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September 2, 2010
Europe: Portfolio Strategy
Strategy Matters
Fat & Flat; fertile for themes
We forecast a flat and volatile market over 3 months withweaker US data offset by supportive micro data andvaluations. Towards the end of the year, we expect themarket to break out of the range on the upside. We continueto focus on BRICs exposure against European domestic andUS exposure, and like stable growers and high yield stocks.
Action beneath the index
So far this year, equities have been disappointing. There has been plentyof action, but very little to show for it. The market has been stuck in whatwe describe as a ‘Fat and Flat’ range with wide sentiment swings driven byconcerns about structural issues and macro data on the one hand, and astrong profit recovery and healthy micro supports on the other. Our senseis that valuation and strong balance sheets will win over investors andpush the market out of this trading range late in the year, but weacknowledge that it may take some time for investors to get sufficientevidence to allay their fears. We forecast 260 on Stoxx 600 over 3 monthsand 280 in 6 months. The more sustained moves have occurred beneaththe surface as stock performance has been dominated by a search forgrowth and the avoidance of domestically vulnerable companies. Weexpect the current environment to remain fertile for themes.
Market discounting further economic weakness
The market seems to be discounting a significant slowdown in activity andfurther weakness in leading indicators. Fears about deflation abound, butthe risks and comparisons with Japan are probably overstated.Nonetheless, our thematic views are consistent with weak domestic activityas a result of deleveraging. In this sense there are some similarities withJapan where globally exposed stocks outperformed domestic stocks afterthe bubble burst and strong balance sheet companies and those with highdividend yields performed well.
Remain focused on EM growth, High yield and ‘stable growers’
We remain long of EM and BRICs exposed companies (GSSTBRIC) relativeto domestic and US exposed companies (GSSTDOME and GSSTAMER).We continue to favour stable growing, strong return companies(GSSTGRTH) and those with high yield and strong balance sheets(GSSTHIDY). We expect corporate activity will also be a key theme. 
Peter Oppenheimer
+44(20)7552-5782 peter.oppenheimer@gs.comGoldman Sachs International
Sharon Bell, CFA
+44(20)7552-1341 sharon.bell@gs.comGoldman Sachs International
Christian Mueller-Glissmann, CFA
+44(20)7774-1714 christian.mueller-glissmann@gs.comGoldman Sachs International
Gerald Moser
+44(20)7774-5725 gerald.moser@gs.comGoldman Sachs International
Anders Nielsen
+44(20)7552-3000 anders.e.nielsen@gs.comGoldman Sachs International
Matthieu Walterspiler
+44(20)7552-3403 matthieu.walterspiler@gs.comGoldman Sachs International
The Goldman Sachs Group, Inc. does and seeks to do business with companies covered in its research reports. As a result, investors should beaware 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 singlefactor in making their investment decision. For Reg AC certification, see the end of the text. Other important disclosures follow the Reg ACcertification, or go to www.gs.com/research/hedge.html. Analysts employed by non-US affiliates are not registered/qualified as research analystswith FINRA in the U.S.
The Goldman Sachs Group, Inc. Goldman Sachs Global Economics, Commodities and Strategy Research
 
September 2, 2010 Europe: Portfolio StrategyGoldman Sachs Global Economics, Commodities and Strategy Research 2
Fat and Flat – but fertile for themes
So far this year, equities in aggregate have been disappointing. There has been plentyof action, but very little to show for it. The market has been stuck in what wedescribe as a ‘Fat and Flat’ range. While the broader market has experienced severalbig swings, the more sustained moves have occurred beneath the surface as stockperformance has been dominated by a search for growth and the avoidance ofdomestically vulnerable companies. Our theme of focusing on companies with highexposure to BRICs demand, particularly against companies with high domesticexposure, has paid off well. But the deep value theme of stocks with higher dividendyields has, so far, not. US exposed companies have started to underperform, and‘stable growers’ have outperformed.
At the start of the year we expected strong aggregate returns but with wideningdifferentiation within the market. Our favoured strategies have reflected a ‘bar bell’approach. We have preferred 1) exposure to companies with high exposure to BRICs andnon domestic growth to reflect the realignment of global growth increasingly towardsemerging markets. 2) Exposure to deep value in higher yielding companies with strongbalance sheets.In addition, more recently we have 3) argued to avoid companies with high exposure to theUS (GSSTAMER) given our below consensus view on the US economy and 4) Focused oncompanies that can generate sustained stable growth and high returns on equity(GSSTGRTH). Since May, we have moderated our view on the overall market given ourgrowing concerns about weakness in the US economy in particular and the roll over ofmomentum in many leading indicators. We continue to expect softer macro data,particularly in the US, to contain the market and have a 260 target on the Stoxx 600 overthe next 3 months, with 280 in 6 months. We think it will take some time for investors toget sufficient evidence to allay their worst fears about a double dip and deflation. At thatpoint, probably when the ‘second derivative’ of growth indicators bottom, attractivevaluation should come into play and support a strong rebound in equity prices.
Fat and Flat
In terms of the broader market, while the overall market has not moved much over thebalance of the year, there has been significant volatility over five distinct phases.
1) Early December to early February – market fell 10%
Mainly, it appeared, reflecting concerns that the 30% rally since July of 2009 had alreadypriced in the likely recovery and the start of concerns about Greece.
2) Early February to middle of April – the market rallied by 14.6% (Feb 5–April 15)
Driven mainly by consistent upgrades to global growth expectations led by upwardrevisions to US growth in particular.
3) Mid-April to mid-May – equities fell by 10.6% (April 21–May 22)
Sentiment was dominated by the European sovereign crisis when government and bankfunding stresses raised fears once again about ‘systemic risk’; the euro fell against thedollar from 1.36 to 1.20.
4) Mid-May to early August – market rallied by 12.9% (May 25–Aug 2)
The strong rally was fuelled by the aggressive policy response in Europe to deal with thecrisis. Measures, including financial rescue packages and bank stress test, that werereminiscent of the actions taken in the US two years earlier were seen to be putting policymakers back on the front foot.
 
September 2, 2010 Europe: Portfolio StrategyGoldman Sachs Global Economics, Commodities and Strategy Research 3
5) Early August to date – market correction of 8%
This short- lived optimism has faded again throughout August following signs that leadingindicators were showing signs of fatigue and, most recently, that the US economy inparticular is loosing momentum. Some further widening in European sovereign spreadshas also been evident.
Despite this wide trading range, however, in aggregate the index has done very little.The broader Stoxx 600 index is down 1% since the start of the year, although thedamage in banks and in some of the peripheral markets has resulted in moreweakness in narrower indices; the Eurostoxx 50, for example, is down 11% year todate while the IBEX remains 15% lower than at the start of the year, despite rising 8%over the past 3 months.The ‘fat and flat’ phase has reflected the constant tug of war between valuation andstrong micro performance (including the recent pick up in M&A) on one side, againstweaker macro momentum and concerns about systemic and structural issues (likedeflation) on the other side.Our sense is that valuation and the micro news will win and, over time, propel themarkets higher. But we acknowledge that it may take some time for investors to getthe sufficient evidence they require to provide the confidence to push prices up. Inparticular, investors need to be more convinced that the risks of a second dip,another recession, and all the associated risks of deflation that come with it, arefading. This is likely to be driven by an improvement in the second derivative ofgrowth indicators.
The 2004 Analogy
Interestingly, a pause in the market following the initial ‘Hope’ phase of the marketrecovery is not unusual.As Exhibit 1 shows, a similar pattern occurred after the initial rebound from the deep bearmarket low in 2003. Admittedly the phase was less volatile – what we might describe as‘flat and skinny’ as opposed to ‘fat and flat’, but it had followed a less powerful reboundand the ‘systemic’ dislocations at the time were less pronounced.
When it did finallybreak out of the range it did so in dramatic fashion. The Stoxx 600 rose 90% betweenAugust 2004 (the end of the range) and June 2007 (only interrupted briefly by a fall of13% between May and June 2006).
 
Exhibit 1:
 
The market has evolved in a similar way as 2004
…the breakout that followed from autumn 2004 was very strong
Source: Datastream, Goldman Sachs Global ECS Research.
150170190210230250270290Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May Jul20042010
of 00

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