized forward 2m returns (1986-present)
Avg forward 2m price
returns (annualized)
12%
Chart 25: S&P 500 Earnings Estimate Revision Ratio – 10/2013
2.5
+11%
10%
2.0
8%
1.5
+6%
6%
1.0
4%
0.5
2%
0%
Strong
86 88 90 92 94 96 98 00 02 04 06 08 10 12
Weak
3-month ERR
Source: BofA Merrill Lynch US Equity & US Quant Strategy
Cumulative long-term average
Source: BofA Merrill Lynch US Quantitative Strategy, I/B/E/S
#4: Long-term valuation model
Valuation: If you’ve got a while
Price to normalized earnings has a very strong relationship to subsequent
returns over the long haul.
The strongest relationship between PE and subsequent market returns is
that with a 10-year holding period. Based on a simple regression, the PE
ratio explains ~85% of the variability of annualized returns for the subsequent
10 years.
The S&P 500’s current trailing normalized PE ratio of 17.8x suggests a 12month price return of 10%.



Chart 26: Normalized PE’s predictive power on S&P 500 returns
R2 of Norm. P/E vs. Subs. Returns
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Variability of Returns Explained by Price to Normalized EPS
(R-Squared of Normalized P/E vs. Subsequent S&P 500 Returns)
0
1
2
3
4
5
6
7
8
9
10
11
12
Holding period (# of years)
Source: BofA Merrill Lynch US Equity and US Quant Strategy
#5: 12-month Price Momentum Model
Reversion to the mean: suggests above-average returns



Our technical model is based on the often cited theory that equity returns
ultimately revert to some “normal” level.
We have found that there is a higher probability of a market correction
following a year of outsized equity market returns, and vice versa.
We simply use the last 12 months’ return to calculate the number of standard
21
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3

deviations above or below average to forecast the next 12 month’s return.
The S&P 500 trailing 12-month return was 18% as of month-end June 2013.
This is 0.6 standard deviations above the historical average, and the model
thus yields a projected 12-month return of 7%.
Table 10: Past returns vs. forward returns
Median 12-Month Return
Standard Deviation of 12 Month Returns
Probability of Negative Returns
Percent of observations
<-2 Std
Dev
23%
19%
19%
3%
Source: BofA Merrill Lynch US Equity and US Quant Strategy
22
-1 to -2
Std Dev
14%
20%
26%
14%
-1 to +1
Std Dev
10%
16%
27%
34%
0 to +1
Std Dev
8%
15%
31%
36%
+1 to +2 +2 or More
Std Dev Std Dev
9%
5%
14%
13%
23%
50%
12%
1%
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
EPS Outlook: modest acceleration in 2014
Our 2014 EPS forecast of $118 implies modest acceleration in EPS growth from
6% in 2013 to 7% in 2014, in line with long-term trend growth of 6-7%. While we
expect global economic growth to accelerate in 2014, growth will continue to be
hampered by global fiscal austerity with limited scope for significant incremental
monetary easing. We expect healthy balance sheets and attractive valuations to
continue to drive share repurchases, which should offset any currency headwinds
from a stronger US Dollar. And while we do not expect margins to collapse unless
we see a recession, we also do not expect significant margin expansion from
current levels.
Chart 27: 2014 BofAML Strategy vs. Consensus
-8.0% -6.0% -4.0% -2.0% 0.0%
Energy
Utilities
Technology
Industrials
Financials
Health Care
Materials
Consumer Staples
Telecom
Cons. Discretionary
-1.3%
-1.5%
-2.5%
-2.5%
-2.8%
-3.3%
-3.4%
-3.7%
-4.4%
-5.3%
We are below consensus for every sector
The bottom-up consensus reflects a generally more optimistic view of this year’s
earnings outlook across every sector (Chart 27). The biggest differences are for
Consumer Discretionary (-5%), Telecom (-4%) and Consumer Staples (-4%). This
generally reflects more modest consumption growth expectations and heightening
competition in Telecom. On average, Wall Street equity strategists (top-down) are
forecasting S&P 500 pro forma EPS of $108.83 for 2013 and $115.76 for 2014,
implying EPS growth of 5% and 6%, respectively. As is typically the case, these
top-down forecasts are below those based on the aggregate consensus EPS
forecasts of the S&P 500 constituents (bottom-up), which are currently $109.49
(+6%) and $121.74 (+11%), respectively. That puts us between the top-down and
bottom-up consensus for 2014 and above both for 2013.
Source: BofAML US Equity and Quant Strategy, First Call
Table 11: S&P 500 EPS Outlook
All earnings based on current constituents unless
specified
2007A
2008A
2009A
2010A
2011A
2012A
S&P 500 Pro-forma EPS (Historical Index)
$85.12
$65.47
$60.80
$85.28
$97.82
$103.80
S&P 500 Pro-forma EPS (Current Constituents)
Sector ($ billions)
Consumer Discretionary
Consumer Staples
Energy
Financials
Health Care
Industrials
Information Technology
Materials
Telecommunication Services
Utilities
S&P 500
S&P 500 ex. Financials
S&P 500 ex. Energy and Financials
Energy Sector ($bn)
Avg. Oil Price ($/bbl)
S&P 500 Dividends (Current Constituents, $)
Key Macro Economic Forecasts
Global GDP growth (real)
US GDP growth (real)
US Civilian Unemployment Rate
FX Rate: US$/Euro (average)
$88.97
$69.24
$63.28
$87.64
$98.40
$103.60
55.6
42.9
48.7
79.6
87.1
90.3
64.9
73.1
73.0
77.8
82.4
83.3
122.3
145.8
64.8
97.9
134.0
124.7
153.3
(18.6)
59.8
129.3
128.5
159.1
84.7
90.3
93.3
106.6
113.9
115.0
85.5
80.9
55.7
74.7
91.1
95.5
98.3
100.0
100.3 148.9
173.7
184.8
27.2
26.3
13.1
30.5
33.2
29.5
24.7
24.9
20.4
21.3
21.1
22.4
26.0
27.1
26.9
28.6
30.3
30.0
742.5
592.6
555.9 795.1
895.4
934.7
589.2
611.2
496.1 665.8
766.9
775.5
466.9
465.5
431.3 567.9
632.9
650.8
122.3
145.8
64.8
97.9
134.0
124.7
$72/bbl $100/bbl $62/bbl $80/bbl $106/bbl $106/bbl
$27.16 $26.38 $22.20 $23.15 $27.59
$32.82
5.3%
2.14%
4.6%
1.37
2.8%
0.44%
5.8%
1.47
-0.7%
-2.60%
9.3%
1.39
5.0%
2.9%
9.6%
1.33
3.8%
1.80%
8.9%
1.39
3.1%
2.20%
8.1%
1.29
Bottom-up
Consensus
2013
2014
$109.49 $121.74
99.4
85.9
116.2
187.2
118.0
98.9
185.3
30.0
23.2
30.8
974.9
787.8
671.6
116.2
112.8
94.7
130.2
207.3
127.8
108.4
204.5
35.5
26.3
32.0
1,079.6
872.3
742.1
130.2
BofAML US Strategy Forecast
2013
y/y
2014
y/y
$110.00
6%
$118.00
7%
98.6
9%
106.9
8%
86.2
3%
91.3
6%
116.5
-7%
128.5 10%
189.1 19%
201.4
6%
118.5
3%
123.6
4%
99.2
4%
105.7
7%
187.0
1%
199.5
7%
29.8
1%
34.3
15%
23.3
4%
25.2
8%
30.7
2%
31.5
3%
978.7
5%
1,047.8 7%
789.7
2%
846.4
7%
673.2
3%
717.9
7%
116.5
128.5
~$102/bbl
~$101/bbl
$35.75
9%
$39.00
9%
2.9%
1.7%
7.5%
~1.33
3.5%
2.6%
7.0%
~1.28
Source: BofA Merrill Lynch US Equity & US Quant Strategy, FactSet, First Call, Compustat
23
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
Short-term themes
Chart 28:High growth, high yield and the middle
Ann. perf (12/31/2010 – today)
17%
15%
13%
11%
High Growth The Middle High Yield /
/ No Yield
No Growth
Note: Based on performance of S&P 500 companies with LTG >1 Standard
deviation above S&P 500 for High Growth No Yield. High Yield/No Growth
based on dividend yield>S&P 500 avg. and LTG<S&P 500 avg.
Source: BofAML US Equity & US Quant Strategy
1)
Fade the tails, buy the middle
2)
Self-help / turnarounds
3)
Cyclical, GDP-sensitive stocks
4)
Foreign diversification
5)
Sell low beta
1) Fade the tails, buy the middle
The last few years have been accompanied by leadership from the tails of the
equity duration spectrum: short duration equities, namely high coupon ex-growth
stocks, or bond surrogates; and long duration equities, namely high growth, low
current earnings companies like biotechnology, smaller higher growth technology
companies and the like (Chart 28). This is not surprising given that the attributes
that those tails represent, namely yield and growth, respectively, have been
scarce for the last several years.
The hybrids: half growth / half yield
As interest rates pick up and the economy accelerates, we believe investors
should shed the extremes of high yield or high growth and move to the middle –
hybrid half-growth / half yield stocks. It may be too early in the rising rates cycle to
ignore equity yield, but we expect investors will move down the yield spectrum
into less expensive and less rate-sensitive stocks, and a pickup in GDP growth
should drive investors out of expensive secular growth into more attractively
valued cyclical growth. We also continue to like multinationals as Europe exits its
recession. Note that while European equities have run significantly, US stocks
with global exposure are still at record cheap levels – this attractive entry point
may be fleeting. But as interest rates begin to rise, bond surrogates could grow
less attractive, and as the economy begins to recover, investors may see less
expensive opportunities to buy growth via cyclical rebounds.
Yield still matters
Few asset classes offer stronger income
potential than US equities: cash balances
of the S&P 500 have hit record highs, but
the payout ratio of the S&P 500 has
barely budged from its century low
levels.
24
Yield could remain a sought after attribute of investments. If one subscribes to the
adage “buy what the baby boomers are buying”, they are now retiring and looking
for income: the proportion of 65+ year-olds in the US is slated to double over the
next twenty years. And few asset classes offer stronger income potential than
equities: cash balances of the S&P 500 have hit multi-decade highs, and the
payout ratio of the S&P 500 is barely budged from its century low levels. But in an
environment of rising rates and a reacceleration in US and global growth, we
prefer stocks with sustainable and/or growing yield to those with the highest
dividends yields.
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
2012
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
160%
140%
120%
100%
80%
60%
40%
20%
1988
Chart 30: S&P 500 dividend payout ratio 1900-present
1,400
1,200
1,000
800
600
400
200
0
1986
Chart 29: S&P 500 Non-Financials Cash ($mn)
Source: Compustat, BofA Merrill Lynch US Equity & US Quant Strategy
Chart 31: S&P 500 factor correlations with
changes in real interest rates (since 1998)
0.3
Avg. 54%
00 05 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 00 05 10
Source:S&P, BofA Merrill Lynch US Equity & US Quant Strategy
The highest dividend yielding stocks—which are chiefly found in Utilities,
Telecom, REITs, and Tobacco—have growth expensive vs. history, and have
been among the worst performers YTD. In fact, our High Dividend Yield factor
has turned in among the worst YTD returns of the nearly 50 factors we follow, and
trades at one of the biggest premiums to Dividend Growth stocks in its history
(Chart 32). It also has the most negative correlation of all factors we follow with
changes in real interest rates (Chart 31).
Chart 32: Relative valuation: High Dividend Growth vs. High Dividend Yield (based on
median forward P/E of top decile), 1990-present
0.2
0.1
100%
0.0
Dividend Growth More Expensive
80%
60%
-0.2
40%
Rel. Strength (30wk/75wk)
EPS Estimate Revisions
Proj. 5yr EPS Growth
Most Active
Earning Momentum
Beta
Estimate Dispersion
5yr ROE Adj
ROA
1yr ROE Adj
Price/ Cash Flow
Variability of Earnings
Low Price
Earnings Torpedo
Price/ Book Value
P/E-to-Growth
ROC
EV/ EBITDA
Neglect - Analyst Covg.
Forward Earnings Yield
Earnings Yield
Dividend Growth
1yr ROE
Small Size
5y ROE
Price/ Sales
Institutional Neglect
Share Repurchase
High Leverage
Free Cash Flow/ EV
Price/ Free Cash Flow
Dividend Yield
-0.1
Source: BofA Merrill Lynch US Equity & US Quant Strategy
20%
0%
-20%
-40%
Dividend Yield More Expensive
'90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12
Source: Compustat, First Call, BofA Merrill Lynch US Equity & US Quant Strategy
For more details on this theme, see our
report: Strategy Snippet: The next leg of
the Great Rotation 25 September 2013.
We suspect that the underperformance of high dividend yield will continue in 2014,
and recommend that investors look for less expensive stocks which still offer
competitive yields but also benefit from a cyclical recovery. As investors move down
the yield spectrum, they should stumble upon what we view as one of the best kept
secrets of the equity market: Quintile 2 by dividend yield of the Russell 1000. This
segment of the market has historically offered by highest returns and the lowest
probability of losing money over time. These “half-growth, half-yield” stocks still offer
an above-market yield but with better growth potential (Table 12), and generally
have lower payout ratios and more potential to grow their dividends over time. We
believe these stocks will likely be an attractive source of yield for Income fund
managers—who now represent nearly 40% of the actively managed pie—who are
seeking to still meet their income mandates but with less expensive and less ratesensitive yield. Additionally, many of these stocks are household names that even
the most gun-shy investor may feel comfortable owning.
25
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
Table 12: Russell 1000 Quintiles 1 vs. Quintile 2
by Dividend Yield
Quintile
Dividend Yield
LTG
Beta
4.34
2.61
5.41
9.37
17%
0.85
1.00
Source: Russell, Compustat, BofAML US Equity & US Quant Strategy
Avg 12-Mth Rolling Returns
1
2
Chart 33: The most underappreciated strategy in the equity market: Quintile 2
Russell 1000 quintiles by dividend yield: Avg. 12m rets vs. probability of loss, 1984-present
Quintile 1
(Highest)
Quintile 2
16%
Quintile 3
15%
14%
Quintile 5 (Lowest)
Quintile 4
13%
12%
No Dividend
14%
15%
16%
17%
18%
19%
20%
21%
22%
23%
24%
Risk - Probability of Loss
Source: Russell, Compustat, BofA Merrill Lynch US Equity & US Quant Strategy
2) Self-help stories
Equity valuations have approached more normal levels as macro risks have
abated. But at this point, more of the onus may be on company management to
drive continued shareholder value. 2013 saw the beginnings of this, as significant
shareholder return within the S&P 500 was driven by capital structure reengineering or operational turnarounds. For example, Best Buy (BBY), the
second best performer of 2013 so far, dramatically cut costs, ramped up their
ecommerce division to compete with on-line retailers, and engaged in other
significant operational changes. Share repurchases also drove returns in 2013:
one of the best quantitative factors in 2013 was that of buying for stocks with the
largest net share count reduction. Apple (AAPL) suffered early in 2013, but rose
from its lows after shareholder activists lobbied for more significant cash return.
Control your own destiny or someone
else will.
-Jack Welch, former CEO of GE
Shareholder activism and corporate re-tooling should remain a strong theme in
2014, as many companies remain underlevered, cash-rich, or, from an operations
standpoint, lower growth and more likely to spinout business lines that are not
complementary. Shareholder activism over the last few years remains strong but
may be trending below average levels, suggesting we could see more companydriven as well as shareholder-driven turnaround stories. Historically, we have
found that stocks with shareholder activist campaigns can be the big winners
(Table 13).
Table 13: Shareholder activism adds alpha
Unlocking value via divestitures
Stocks with announced shareholder activist
campaigns (2000 to today)
Avg. Excess % of times
Return
outperformed
Stocks vs. Industry Group
8%
49%
Stocks vs. S&P 500
12%
52%
Ironically, one driver for outperformance for large companies is that of getting
smaller via streamlining operations and spinning out divisions. In the last two
years, we have seen a pickup in instances of divestitures, with 81 companies in
the US equity market announcing spinoffs of greater than $500mn in value. We
tracked performance of parent companies with spinoffs over the last thirteen
years, and in all but two of the last 13 years, companies announcing spinoffs
outperformed the S&P 500. The average outperformance was about 7% vs. the
company’s industry group and 9% vs. the S&P 500 index. Further, in the postcrisis era, a strategy of spinning out divisions has been almost uniformly
rewarded.
Source: BofA ML US Equity Strategy. Note: Based on S&P 500 stocks with
announced shareholder activists actions since 2000. Avg. excess return
based on the company returns starting 1-mth prior to the announcement to
12-mth after the announcement.
26
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
Chart 34: Post spin-off performance of parent vs. industry group
Chart 35: Post spin-off performance of parent company vs. S&P 500
60%
70%
60%
80%
50%
60%
50%
70%
50%
40%
60%
30%
50%
20%
40%
10%
30%
0%
20%
40%
30%
40%
20%
30%
10%
20%
0%
-10%
-20%
Excess return
10%
Hit ratio, rhs
'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12
Avg. excess return of the parent company vs. its industry group
starting 1-mth prior to the announcement to 12-mth after the
announcement
0%
-10%
-20%
Excess return
10%
Hit ratio, rhs
'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12
0%
Avg. excess return of the parent company vs. S&P 500 starting 1mth prior to the announcement to 12-mth after the announcement
Source: BofA Merrill Lynch US Equity and Quant Strategy
Source: BofA Merrill Lynch US Equity and Quant Strategy
Capital structure – buybacks and debt issuance
Given the still wide valuation gap between equities and fixed income, stock
buybacks may continue to make sense in many cases. This strategy has been
rewarded handsomely over the last 3 years – note that companies with the
largest net share count reduction outperformed the market by 36ppt points since
January of 2011 (Chart 36). This strategy may begin to taper off in efficacy given
that (1) valuations have risen, and (2) the majority of cash use over the last few
years has been via buybacks suggesting that buying back stock is the norm
rather than the exception. But on a case by case basis, we think this still makes
sense for corporations. We would continue to seek out companies most likely to
repurchase shares that are still trading at attractive valuations.
Chart 36: Top decile of S&P 500 by Share Repurchases
200
190
180
170
160
Equal-Weighted Relative Cumulative Performance vs.
Equal-Weighted S&P 500
150
140
130
June 1989 = 100
120
110
100
90
Backtested Actual
86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13
Note: The shaded portion represents backtested performance from month-end March 1986 to month-end December 2004. The unshaded portion
represents actual performance since January 2005. Backtesting is hypothetical in nature and reflects application of the screen prior to its introduction.
It is not intended to be indicative of future performance. Please see Appendix for performance data and performance calculation methodology.
Source: BofA Merrill Lynch US Equity & US Quant Strategy
27
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
3) Buy GDP-sensitive stocks
Chart 37: BofAML Forecasts for US GDP
Growth (QoQ %SAAR)
Over the last several years, investors have shunned cyclicals and paid increasing
premiums for secular growth stocks (Biotech, internet stocks, etc.), which have
become expensive and crowded. We believe stocks that are most tethered to
cyclical growth should outperform as US GDP growth picks up in 2014. BofAML
economists expect US GDP growth to accelerate from 1.7% in 4Q13 to over 3%
by the end of 2014. Our overweight sectors of Industrials, Tech and Energy have
the highest sensitivity to GDP growth (Table 14).
3.5
3.0
2.5
2.0
1.5
Table 14: Sectors sensitivity to and correlation with US GDP Growth, 1995-present
Sector
Slope (GDP Beta)
Correlation
Combined Rank
1.0
0.5
0.0
Industrials
Tech
Energy
Financials
Health Care
Discretionary
Materials
Staples
Utilities
Telecom
1Q 132Q 133Q 134Q 131Q 142Q 143Q 144Q 14
Source: BofA Merrill Lynch Global Research
1.7
2.3
1.6
1.8
1.2
1.4
1.3
1.1
0.9
0.9
45.2%
40.5%
43.4%
37.4%
40.8%
37.3%
31.3%
37.3%
27.0%
21.0%
1
2
3
4
5
6
7
8
9
10
Source: S&P, BEA, BofA Merrill Lynch US Equity & US Quant Strategy
4) Buy multinationals, sell US-centric stocks
Chart 38: 3-month earnings revision ratio for
top decile of S&P 500 by high foreign exposure
vs. pure domestics
1.4
1.0
0.8
0.6
3-month ERR
1.2
Jul-12
Aug-12
Sep-12
Oct-12
Nov-12
Dec-12
Jan-13
Feb-13
Mar-13
Apr-13
May-13
Jun-13
Jul-13
Aug-13
Sep-13
Oct-13
0.4
Pure Domestics
High Foreign Exposure
Source: BofA Merrill Lynch US Equity & US Quant Strategy
28
0.2
A few years ago, we wrote a note called “Back to the USA” arguing that the more
domestically-focused stocks within the S&P 500 looked attractive, as they were
inexpensive, underowned, and were likely to hold up better than those exposed to
the rest of the world. Indeed, stocks more sensitive to growth outside of the US
saw their earnings estimates slashed, and the top 50 stocks by overseas sales
exposure underperformed the S&P 500 by 8ppt in both 2011 and 2012, while
homebuilders, regional banks and other US-centric areas of the market
outperformed. In 2013, we changed our call as our reasons for preferring purely
domestic stocks had reversed, and continue to prefer multinationals for 2014 (as
first outlined in our 2013 Year Ahead).
US large cap active managers are underweight foreign-exposed stocks, and
relative valuations suggest the most attractive entry point to buy multinationals that
we have seen in at least a decade (Chart 39). Meanwhile both US and global
growth are slated to reaccelerate over the coming quarters, and the most foreignexposed stocks in the S&P have seen improving estimate revisions. In fact, the 3month earnings revision ratio for the most globally-exposed stocks is at its highest
level in 16 months, while pure domestics have recently seen revisions deteriorate
(Chart 38). Additionally, US housing data has begun to surprise to the downside,
and we think upside surprises in economic data are more likely to come from
outside the US.
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
Chart 39: Relative EV/Sales of S&P 500 top decile by foreign exposure vs. pure domestics
1.80
1.60
1.40
1.20
1.00
01
02
03
04
05
06
07
08
09
10
11
12
13
Relative EV/Sales (High Foreign Exposure vs. Pure Domestics)
Source: WorldScope, Compustat, BofA Merrill Lynch US Equity & US Quant Strategy
5) Sell low beta stocks
Chart 40: Change in beta (1yr vs. 5yr) by sector
< Less risky
More risky->
Telecom Svcs
Utilities
Staples
Energy
Discretionary
Technology
Health Care
Industrials
Materials
Financials
-0.3 -0.2 -0.1 0
0.1 0.2 0.3
Source: FactSet, BofA Merrill Lynch US Equity & US Quant Strategy
Over the last several years, investors have sought out “safety”, paying up for low
beta stocks in sectors such as Telecom and Utilities that also offer high dividend
yields. As Chart 40 shows, the lowest beta companies in the S&P 500 have been
trading at a premium to the highest beta companies for the last fifteen years. We
expect this “low beta bubble” will soon deflate, particularly as rates continue to
rise and the Fed pulls back from easing. We note that beta is a backward-looking
measure, and the 5-year (60-month) beta that many investors use to evaluate
stocks may soon change dramatically, given that low-beta stocks have not
behaved like low beta stocks in recent years. In fact, an analysis of the 5-year vs.
1-year beta of the 10 GICS sectors in the S&P 500 reveal that Telecom and
Utilities—the two lowest beta sectors—have become more risky, with the biggest
difference between their one-year and five-year betas. We think buying stocks
with low “fundamental betas” is more prudent, particularly for the long-term; see
our discussion on this later in this section.
Chart 41: Relative Forward (Next Year Est.) P/E by Low Beta vs. High Beta S&P 500 Stocks
2.0
1.8
1.6
1.4
1.2
1.0
0.8
0.6
0.4
86
88
90
92
94
96
98
00
02
04
06
08
10
12
High Beta Quintile Next Year Est P/E Relative to the S&P 500
Low Beta Quintile Next Year Est P/E Relative to the S&P 500
Source: BofA Merrill Lynch US Equity & US Quant Strategy
29
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
Long-term themes
1)
Stocks over bonds
2)
Large caps over small caps
3)
High quality, cash-rich companies
1) Stocks over bonds
Chart 42: S&P 500 dividend payout ratio (1900present)
40%
We believe bonds, which have prices inversely related to rates, will underperform
equities over the course of the next cycle. In particularly, beneficiaries of rising
rates, such as Tech and Industrials stocks, are likely to fare best. While bonds
offering a fixed yield will be increasingly less attractive as rates rise, US equities
have great potential to grow their dividends—the S&P 500 payout ratios has
barely risen from all-time lows, and remains significantly below its long-term
average (Chart 42). And a still-elevated equity risk premium suggests that on a
valuation basis, equities are very attractive relative to bonds (Chart 43). This is
also reflected in our normalized equity risk premium (see Chart 21).
20%
Chart 43: S&P 500 Risk Premium (DDM Expected Return less AAA Corp. Bond Yield)
140%
120%
100%
Avg. 54%
80%
2010
2000
1990
1980
1970
1960
1950
1940
1930
1920
1910
1900
60%
Basis Points
Source: S&P, BofA Merrill Lynch US Equity & US Quant Strategy
1000
900
800
700
600
500
400
300
200
100
0
Current: 662
Long-Term Average: 439
81
83
85
87
89
91
93
95
97
99
01
03
05
07
09
11
13
Source: BofA Merrill Lynch US Equity & US Quant Strategy
We think the “Great Rotation” out of bonds and into equities has only just begun, as
while global equities have seen $234bn in inflows this year vs. just $17bn for bonds,
inflows into equities since 2009 are still significantly below bonds (Chart 44).
Chart 44: Cumulative flows into global equities vs. bonds, 2009-11/13/13
800
Equities
700
Bonds
$696bn
$ Billions
600
500
$359bn
400
300
200
100
0
-100
09
10
Source: EPFR, BofA Merrill Lynch Global Investment Strategy
30
11
12
13
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
2) Large caps over small caps
Chart 45: S&P 500 Trailing P/E, 1960-present
35
30
25
20
Avg = 16x
15
10
5
60 65 70 75 80 85 90 95 00 05 10
Source: BofA Merrill Lynch US Equity & US Quant Strategy
Over the past three and a half decades, smaller caps—which are generally more
leveraged and thrive on access to cheap capital—have outperformed large caps
by 1.2ppt/year on average. The most recent and consistent streak of
outperformance has lasted since the late ‘90’s (Chart 46)—the same period
during which low quality stocks have traded at a premium to high quality stocks
(more on this below). Monetary and fiscal stimulus coupled with falling rates
caused investors to take on more risk, driving up the valuations for small caps to
now trade near all-time highs (Chart 47). In contrast, we think large caps still look
attractive across valuation metrics, and forecast modest P/E expansion as the
S&P 500 returns 11% from current levels.
Chart 46: Relative performance of small caps(Russell 2000) vs. large
caps (S&P 500), 12/31/78-present
Chart 47: Small cap valuations are near all-time highs
25.0
180
Absolute Trailing P/E
160
20.0
140
120
15.0
100
10.0
80
60
78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12
Russell 2000 vs. S&P 500
Source: Bloomberg, BofA Merrill Lynch US Equity & US Quant Strategy
5.0
1Q79 1Q83 1Q87 1Q91 1Q95 1Q99 1Q03 1Q07 1Q11
.
Source: BofA Merrill Lynch US Equity Small Cap Strategy
3) High quality, cash-rich companies
Chart 48: Net Debt to Market Cap: S&P 500 ex.
Financials vs. Russell 2000 ex. Financials
60
50
40
30
20
10
0
88 90 92 94 96 98 00 02 04 06 08 10 12
Small Caps
Large Caps
Over the last one to two decades, high quality companies—those with greater
earnings stability—have traded at a persistent discount to low quality companies
with high earnings volatility that likely thrived on access to inexpensive capital
(Chart 49). Every time this gap narrowed, some form of stimulus (rate cuts, QE, etc)
caused the valuation gap to re-widen. As stimulus is withdrawn, we believe lower
quality companies will see multiples compress, while higher quality companies
could re-rate higher. Additionally, we like companies with strong balance sheets and
high cash balances that can fund their own growth---this supports our preference for
large caps over small caps, as well as our preference for US multinationals. As
Chart 48 shows, S&P 500 non-Financials leverage is at an all-time low, while small
caps are more levered. And cash to market cap for the S&P 500 remains near alltime highs (Chart 50).
Source: Compustat, BofA Merrill Lynch US Equity & US Quant Strategy
31
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
Chart 49: Relative forward P/E of high quality (B+ or better) vs. low quality (B or worse)
stocks sine 1987
Fed rate cut
Chart 50: S&P 500 ex. Financials Cash/Mkt Cap
14%
1.3
12%
1.2
10%
Gov't
bailout
Fiscal
Stimulus
QE2
LTRO
QE3
1.1
8%
6%
1.0
4%
0.9
2%
0%
B+ or Better
B or Worse
0.8
86 88 90 92 94 96 98 00 02 04 06 08 10 12
Cash/Mkt Cap - S&P 500 ex. Fins.
87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13
Source: S&P, I/B/E/S, BofA Merrill Lynch US Equity & US Quant Strategy
Source: Compustat, BofA Merrill Lynch US Equity & US Quant Strategy
A fundamental mispricing of risk
Our overweight sectors of Tech, Industrials and Energy all currently have high
price betas, but we believe these sectors may be unfairly penalized as being too
risky. Based on the “fundamental betas” (earnings volatility) of the ten sectors,
these three sectors (along with Consumer Staples) show up as the least risky,
particularly Industrials. In contrast, the defensive sectors of Telecom and Utilities
have the lowest price betas, but among the most risky earnings. And as noted
above, price movement over the last year would suggest that betas for the more
cyclical sectors are likely to decline, while Telecom and Utilities are likely to
become higher beta. We think investors can exploit this mispricing of risk by
buying our overweight sectors of Tech, Industrials and Energy, and selling our
underweight sectors of Utilities and Telecom.
Chart 51: Price Risk (Beta) vs. Earnings Risk for S&P 500 Sectors
1.80
Price risk: Beta (5-year)
1.60
Financials
Risk overestimated
1.40
Materials
Industrials
1.20
Energy
Cons. Disc.
Tech
1.00
S&P 500
0.80
Health Care
0.60
0.40
Risk underestimated
Cons. Staples
Telecom
Utilities
10%
15%
20%
25%
30%
35%
40%
45%
50%
EPS risk: % Low Quality (B or Worse) Stocks (Cap-Wtd)
Source: S&P, FactSet, BofA Merrill Lynch US Equity & US Quant Strategy
32
55%
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
Sector preferences
Our sector preferences generally align with our themes, as we remain overweight
Tech, Industrials and Energy—three globally-oriented sectors which should benefit
from a pick-up in global growth. We are underweight the defensive bond-proxy
sectors of Utilities and Telecom, which are likely to underperform in a rising rate
environment, as well as Consumer Discretionary, which we downgraded to
underweight in August. For our marketweight sectors, our positioning remains as
we advised going into 2013. We expect some of the shifts we have observed in
market leadership in the latter half of this year to continue into 2014, as we enter a
new regime of rising rates, tighter monetary policy, and fiscal austerity.

Overweight: Tech, Industrials, Energy

Marketweight: Health Care, Consumer Staples, Financials, Materials

Underweight: Consumer Discretionary, Utilities, Telecom
Overweight Technology, Industrials, Energy
Reasons
•
•
•
•
•
•
to overweight Tech:
Healthy balance sheets
Outperforms when rates rise
Attractive valuations
High foreign exposure
Dividend growth and cash
deployment potential
High quality despite high beta
The sector is still trading near all-time
low valuations.

All three of these sectors benefit from many of our favorite themes:

Cyclicality and foreign exposure position them to benefit from improving
growth outside the US.

Despite their cyclicality, the companies in these sectors are generally higher
quality (less earnings volatility) and trading at cheaper valuations than other
cyclical sectors as well as the more traditional defensive sectors.

Strong balance sheets and cash flows, along with low payout ratios give
them the flexibility to return cash to shareholders, invest in growth/innovation
and make strategic acquisitions.

Tech and Industrials tend to outperform in rising interest rate environments.
Overweight Technology: our preferred overweight
No sector exemplifies our favored themes more than Technology. It trades at the
steepest discount to history, has the cleanest balance sheets (the only sector with
more cash than debt), has the highest foreign exposure, is buying back the most
stock and is growing its dividends the fastest. It has also historically outperformed
all of the other sectors when interest rates have been rising.
Chart 52: S&P 500 Tech sector relative forward P/E, 1986-present
2.2x
Tech Relative Fwd. P/E
Average ex. Tech Bubble
2.0x
1.8x
1.6x
1.4x
1.2x
1.0x
0.8x
86
88
90
92
94
96
98
00
02
04
06
08
10
12
Source: FactSet/First Call, BofA Merrill Lynch US Equity & US Quant Strategy
33
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
S&P 500
Telecom
Utilities
Health Care
Financials
Cons. Staples
Cons. Disc.
Industrials
Materials
Tech
Tech has the highest foreign exposure in
the S&P 500, with approximately 60% of
its sales from overseas.
70%
60%
50%
40%
30%
20%
10%
0%
Energy
Chart 53: Foreign sales exposure by sector
Source: WorldScope, Company reports, BofAML US Equity & Quant Strategy
Chart 54: Net Debt (Cash) to Market Cap and Dividend Payout Ratio by Sector
Tech is the only sector in the S&P 500
with net cash, and has one of the lowest
dividend payout ratios within the S&P,
signaling it has ample room to raise
dividends and deploy excess cash.
Dividend Payout Ratio
100%
Utilities
90%
80%
70%
Staples
60%
Materials
50%
40%
Health Care
Industrials
S&P 500
Energy
Cons. Disc.
Tech
30%
20%
-20%
0%
20%
40%
60%
Net Debt (Cash) to Market Cap
80%
100%
Note: Telecom (not pictured has payout ratio >300% and net debt/market cap of 43%. Net debt/market cap for S&P 500 excludes Financials.
Source: Compustat, BofA Merrill Lynch US Equity & US Quant Strategy
Note: YTD as of 10/31/13
Source: Bloomberg, BofA Merrill Lynch US Equity & US Quant Strategy
34
Utilities
Materials
Telecom
Energy
Cons. Staples
Financials
Industrials
Health Care
Cons. Disc.
Year-to-date, Tech has had the highest
dollar amount of announced share
buybacks of all ten sectors.
120,000
100,000
80,000
60,000
40,000
20,000
0
Tech
Chart 55: Announced share buybacks by sector ($mn), YTD 2013
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
Chart 56: Dividend Growth (YoY) vs. Dividend Yield by sector
50%
Dividend Growth (YoY %)
Tech currently has the highest YoY
dividend growth of all ten sectors.
Tech
40%
30%
20%
10%
Financials
Cons. Disc.
S&P 500
Energy
Industrials
Health Care
Cons. Staples
Materials
0%
-10%
1.0%
Telecom
Utilities
1.5%
2.0%
2.5%
3.0%
3.5%
Dividend Yield (Trailing 12m)
4.0%
4.5%
5.0%
Note: Dividend growth and dividend yield based on trailing 12m dividends as of 10/31/13
Source: Compustat, BofA Merrill Lynch US Equity & US Quant Strategy
In rising rate environments, Tech has
historically outperformed.
Table 15: S&P 500 sectors’ sensitivity to changes in real interest rates (since 1990)
Sector
Slope (Interest Rate Beta)
Correlation
Information Technology
Industrials
Consumer Discretionary
Telecommunication Services
Financials
Materials
Health Care
Energy
Consumer Staples
Utilities
0.61
-0.04
-0.21
-0.29
-0.43
-0.94
-1.98
-2.05
-2.09
-4.27
2%
0%
-1%
-1%
-1%
-3%
-10%
-8%
-12%
-21%
Note; Based on regression of monthly sector returns from monthly changes in TIPS yield Jan 2003-now, Bloomberg constant maturity real 10yr yield
Jan 1997-Dec 2002, and 10yr Treasury less Livingston Survey next 10yrs inflation expectations June 1990-Dec 1996.
Source: FRB, Bloomberg, BofA Merrill Lynch US Equity & US Quant Strategy
Overweight Industrials: high quality cyclical growth
Reasons to overweight Industrials:
•
Benefits from cyclical
recovery/improving global
growth/capex recovery
•
High foreign exposure
•
Highest quality sector despite
high beta
•
Less impacted by rising rates
•
Half yield, half growth
•
Benefits from US manufacturing
renaissance
We have been overweight Industrials since last November, and year-to-date the
sector has been the third best-performer following Discretionary and Health Care.
Industrials began to outperform in the spring, and we believe outperformance can
continue in 2014 as global growth reaccelerates and Europe continues to recover.
The sector will also benefit from a pick-up in capex, and our economists forecast
business investment in equipment will grow approximately 3-4x times faster than
consumer spending by early next year. It should also benefit from US
manufacturing becoming more competitive due to lower energy costs, a
narrowing wage gap between the US and EMs, and persistently low inflation. The
sector has also become one of the most high quality sectors.
35
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
Chart 57: Consumer Spending vs. Investment in Equipment, %SAAR
Our economists expect business
investment in equipment will growth 3-4x
faster than consumer spending by early
2014.
10
8
6
4
2
0
-2
-4
-6
3Q12
4Q12
1Q13
2Q13
3Q13E
Consumer Spending
4Q13E
1Q14E
2Q14E
3Q14E
4Q14E
Equipment
Source: BofA Merrill Lynch Global Research
Industrials surprisingly has the highest
cap-weighted proportion of high quality
stocks of all 10 sectors in the S&P 500,
despite its high beta.
Table 16: Despite a high beta, Industrials has the highest proportion of high quality stocks
Percentage of Companies
Cap-Weighted
ranked B+ or Better by
Proportion of B+ or
S&P Common Stock
Better Stocks
Ranks
Beta
Industrials
Consumer Staples
Information Technology
Consumer Discretionary
S&P 500
Energy
Health Care
Materials
Utilities
Telecommunication Services
Financials
84%
84%
74%
67%
66%
63%
61%
60%
61%
50%
46%
75%
78%
43%
52%
53%
37%
58%
52%
52%
17%
40%
1.25
0.61
1.00
1.15
1.00
1.08
0.77
1.41
0.45
0.44
1.62
Source: S&P, FactSet, BofA Merrill Lynch US Equity & US Quant Strategy
Overweight Energy: we like it because nobody else does
Reasons
•
•
•
•
•
36
to overweight Energy:
Attractive valuations
Underweight by active managers
Benefits from accelerating US &
global GDP growth
High foreign sales
Half yield, half growth
Last November we upgraded Energy to overweight from marketweight, and the
index has slightly lagged the market this year (+20%), but outperformed the
defensive sectors of Staples, Telecom, and Utilities, along with Materials and Tech.
One of the reasons we like Energy is because it’s so hated—Energy carries over a
20% underweight by US large cap active managers, and also is also the most
underweight sector globally vs. history according to our Global Investment Strategy
team’s Fund Manager Survey (Chart 55). Valuations for Energy stocks are also
below historical average levels on book value, cash flow, and forward earnings, and
the sector’s performance since the crisis has entirely been driven by earnings
growth—no P/E expansion. We therefore believe risks are skewed to the upside.
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
Chart 58: November 2013 global asset class positioning relative to history*
The BofAMLGlobal Fund Manager Survey
suggests that Energy is the most
underweight sector vs. history.
Source: BofA Merrill Lynch Global Investment Strategy
Underweight Discretionary, Utilities & Telecom
What these sectors have in common is expensive valuations, low global
diversification and are the most negatively impacted by rising interest rates.
Underweight Discretionary: the expensive consensus trade
Reasons to underweight Consumer Disc:
•
Leadership overextended,
underperforms mid/late cycle
•
Valuations stretched
•
Overweight by active managers
•
Overshot improvement in claims
•
Underperforms when rates rise
(shift from spending to saving)
•
Positing more negative EPS
surprises
•
Housing data surprising to
downside
After going into the year with a marketweight on Consumer Discretionary, we
downgraded the sector to underweight in August as leadership looks overextended
(Chart 59). In our view, the sector’s valuations have overshot the fundamentals,
especially given that rising interest rates generally result in higher savings and
tighter wallets. Rising rates are also a headwind to the housing recovery as we
have already seen this year. At this point in the cycle, the sector generally cedes
leadership to mid and late cycle sectors.
Chart 59: Relative performance of Consumer Discretionary index since 1990
150
140
Mid to LateCycle
130
Mid to LateCycle
120
110
100
90
80
90
92
94
96
98
00
02
04
06
08
10
12
Cons. Disc. vs. S&P 500 relative performance
Source: S&P, BofA Merrill Lynch US Equity & US Quant Strategy
Note: Shading denotes recessions
37
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
Chart 60: Personal savings rate vs. 10yr Treasury rate, 1980-present
Chart 61: Personal savings and relative cumulative performance of
Consumer Staples vs. Consumer Discretionary, 1989-present
16
10
200
8
175
6
150
4
125
2
100
12
8
4
R-squared = 67%
75
0
0
80
84
88
92
96
Savings Rate (% of PDI)
00
89
04
08
12
10yr Treasury yield
91
93 95 97 99 01 03 05 07 09 11
Personal Savings as % of PDI (lhs)
Staples vs. Discretionary Relative Perf Index (rhs)
Source: S&P, BEA, BofA Merrill Lynch US Equity & US Quant Strategy
Source: BEA, BofA Merrill Lynch US Equity & US Quant Strategy
Chart 62: Consumer Discretionary: % of companies negatively surprising on EPS by quarter
Consumer Discretionary has seen an
increasing proportion of negative
surprises over the last several quarters.
25%
20%
15%
10%
3Q13
2Q13
1Q13
4Q12
3Q12
2Q12
1Q12
4Q11
3Q11
2Q11
1Q11
4Q10
3Q10
2Q10
1Q10
0%
4Q09
5%
Source: FactSet/First Call, B ofA Merrill Lynch US Equity & US Quant Strategy
Underweight Utilities & Telecom: the bond proxies
These stocks are expensive despite the fact they have the highest sensitivity to
rising interest rates. High payout ratios and modest earnings growth suggest their
ability to grow dividends over time may be diminishing. These sectors also have
very little exposure to improving growth outside the US. We also note that
Telecom has the worst risk/reward tradeoff of all ten sectors—see Chart 65.
Chart 63: S&P 500 Utilities sector relative forward P/E, 1986-present
Chart 64: Utilities dividend yield vs. the 10y Tsy yield, 1986-present
1.4x
300%
Utilities Relative Fwd. P/E
Average
1.2x
250%
200%
1.0x
150%
100%
0.8x
50%
0.6x
0.4x
0%
86
88
90
92
94
96
98
00
02
04
Source: FactSet/First Call, BofA Merrill Lynch US Equity & US Quant Strategy
38
06
08
10
12
86 88 90 92 94 96 98 00 02 04 06 08 10 12
Utilities dividend yield/10yr Tsy. yield
Avg. (1986-2007)
Source: Compustat, Bloomberg, BofA Merrill Lynch US Equity & US Quant Strategy
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
Chart 65: Average 12-month returns vs. probability of negative returns for S&P 500 sectors
Average 12-month return
14%
Cons. Staples
Tech
12%
Industrials
10%
Energy
Health Care
Cons. Disc.
Financials
Materials
8%
Utilities
6%
4%
Telecom
20%
22%
24%
26%
28%
30%
32%
34%
36%
38%
40%
Probability of Loss (% of negative 12-mth returns)
Note: Based on data from Feb. 1981-Dec. 2012, except for Telecom which is based on data since Dec. 1995
Source: BofA Merrill Lynch US Equity & US Quant Strategy
Marketweight Health Care
Inexpensive, surprising to the upside
Reasons
•
•
•
•
to marketweight Health Care:
Attractive valuations
Lags in cyclical recoveries
Overweight by active managers
Most government spending
exposure
We remain marketweight Health Care, has had the highest total returns in 2013
thus far, chiefly due to multiple expansion. However the sector still remains
inexpensive vs. history on forward earnings, operating cash flow, and book
value—the only sector besides Energy and Tech trading below average on all
three relative multiples. Earnings have also continued to surprise to the upside,
and this past earnings season Health Care had the highest proportion of
companies beating on both the top and bottom line (~50%).
…but risks around reform, and should lag as growth picks up
Health Care Reform is a positive for many industries given that increased coverage
will lead to greater volumes and usage of health care services and products, but
issues with the roll-out and weaker than expected enrollment trends could provide
headwinds. Sequestration also poses a continued headwind, as Health Care has
the most US government spending exposure of any sector in the S&P 500. And
despite attractive valuations, we would expect Health Care to lag in a cyclical
recovery. The sector is also overweight by large cap active managers.
Within Health Care, we prefer Pharmaceuticals as a source for inexpensive
dividend yield. Pharma is the only high-yielding sector that is still attractive vs.
history on relative forward P/E.
Chart 66: S&P 500 government spending exposure by sector—Health
Care has the most exposure
Tech,
Industrials,
Energy/Utilities
& Other
25%
Health Care
40%
Defense
35%
Source: Company reports, BofA Merrill Lynch US Equity & US Quant Strategy
Chart 67: Dividend yield vs. implied upside vs. history on relative
forward P/E—Pharma is only inexpensive high yielding industry
Implied upside on rel. fwd. P/E
Pharma is our preferred high-yielding
industry.
10%
5%
Pharma
0%
-5%
-10%
-15%
-20%
-25%
-30%
2.75%
Diversified
Telecom
HH Products
Metals &
Mining Leisure Equip &
Products
Electric Utilities
REITs
Multi-Utilities
Tobacco
3.25%
3.75%
4.25%
Dividend Yield
4.75%
5.25%
Note: All data s of month-end 10/31/13
Source: FactSet/First Call, Compustat, BofA Merrill Lynch US Equity & US Quant Strategy
39
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
Reasons
•
•
•
•
•
Marketweight Consumer Staples
to marketweight Staples:
Lags in cyclical recoveries
Globally diversified
Best risk-reward tradeoff
Attractive yield and low payout
ratio
Fairly valued vs. history
Quality and sustainable/growing yield…
We are marketweight Consumer Staples, as while it is the highest quality sector
(along with Industrials) and has good global diversification. Consumer Staples
offers the best risk-reward trade-off of all ten sectors, given it has historically
offered the highest average 12-month returns but the lowest volatility of returns
(Chart 68). It also offers attractive dividend yield but at lower valuations than
Telecom and Utilities, and a lower payout ratio (more room to raise dividends).
..but at a fair price
Within Staples, we recommend investors
avoid Tobacco, which is very stretched
vs. history on valuation.
However, the sector tends to lag in cyclical recoveries and appears fairly valued
relative to history. Of the two Consumer sectors we prefer Staples over
Discretionary, given Staples tends to outperform Discretionary in rising rate
environments (when the savings rate generally rises). Within Staples, we
recommend investors avoid Tobacco, which looks very stretched relative to
history.
Chart 68: Average 12-month returns vs. volatility of returns for S&P
500 sectors
Cons. Staples
12%
Tech
Health Care
Cons. Disc.
Energy Industrials
10%
Financials
Materials
8%
6%
4%
19%
21%
23%
25%
27%
Volatility (standard deviation) of 12-mth returns
Note: Based on data from Feb. 1981-Dec. 2012, except for Telecom which is based on data since Dec. 1995
Source: FactSet, BofA Merrill Lynch US Equity & US Quant Strategy
Reasons to marketweight Financials:
•
High dividend growth
•
Some segments benefit from
steepening yield curve
•
Credit sensitive
•
Litigation, regulatory reform
•
High beta, low quality
•
Attractive vs. history on P/B,
but expensive on fwd. P/E
•
Slowdown in housing, mortgage
refi boom over
40
Telecom
80%
70%
Materials
60%
50%
30%
29%
Utilities
90%
40%
Telecom
17%
310%
100%
Dividend Payout
Average 12-month return
14%
Chart 69: Dividend yield vs. dividend payout ratio for S&P 500
sectors
Consumer
Industrials Staples
Health Care
Cons. Disc.Tech
Financials
Energy
20%
1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 5.0% 5.5%
Dividend Yield
Source: Compustat, BofA Merrill Lynch US Equity & US Quant Strategy
Marketweight Financials
Unloved, deploying cash, benefit as long rates rise
We remain marketweight Financials, and some of the reasons we like the sector
include that it remains unloved by large cap active managers and also continues
to have strong cash deployment potential—the largest proportion of high dividend
growth stocks are currently Financials, and the sector has had the second highest
dividend growth after Tech year-to-date. Banks have cleaned up their balance
sheets, and while loan growth remains tepid, lending should continue to pick up
as credit conditions ease. With short rates likely to stay low while long rates rise
as the Fed begins to taper, banks that benefit from a steepening yield curve
should do well in 2014.
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
Chart 70: Loan growth (YoY) at all US commercial banks
15%
10%
5%
0%
-5%
-10%
80
82
84
86
88
90
92
94
96
98
00
02
04
06
08
10
12
Loan growth (y/y %)
Source: FRB, BofA Merrill Lynch US Equity & US Quant Strategy
But many headwinds remain
These positives, however, are tempered by many issues that continue to face
Financials. Regulatory reform and litigation remain continued headwinds for the
sector, and proposals for higher liquidity and short-term funding could pose a
structural headwind to margins for the large banks. Our analysts also believe that
the tailwind to earnings from lower credit costs has also reached its end, and
we’ve recently observed the estimate revision ratio for Financials appears to be
peaking. Additionally, the slowdown in US housing amid rising rates caused
weaker than expected mortgage banking revenues at many of the large banks
this past quarter, and we thus remain more cautious on banks most exposed to
mortgages/housing, as well as REITs (many of which are expensive and have
high dividend yields and should come under pressure as rates continue to rise).
Additionally, similar to Consumer Discretionary, Financials is an early-cycle
sector, and could cede leadership to the globally-oriented cyclical sectors as
growth recovers and the Fed begins to taper (and eventually tighten). Financials
trade at a premium to history on forward earnings despite remaining inexpensive
on book value. And from an earnings volatility perspective, Financials has
deteriorated in quality over the last decade, and currently just 40% of Financials
stocks are ranked B+ or better by the S&P, compared to nearly 75% of stocks ten
years ago (Chart 71), making the sector seem fairly priced by its beta.
Chart 71: Financials: % of High Quality vs. Low Quality stocks 10yrs
ago vs. now
100%
80%
1.0x
57%
0.9x
0.8x
73%
0.7x
43%
20%
0%
2002
High Quality (B+ or Better)
1.2x
1.1x
27%
60%
40%
Chart 72: S&P 500 Financials relative forward P/E, 1986-present
0.6x
0.5x
2012
Low Quality (B or Worse)
Source: S&P, BofA Merrill Lynch US Equity & US Quant Strategy
Within Financials we prefer mega-caps
with global exposure, plus Capital
Markets and Consumer Finance.
86
88
90
92
94
96
98
00
02
Financials Relative Fwd. P/E
04
06
08
10
12
Average
Source: FactSet/First Call, BofAML US Equity & US Quant Strategy
Within Financials, we prefer mega-caps with global diversification (our analysts
are similarly bullish on the large banks), Capital Markets (particularly the Asset
Managers, which should benefit from equity inflows as the Great Rotation
41
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
continues), and Consumer Finance. We would avoid REITs and companies most
tied to mortgage banking/housing. BofAML analyst Erika Najarian also notes that
not all banks benefit from a steepening yield curve, and thus we would prefer
banks that benefit from the long end of the curve rising over those with a
concentration of loans are priced more against the short end of the curve such as
home equity loans, credit card loans and C&I loans.
Marketweight Materials
Most tied to China
Reasons to marketweight Materials:
•
Globally-oriented cyclical sector
•
Most sensitive to growth in
China
•
Fairly valued vs. history
•
Risk appears fairly priced – high
price beta and high earnings
volatility
We remain marketweight Materials, the other globally-oriented cyclical sector
besides Tech, Industrials and Energy. Yet in contrast to those sectors, Materials
is much more sensitive to China’s economy, where our economists expect GDP
growth will decelerate slightly in 2014 to 7.6% from 7.7% in 2013. We found that
Materials stocks are more correlated to Chinese equities than any other sector
(Table 17), particularly the Metals & Mining industry (Chart 73). Better than
expected growth in China would be a tailwind to Materials, but renewed concerns
over a hard landing would cause the sector to underperform.
Table 17: S&P 500 sectors’ correlations with Europe & China equities
Correlation with Europe Correlation with China
Sector
Equities (Euro Stoxx) Equities (MSCI China)
Consumer Discretionary
Consumer Staples
Energy
Financials
Health Care
Industrials
Information Technology
Materials
Telecom Services
Utilities
0.71
0.41
0.64
0.73
0.61
0.76
0.70
0.50
0.66
0.61
Note: Based on regression of monthly sector returns vs. country index returns since 1990
Source: MSCI, Bloomberg, S&P, BofA Merrill Lynch US Equity & US Quant Strategy
Within Materials, we prefer Chemicals.
42
0.28
0.15
0.55
0.26
-0.01
0.45
0.32
0.65
0.25
0.26
Chart 73: MSCI China Index vs. S&P 500 Metals & Mining (1995-now)
90%
150%
60%
100%
30%
50%
0%
0%
-30%
-50%
-60%
-90%
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13
Metals and Mining (lhs)
-100%
MSCI China Index, local currency (rhs)
Source: MSCI, Bloomberg, S&P, BofA Merrill Lynch US Equity & US Quant Strategy
Materials trades at a slightly premium to history on forward earnings, and within
the sector we prefer Chemicals stocks, which have better global diversification.
Materials’ risk also looks fairly priced, in our view, given it has the most volatile
earnings of the Non-Financial cyclical sectors, and also the highest price beta.
Table 18: Sector weightings & themes (sectors listed in order of preference)
Sector
Weight in
BofAML
S&P 500 Weight (+/=/-) Comments
Information
Technology
17.9%
+
Industrials
10.7%
+
Energy
10.5%
+
13.0%
=
Consumer
Staples
10.0%
=
Financials
16.3%
=
Materials
3.5%
=
Consumer
Discretionary
12.5%
-
Utilities
3.2%
-
Telecom
2.4%
-
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Industry Preferences/Themes
Cash rich - dividend, buyback, capex play
Attractive valuation - greatest implied upside on forward P/E of any sector
Highest foreign exposure, secular and cyclical growth, lower EPS volatility vs. history
Mega cap Tech
Stock pickers' industries: Tech Hardware and Software
Risks: Consensus overweight, govt. spending cuts (Comm. Eqp.), capex recovery could fail to materialize, no
reacceleration in global growth
Less cyclical than you might expect: highest percentage of high quality stocks
Industrial Conglomerates and other large cap, cashGDP-sensitive, capex exposure, global exposure; beneficiary of recovery in Europe
rich multinationals
Risks: Govt. spending cuts (Defense), capex recovery could fail to materialize, no reacceleration in global growth
Most underowned it's been since 2008: 25% underweight in the average mutual fund
Attractive valuation: the only sector besides Health Care & Tech with upside on relative P/B, P/OCF and fwd. P/E
Benefits from US domestic energy advantage
Oil & Gas
Benefits from reacceleration in global growth, high foreign exposure, attractive yield at many mega-caps
Risks: oil price volatility, no reacceleration in global growth
Large cap pharmaceuticals are our preferred yield play (cheap, underowned)
Attractive valuation: only sector besides Energy & Tech with implied upside on relative P/B, P/OCF and fwd. P/E
Pharmaceuticals
Health Care Reform benefits hospitals, Medicaid managed care, labs, and PBMs
Risks: Most govt. exposure of any sector, overweight by mutual funds; implementation risk around HC Reform
Contrarian - underowned by fund managers
High quality, dividend yield, and dividend growth potential (lower payout ratio than Utilities/Telecom)
Avoid Tobacco on valuation
Higher foreign exposure and less government risk than the other defensive sectors
Risks: inflation, upside surprise to profits growth
Benefits from US cyclical recovery / housing recovery, cash deployment potential
Globally diversified banks, Capital Markets,
Attractively valued on relative P/B, but remains expensive vs. history on relative fwd. P/E
Consumer Finance, beneficiaries of steepening yield
High beta, deteriorated in quality, likely to underperform mid/late cycle
curve
Tailwind to banks from refinancing boom and from lower credit costs have likely ended
Avoid REITs (expensive/rate sensitive)
Risks: continued litigation, regulatory reform, stress in European financial system, US recession
Poor risk-reward vs. other non-financial cyclicals (high beta but lower LTG)
Risk: no bottoming in China growth (more leveraged to improvement in China than Industrials, which is also
Chemicals
highly exposed to improvement in Europe as well as EM)
Overweight by active managers, expensive across various valuation metrics, and deteriorating EPS revisions
Media (business spending exposure)
Rising rates may drive shift from spending to saving and may slow housing recovery
Select Specialty Retail & Household Durables
Sector performance has overshot its historical relationship with jobless claims
(home renovation theme), Autos,
Operating margins are at peak levels
Globally diversified consumer stocks
Business spending forecast to grow 3x faster than consumer spending by early next year
Most expensive sector vs. history on relative fwd. P/E, no growth, high payout ratios (little room to raise dividends
as rates rise)
High dividend yield, underowned by fund managers, hedge against macro uncertainty, purely domestic
High payout ratios (little room to raise dividends as rates rise)
Highest dividend yield, hedge against macro uncertainty, low intra-stock correlations
Worst risk-reward tradeoff of all ten sectors
Note: Weights in S&P 500 index as of 10/31/13. May not add to 100% due to rounding.
Source: BofA Merrill Lynch US Equity & US Quant Strategy
US Eq u ity Strategy Year Ahe ad
Health Care
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2 6 Nov embe r 2013
Sector Snapshot
43
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
Appendix/Methodology
Spin-off analysis
We analyzed the performance of companies that divested significant (>$500mn)
entities from 2000 to 2012. We tracked the performance of the parent company
from one month prior to the announcement to 12 months after the announcement.
We then compared the company performance to that of the industry group and
that of the S&P 500 index over the same time period. Our time series analysis
includes relative performance of companies that announced the divestiture at any
point during each year.
Shareholder activism analysis
We analyzed the performance of companies with announced shareholder
activism campaigns from 2000 to 2012. We tracked the performance of the
company from one month prior to the announcement to 12 months after the
announcement. We then compared the company performance to that of the
industry group and that of the S&P 500 index over the same time period.
Normalized equity risk premium assumptions
We estimate the fair PE multiple on normalized EPS based on the inverse of the
fair real cost of equity. This assumes that, in aggregate, companies earn their
cost of capital and that earnings are real (grow with inflation). The real cost of
equity is the sum of the real normalized risk-free rate and the equity risk premium.
For example, if the real normalized risk-free rate was 2.5% and the ERP was
350bp, then the real cost of equity would be 6% and the fair PE on normalized
EPS would be 16.7x (1 ÷ 6%).
44

Normalized EPS: Earnings are volatile over the course of a cycle, so we
normalize earnings for this cyclicality. Our historical normalized EPS
estimates are calculated using a log linear regression to come up with a
smoothed series. For our forecasted normalized EPS assumptions, we take
an average of our bull and our bear case EPS forecasts.

Normalized real risk-free rate: We assume that the market’s interest rate
and inflation expectations are a function of recent history and current market
dynamics. As such, we take (1) the average of the current 30-yr Treasury
yield and the rolling five year average 10-yr Treasury yield and we subtract
(2) the average of 10-yr TIPS yield and the rolling five year CPI inflation rate.

Normalized equity risk premium: The equity risk premium is the amount of
additional return beyond the risk free rate that investors require as
compensation for accepting the investment risks and costs associated with
owning stocks. When investor fear is high, and the market perceives equities
to be very risky, the equity risk premium is high to compensate for higher
perceived risk, and vice versa. We estimate the historical ERP as the
normalized EPS yield (normalized EPS ÷ current price) less the normalized
real risk-free rate
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
Performance of mentioned quantitative strategies
Table 19: Performance of quantitative strategies (as of 10/31/13)
2 Yr Perf.
Strategies (Universe based on the S&P 500)
ROE (1-Yr Avg. Adj. by Debt)
ROE (5-Yr Avg. Adj. by Debt)
ROE (1-Yr Average)
High Projected 5-Yr Growth
ROA
High Foreign Exposure
Forecast Positive Earnings Surprise
Upward Estimate Revisions
Relative Strength (5wk/30wk)
ROC
EPS Momentum
Share Repurchase
Price Returns (3-Month)
Forward Earnings Yield
Analyst Coverage Neglect
Most Active
S&P 500 Equal Weighted (Price Return)
Low PE to GROWTH
Dividend Yield (Price Return)
S&P 500 Equal Weighted (Total Return)
Price Returns (12-Month plus 1-Month Reversal)
High Duration
Forecast Negative Earnings Surprise
S&P 500 Index (Price Return)
Institutional Neglect
Price Returns (11-Month since 1 year ago)
Low Price
High Dividend Growth (Total Return)
Relative Strength (10wk/40wk)
ROE (5-Yr Average)
High Dividend Growth (Price Return)
Relative Strength (Price/200-Day Moving Avg)
Alpha Surprise Model
Dividend Yield (Total Return)
High Variability of EPS
DDM Valuation
Price Returns (12-Month plus 1-Month)
Price Returns (9-Month)
Price Returns (12-Month)
Relative Strength (30wk/75wk)
High Beta
Low Price to Free Cash Flow
Earnings Yield
High Free Cash Flow to EV
Small Size
Low Price to Sales
Low EPS Torpedo
Low Price to Cash Flow
Low Price to Book Value
Low EV/EBITDA
High EPS Estimate Dispersion
3 Yr Perf.
5 Yr Perf.
1 M 3 M 6 M 12 M YTD Gross Anlzd Gross Anlzd Gross Anlzd
Quality
Quality
Quality
Growth
Quality
Miscellaneous
Growth
Growth
Technical
Quality
Growth
Corp Cash Deployment
Technical
Value
Miscellaneous
Technical
Benchmark
GARP
Corp Cash Deployment
Benchmark
Technical
Growth
Growth (Negative)
Benchmark
Miscellaneous
Technical
Risk
Corp Cash Deployment
Technical
Quality
Corp Cash Deployment
Technical
GARP
Corp Cash Deployment
Risk
Value
Technical
Technical
Technical
Technical
Risk
Value
Value
Value
Miscellaneous
Value
Growth (Negative)
Value
Value
Value
Risk
2.4 5.7
3.0 5.3
3.2 5.8
3.3 7.1
3.4 6.8
3.4 6.7
3.7 6.1
3.8 7.7
3.8 5.6
3.8 6.5
3.8 3.4
4.0 5.1
4.0 5.7
4.0 4.2
4.1 4.7
4.1 3.7
4.2 5.0
4.2 4.7
4.3 1.2
4.3 5.5
4.3 6.4
4.3 6.0
4.4 5.6
4.5 4.2
4.5 2.2
4.5 7.0
4.5 5.4
4.6 2.5
4.6 6.9
4.7 5.3
4.7 6.7
4.8 6.8
4.8 6.1
4.8 7.2
4.8 7.8
4.9 3.7
4.9 6.4
5.1 6.8
5.1 8.7
5.3 6.8
5.3 7.7
5.5 7.0
5.5 5.4
5.6 8.7
5.8 6.8
6.2 7.2
6.4 7.1
6.4 6.9
6.5 5.8
6.7 7.9
7.0 11.1
13.8
13.9
15.4
18.8
13.8
15.1
16.4
16.1
15.6
14.0
9.4
20.4
13.3
19.4
14.0
13.0
12.3
15.8
2.3
13.4
17.5
12.0
14.9
10.0
4.0
17.3
20.9
4.9
20.2
11.6
12.6
15.8
17.9
13.6
15.3
13.6
12.0
19.1
19.0
13.7
19.8
16.3
15.7
18.7
22.1
20.1
11.6
16.5
19.3
17.8
16.2
31.9
33.0
33.5
47.5
33.0
35.8
39.7
36.6
36.9
33.0
28.5
50.6
37.3
51.1
34.1
35.4
31.7
37.5
17.1
34.5
38.1
28.8
33.2
24.4
18.5
39.2
51.9
23.3
42.1
34.7
29.7
35.1
41.7
32.7
37.6
32.9
33.0
39.7
42.1
33.4
43.7
41.0
37.0
46.0
48.2
55.3
31.5
35.9
44.2
49.5
35.6
26.5
27.0
30.1
38.3
27.6
28.9
35.6
32.6
31.0
28.2
23.2
45.0
30.8
43.9
31.7
30.0
27.6
31.1
19.1
29.5
32.3
25.5
30.0
23.2
17.9
34.2
42.5
23.8
37.2
31.9
25.6
31.9
39.7
27.4
29.8
31.5
31.9
37.5
36.8
29.3
31.9
35.1
31.0
38.0
38.5
45.4
30.1
31.4
38.6
41.0
29.2
44.5
35.8
44.0
56.5
43.7
29.9
53.1
52.4
46.9
42.8
42.6
75.5
58.5
57.9
50.0
49.3
45.4
48.4
29.4
51.7
47.1
36.4
40.8
40.2
30.4
51.6
67.1
43.3
49.4
41.1
49.9
45.1
55.6
57.2
40.5
56.1
56.7
56.8
55.3
47.6
52.5
60.8
52.9
60.4
62.0
68.9
34.7
43.9
69.0
55.2
57.3
20.2
16.6
20.0
25.1
19.9
14.0
23.7
23.5
21.2
19.5
19.4
32.5
25.9
25.6
22.5
22.2
20.6
21.8
13.8
23.2
21.3
16.8
18.7
18.4
14.2
23.1
29.3
19.7
22.2
18.8
22.4
20.5
24.7
25.4
18.6
25.0
25.2
25.2
24.6
21.5
23.5
26.8
23.7
26.7
27.3
30.0
16.1
20.0
30.0
24.6
25.4
59.4
50.4
59.7
71.1
60.9
39.4
65.1
56.4
59.2
58.5
43.0
89.5
66.9
61.8
60.5
47.5
55.6
61.1
44.8
65.3
48.3
49.7
45.5
48.5
36.4
55.6
59.1
68.6
48.9
61.1
64.0
55.3
71.4
75.9
42.9
66.4
67.0
64.4
66.2
52.4
47.8
71.7
64.4
70.3
72.2
92.4
49.3
52.6
65.5
70.7
59.2
16.8
14.6
16.9
19.6
17.2
11.7
18.2
16.1
16.8
16.6
12.7
23.8
18.6
17.4
17.1
13.8
15.9
17.2
13.1
18.2
14.0
14.4
13.3
14.1
10.9
15.9
16.8
19.0
14.2
17.2
17.9
15.8
19.7
20.7
12.6
18.5
18.6
18.0
18.5
15.1
13.9
19.7
18.0
19.4
19.9
24.4
14.3
15.1
18.3
19.5
16.8
124.8
121.3
121.5
152.2
117.0
130.7
140.8
94.3
17.6
17.2
17.2
20.3
16.8
18.2
19.2
14.2
121.3
98.9
159.7
17.2
14.8
21.0
222.1
139.6
141.2
131.5
171.5
72.1
157.1
26.4
19.1
19.3
18.3
22.1
11.5
20.8
119.0
104.7
81.3
86.9
17.0
15.4
12.6
13.3
239.3
126.7
27.7
17.8
143.1
154.6
19.5
20.6
135.4
188.7
140.7
78.3
18.7
23.6
19.2
12.3
53.1
237.8
203.0
172.1
8.9
27.6
24.8
22.2
264.6
326.5
196.7
169.0
197.9
192.6
161.0
29.5
33.7
24.3
21.9
24.4
24.0
21.2
Inception Date
4/30/1997
4/30/1997
4/30/1997
12/31/1988
4/30/1997
12/31/1988
12/31/1988
12/31/1988
1/31/2010
4/30/1997
12/31/1988
12/31/2004
1/31/2010
12/31/1988
6/30/1989
8/31/2003
12/30/1988
12/31/1988
1/31/2010
12/31/1988
12/31/1988
12/31/1988
1/31/2010
12/31/1988
12/31/2004
1/31/2010
4/30/1997
12/31/2004
1/31/2010
12/31/1988
12/31/1988
12/31/1988
12/31/1988
1/31/2010
1/31/2010
1/31/2010
8/31/1995
12/31/1988
7/30/2003
12/31/1988
7/31/2010
12/31/1988
12/31/1988
12/31/1988
12/31/1988
12/31/1988
9/30/2001
12/31/1988
Backtest Period
2/86 - 4/97
2/86 - 4/97
2/86 - 4/97
2/86 - 12/88
2/86 - 4/97
2/86 - 12/88
2/86 - 12/88
1/87 - 1/10
2/86 - 4/97
2/86 - 12/88
4/86 - 12/04
1/87 - 1/10
4/86 - 12/88
4/86 - 8/03
2/86 - 12/88
2/86 - 12/88
1/87 - 1/10
2/86 - 12/88
2/86 - 12/88
2/86 - 12/88
1/87 - 1/10
2/86 - 12/88
4/86 - 12/04
1/87 - 1/10
2/86 - 4/97
4/86 - 12/04
1/87 - 1/10
2/86 - 12/88
2/86 - 12/88
2/86 - 12/88
2/86 - 12/88
1/87 - 1/10
1/87 - 1/10
1/87 - 1/10
2/86 - 8/95
2/86 - 12/88
4/86 - 7/03
2/86 - 12/88
2/86 - 7/10
2/86 - 12/88
2/86 - 12/88
4/86 - 12/88
2/86 - 12/88
2/86 - 12/88
4/86 - 9/01
-
Note: Please see Quantitative Profiles: A PM’s guide to stock picking 11 November 2013 for a description of our strategies and the performance calculation methodology. The performance does not reflect transaction costs or tax withholdings or
any applicable advisory fees. Had these costs been reflected, the performance would have been lower. Performance is calculated on the basis of price return unless noted. Total return performance calculations assume dividends paid on securities
in a portfolio are deposited in a cash account on the ex-dividend date and are not reinvested. Past performance cannot and should not be viewed as an indicator of future performance. A complete performance record is available upon
request.
Source: BofA Merrill Lynch US Equity & US Quant Strategy
45
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
Advances & declines for mentioned quantitative strategies
Table 20: Advances & declines as of 10/31/13
Quantitative Strategies
High EPS Estimate Dispersion
Low EV/EBITDA
Low Price to Book Value
Low Price to Cash Flow
Low EPS Torpedo
Low Price to Sales
Small Size
High Free Cash Flow to EV
Earnings Yield
Low Price to Free Cash Flow
High Beta
Relative Strength (30wk/75wk)
Price Returns (12-Month)
Price Returns (9-Month)
Price Returns (12-Month plus 1-Month)
DDM Valuation
High Variability of EPS
Dividend Yield (Total Return)
Alpha Surprise Model
Relative Strength (Price/200-Day Moving Avg)
ROE (5-Yr Average)
High Dividend Growth (Price Return)
Relative Strength (10wk/40wk)
High Dividend Growth (Total Return)
Low Price
Price Returns (11-Month since 1 year ago)
Institutional Neglect
Forecast Negative Earnings Surprise
High Duration
Price Returns (12-Month plus 1-Month Reversal)
Dividend Yield (Price Return)
Low PE to GROWTH
Most Active
Analyst Coverage Neglect
Forward Earnings Yield
Price Returns (3-Month)
Share Repurchase
EPS Momentum
ROC
Relative Strength (5wk/30wk)
Upward Estimate Revisions
Forecast Positive Earnings Surprise
High Foreign Exposure
ROA
High Projected 5-Yr Growth
ROE (1-Yr Average)
ROE (5-Yr Avg. Adj. by Debt)
ROE (1-Yr Avg. Adj. by Debt)
Source: BofA Merrill Lynch US Equity & US Quant Strategy
46
Adv.
31
43
43
42
41
39
38
33
42
39
40
38
37
36
38
47
49
44
39
37
43
39
35
40
36
36
44
55
40
40
42
36
40
39
37
36
39
37
37
36
38
56
37
35
31
38
37
36
1M
Dec.
7
6
7
7
9
10
12
8
8
11
10
12
12
12
11
11
13
6
7
12
7
10
14
9
14
13
6
15
10
10
8
13
10
12
12
14
11
13
13
13
11
17
13
15
19
12
13
14
Adv.
76
96
90
89
86
91
91
81
94
94
97
88
93
91
95
95
127
85
86
94
93
93
86
96
86
90
80
126
92
90
78
84
85
88
87
90
94
86
89
91
98
133
95
87
85
90
85
86
3M
Dec.
38
53
60
60
64
58
59
44
56
56
55
62
56
57
54
83
62
65
54
55
57
56
63
53
64
59
70
79
58
60
72
65
65
55
62
60
56
64
61
58
51
82
55
63
65
60
65
64
Adv.
151
202
207
188
171
197
197
167
204
197
199
180
187
193
183
212
259
174
197
189
184
188
188
193
191
185
161
260
183
186
163
193
181
174
208
181
207
176
186
188
198
294
189
180
189
189
183
182
6M
Dec.
90
96
92
109
128
101
101
82
95
102
106
120
111
104
115
141
129
125
89
109
115
111
110
106
108
114
137
132
116
114
136
106
118
102
90
118
93
124
114
110
101
144
110
120
111
110
117
118
Adv.
308
408
409
374
353
410
386
337
410
408
406
372
384
385
387
430
536
382
389
383
391
396
380
402
391
381
367
536
381
383
361
394
385
354
417
375
425
373
386
379
398
573
399
382
399
391
387
390
12M
Dec.
198
190
188
219
244
186
211
146
188
190
200
227
213
211
210
259
243
216
185
214
208
203
218
196
205
217
229
271
217
215
237
204
211
186
181
221
175
226
213
216
199
275
199
218
202
207
213
210
Adv.
251
341
351
311
303
339
319
284
340
342
330
315
324
328
332
374
445
340
334
321
333
337
317
342
320
322
321
446
321
320
324
328
323
312
349
313
360
311
326
315
335
485
327
321
329
330
320
324
YTD
Dec.
162
157
146
182
194
157
178
123
158
156
173
185
173
168
165
201
203
158
143
176
166
162
181
157
175
176
175
210
177
179
174
170
173
151
149
184
140
188
173
181
162
224
171
179
171
168
180
176
Adv.
664
723
772
689
668
727
711
630
763
761
729
719
733
750
756
893
959
772
704
731
725
765
734
777
714
739
728
984
726
727
731
718
729
671
730
728
795
726
726
732
753
1031
693
714
730
734
726
744
2Yr
Dec.
473
474
435
501
527
466
485
371
433
436
486
480
463
443
440
542
589
426
421
462
473
434
463
420
478
458
467
611
472
471
466
479
464
419
465
465
404
471
473
460
442
636
504
486
477
463
474
456
3Yr
Adv.
Dec.
995
803
1041
756
1057
753
994
794
991
802
1048
744
1002
794
902
641
1073
723
1072
724
1016
798
1041
755
1055
739
1074
718
1091
705
1294
864
1338
966
1137
658
1004
680
1059
734
1058
738
1085
712
1044
753
1101
694
991
799
1047
748
1041
755
1375
958
1046
752
1042
755
1071
721
1025
772
1016
775
951
710
1026
768
1060
733
1120
679
1021
776
1050
749
1063
727
1058
735
1439
1004
1011
786
1039
761
1058
749
1055
741
1055
745
1070
730
Adv.
1867
1745
1744
1697
1683
1742
1670
1551
1781
1791
1706
1677
1697
1707
1736
2018
2245
1886
1577
1689
1754
1775
1699
1802
1666
1693
1729
2193
1725
1695
1791
1735
1694
1680
1711
1720
1825
1703
1739
1713
1711
2297
1690
1720
1901
1747
1714
1731
5Yr
Dec.
1517
1248
1270
1286
1307
1246
1323
1051
1209
1197
1317
1319
1290
1279
1251
1407
1644
1105
1103
1300
1242
1218
1291
1187
1318
1294
1266
1575
1273
1296
1196
1257
1288
1252
1274
1267
1173
1291
1260
1272
1282
1674
1302
1278
1333
1248
1285
1266
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
Link to Definitions
Macro
Click here for definitions of commonly used terms.
47
US Eq u ity Strategy Year Ahe ad
2 6 Nov embe r 201 3
Important Disclosures
FUNDAMENTAL EQUITY OPINION KEY: Opinions include a Volatility Risk Rating, an Investment Rating and an Income Rating. VOLATILITY RISK
RATINGS, indicators of potential price fluctuation, are: A - Low, B - Medium and C - High. INVESTMENT RATINGS reflect the analyst’s assessment of a
stock’s: (i) absolute total return potential and (ii) attractiveness for investment relative to other stocks within its Coverage Cluster (defined below). There
are three investment ratings: 1 - Buy stocks are expected to have a total return of at least 10% and are the most attractive stocks in the coverage cluster;
2 - Neutral stocks are expected to remain flat or increase in value and are less attractive than Buy rated stocks and 3 - Underperform stocks are the least
attractive stocks in a coverage cluster. Analysts assign investment ratings considering, among other things, the 0-12 month total return expectation for a
stock and the firm’s guidelines for ratings dispersions (shown in the table below). The current price objective for a stock should be referenced to better
understand the total return expectation at any given time. The price objective reflects the analyst’s view of the potential price appreciation (depreciation).
Investment rating
Total return expectation (within 12-month period of date of initial rating) Ratings dispersion guidelines for coverage cluster*
Buy
≥ 10%
≤ 70%
Neutral
≥ 0%
≤ 30%
Underperform
N/A
≥ 20%
* Ratings dispersions may vary from time to time where BofA Merrill Lynch Research believes it better reflects the investment prospects of stocks in a Coverage Cluster.
INCOME RATINGS, indicators of potential cash dividends, are: 7 - same/higher (dividend considered to be secure), 8 - same/lower (dividend not considered
to be secure) and 9 - pays no cash dividend. Coverage Cluster is comprised of stocks covered by a single analyst or two or more analysts sharing a common
industry, sector, region or other classification(s). A stock’s coverage cluster is included in the most recent BofA Merrill Lynch Comment referencing the stock.
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48
US Eq u ity Strategy Year Ahe ad
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