You are on page 1of 16

February 5, 2010 Portfolio Strategy: Strategy Matters

Portfolio Strategy

Strategy Matters
Fears fog the fundamentals
EM monetary tightening and Greek debt concerns have
masked a continued improvement in fundamentals. Macro
data remains supportive, profits are recovering better than
expected, and valuations are still attractive. The
consolidation since Sept 2009 is similar to that of March-Aug
2004, which preceded a continued rise in the ‘Growth’ phase.
A correction like 2004 ...
Despite the current focus on Greece and contagion, macro data remains Peter Oppenheimer
+44(20)7552-5782 | peter.oppenheimer@gs.com
supportive; 20 of 25 key country manufacturing surveys have recently Goldman Sachs International
shown robust results. Meanwhile, earnings data on both sides of the
Atlantic continue the trend of upside surprises. Coupled with attractive Erik F. Nielsen
valuations, this suggests that the fundamental positive underlying support +44(20)7774-1749 | erik.nielsen@gs.com
Goldman Sachs International
for the market remains intact. We continue to see the market following a
classic ‘Hope’ to ‘Growth’ phase transition. We believe the modest
Christian Mueller-Glissmann, CFA
correction and consolidation between March and August 2004, following +44(20)7774-1714 | christian.mueller-
an initial sharp market recovery over the previous year, serves as a useful glissmann@gs.com
comparison. Goldman Sachs International

Gerald Moser
Sovereign debt ... reinforces our country views +44(20)7774-5725 | gerald.moser@gs.com
Concerns over monetary tightening in China appear to be overdone. We Goldman Sachs International
see this policy move as an appropriate response to strong growth and one
that should reduce the risks of policy error later. With regard to sovereign Anders Nielsen
+44(20)7552-3000 | anders.e.nielsen@gs.com
contagion, while much will depend on the response of Greece and the
Goldman Sachs International
Eurozone, we believe the rest of Southern Europe and Ireland are
considerably less vulnerable than Greece given their lower government Matthieu Walterspiler
financing requirements. These countries all require primary surpluses that +44(20)7552-3403 |
are only a fraction of Greece’s surplus to stabilise their debt ratios for the matthieu.walterspiler@gs.com
Goldman Sachs International
same growth rate and real interest rate. Nevertheless, domestic retail
banks in Southern Europe remain vulnerable to widening CDS spreads if
contagion spreads. We introduce a basket Bloomberg Ticker, GSSTMEDB,
to hedge or trade views on these banks. We also reiterate our underweight
position on the IBEX and overweight in the FTSE (benefiting from looser
financial conditions) and DAX (a beneficiary of any further euro weakness).

The Goldman Sachs Group, Inc. 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. For Reg AC certification, see the end of the text. Other important disclosures follow the Reg AC
certification, or go to www.gs.com/research/hedge.html. Analysts employed by non-US affiliates are not registered/qualified as research analysts
with FINRA in the U.S.

The Goldman Sachs Group, Inc. Goldman Sachs Global Economics, Commodities and Strategy Research
Goldman Sachs Global Economics, Commodities and Strategy Research 1
February 5, 2010 Portfolio Strategy: Strategy Matters

Fears fog the fundamentals


In our 2010 outlook report (Outlook 2010: Strategy and themes, published December
2, 2009), we argued that the European equity market was likely to have a strong start
to the year. This reflected a number of factors: positioning, attractive valuation,
seasonality and our stronger than consensus macro and earnings expectations. So far,
however, we have been wrong; while the market generally rewarded pro-risk
trades in the first week of the year, this more than reversed in the recent sell-off. As
of today (February 4, 2010), the DJ Stoxx is down 4.4% so far this year while the
Eurostoxx 50 is down 8.7%.
The main concerns revolve around policy tightening in China, and contagion risks
from Greece. These issues have clouded the underlying improvement in both macro
and micro fundamentals. The consolidation that the market has experienced since
September 2009 is, in our minds, similar to the March-August 2004 period, when
rising doubts about profit quality and monetary tightening also caused an ‘air pocket’
in the market before it resumed an upward trend.
In the near term, until a more decisive resolution of Greek financing issues emerge,
we believe southern European domestic retail banks remain vulnerable to further
rises in sovereign CDS and introduce a Bloomberg basket GSSTMEDB to hedge
positions or reflect this theme. We also reiterate our underweight position in IBEX
and overweight in FTSE and DAX. The FTSE should benefit from looser financial
conditions, and Germany should benefit from any further euro weakness.

Risks overshadow the continued improvement in macro data


Policy tightening in China and the situation in Greece appear to be monopolizing mind
share at present. Both, however, need to be seen in the context of a further improvement
in the underlying drivers of the equity markets. Indeed, despite weakness in the markets,
macro data has generally been strong. US 4Q09 GDP came in at +5.7% qoq, stronger than
consensus (although inventory corrections contributed 3.4% of this and our economists
expect a weaker 1Q10 GDP reading). There have also been a number of more positive
economic data points from Japan; our economists now see significant upside risk to their
4Q09 GDP estimate of 0.5% (and believe it could be as high as 3.7% qoq). Meanwhile, the
IMF raised its forecast for world GDP growth in 2010 to 3.9% from its previous estimate of
3.1% (compared with our economists’ estimate of 4.5%).

In terms of activity data, the ISM came in at 58.4, much stronger than expected, and the
highest level since April 2004. This upbeat report on the state of US manufacturing comes
on the heels of a few mildly positive surprises in US consumer confidence and spending
and a strong durable goods report – with strength in the forward-looking ratio of inventory
to sales particularly encouraging. The US ISM print helped push the final headline GS Global
Leading Indicator (GLI) reading up solidly for January (see Exhibit 1), with eight of ten
components continuing to improve.

Goldman Sachs Global Economics, Commodities and Strategy Research 2


February 5, 2010 Portfolio Strategy: Strategy Matters

Exhibit 1: Goldman Sachs GLI (headline) Exhibit 2: Goldman Sachs GLI (momentum)

6 1.5

4
1.0
2
0.5
0

-2 0.0

-4 -0.5
-6
-1.0
-8 Headline GLI GLI M omentum
-1.5
-10

-12 -2.0
Jan-00 Jul-01 Jan-03 Jul-04 Jan-06 Jul-07 Jan-09 Jan-00 Jul-01 Jan-03 Jul-04 Jan-06 Jul-07 Jan-09

Source: Goldman Sachs Global ECS Research. Source: Goldman Sachs Global ECS Research.

Macro data in Europe has also been encouraging, with the PMI final reading being
considerably above the flash estimates. It also showed that the largest economies
continued to improve (Germany 53.7, France 55.4, Italy 51.7). The data are consistent with
GDP growth of about 0.5% qoq at the start of 1Q. Meanwhile, the UK manufacturing PMI
increased to 59 in January, a level consistent with sequential growth of about 5%
annualized. Indeed, the breadth of global strength in industrial activity is impressive; 20 of
25 key country manufacturing surveys have recently shown robust results.

Exhibit 3: Euroland PMI

65

60

55

50

45

40
Euroland PMI
35

30
Jun-97 Dec-98 Jun-00 Dec-01 Jun-03 Dec-04 Jun-06 Dec-07 Jun-09

Source: Goldman Sachs Global ECS Research.

Goldman Sachs Global Economics, Commodities and Strategy Research 3


February 5, 2010 Portfolio Strategy: Strategy Matters

Earnings are recovering nicely too …


In addition to the continued supportive macro data, earnings data also shows further
improvement. Our US strategists have shown that companies accounting for around 74%
of market capitalisation have reported so far in the US. Of these, 48% have beaten
consensus estimates (above the historical average of 40%) and 9% have missed the
estimates (versus an average of 15%). The average EPS surprise has been 15.6%, above
the 2.6% historical average. Excluding Financials, there are more positive surprises (51%)
and fewer negative surprises (7%). A similar trend appears to be under way in Europe,
where both EPS and top-line growth have surprised to the upside.

Exhibit 4: Europe sales surprise relative to consensus estimates by sector

Sales Surprise Sales Surprise (Market Sales Surprise


Avg Cap Weighted) Median
Automobiles & Parts 7.5% 7.5% 7.5%
Banks 12.7% 9.8% 1.7%
Basic Resources 3.3% 4.4% 4.3%
Financial Services 1.2% 1.2% 1.2%
Food & Beverage -3.1% -3.1% -3.1%
Health Care -1.6% 2.3% -0.5%
Industrial Goods & Services 0.0% -1.1% -1.8%
Insurance NM NM NM
Media 5.1% 3.3% 5.1%
Oil & Gas 2.2% 2.2% 2.2%
Personal & Household Goods 0.7% 1.4% 0.5%
Real Estate -0.7% -0.7% -0.7%
Retail 0.9% 4.4% 1.2%
Technology 2.8% 3.0% 2.7%
Telecommunications -1.9% -1.9% -1.9%
Travel & Leisure -1.6% 1.5% 2.5%
Utilities 3.6% 0.2% -5.5%
Market 1.6% 2.3% 0.9%

Source: Bloomberg, Goldman Sachs Global ECS Research.

Exhibit 5: Europe EPS surprise relative to consensus estimates by sector

EPS Surprise EPS Surprise (Market Cap EPS Surprise


Average Weighted) Median
Automobiles & Parts -93.6% -93.6% -93.6%
Banks 17.3% 5.7% 2.6%
Basic Resources 73.6% 73.6% 73.6%
Financial Services 14.7% 14.7% 14.7%
Food & Beverage 5.3% 5.3% 5.3%
Health Care -3.6% -12.1% -2.4%
Industrial Goods & Services 11.9% 37.2% 2.4%
Insurance 11.3% 28.6% 11.3%
Media -4.1% -4.1% -4.1%
Oil & Gas 7.0% 7.0% 7.0%
Personal & Household Goods 0.7% -12.7% 14.1%
Real Estate -41.2% -41.2% -41.2%
Retail 19.1% 19.1% 19.1%
Technology 0.3% 2.8% -3.7%
Telecommunications NM NM 173.5%
Travel & Leisure 79.8% 79.8% 79.8%
Utilities 11.5% 6.6% 11.5%
Market 6.0% 4.2% 3.6%

Source: Bloomberg, Goldman Sachs Global ECS Research.

Goldman Sachs Global Economics, Commodities and Strategy Research 4


February 5, 2010 Portfolio Strategy: Strategy Matters

… but sentiment has turned bearish again


Despite the strong backdrop, sentiment in the market has turned sharply negative. The
significant rise in short interest in many ‘risk on’ markets is evidence of this shift. As
Exhibit 6 shows, although data is difficult to interpret, the total speculative short position
in E-mini contracts (US equities as reported by the CFTC) is the largest it has been since
June 2009. This probably reflects a mix of ‘straight’ directional shorts and equity portfolio
hedges. The number of shorts also increased in the commodity space and in the euro
(Exhibit 7). This again is part of the same mood shift – the correlation between the dollar
and the equity market has re-established itself, and rising concerns have rewarded the
dollar at the expense of the euro. Of course, the negative sentiment on the euro also
reflects the mounting concerns over Greek ‘contagion’, an issue that we focus on later.

Exhibit 6: E-mini S&P non-commercial short Exhibit 7: Euro non-commercial position


Net contracts

550000
E-mini S&P no n-co mmercial sho rts 110000

500000 90000

70000
450000
50000
400000
30000

350000 10000

-10000
300000
-30000
Net no n-co mmercial o pen interest
250000 -50000
Feb-09 A pr-09 Jun-09 A ug-09 Oct-09 Dec-09 00 01 02 03 04 05 06 07 08 09

Source: CFTC, Goldman Sachs Global ECS Research. Source: CFTC, Goldman Sachs Global ECS Research.

At the same time, implied volatility has spiked again, along with volumes, once more
suggesting that long positions coming into the year may have been flushed out.

Exhibit 8: DJ Stoxx volume Exhibit 9: VIX index


5-day moving average

5 60

50
4

40
3
30

2
20
DJ Sto xx 600 vo lume VIX index
1 10
Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10

Source: Bloomberg, Goldman Sachs Global ECS Research. Source: Bloomberg, Goldman Sachs Global ECS Research.

Goldman Sachs Global Economics, Commodities and Strategy Research 5


February 5, 2010 Portfolio Strategy: Strategy Matters

Are the fears justified?

Why fears over China tightening are exaggerated


In terms of the China tightening cycle, most of the concerns seem to relate to choking off
the one engine of growth that the global economy has. Nevertheless, the economy
continues to grow strongly, so a modest tightening in policy is, our economists believe,
appropriate. Indeed, the January PMI reading for China, at 55.8%, is the highest level, on a
seasonally adjusted basis, since the series began in 2005. The government is moving to
contain total CNY lending to about RMB7.5 trillion in 2010, down from about
RMB9.6 trillion in 2009, which seems understandable given the momentum of growth.
According to our economists, given that CNY loans increased 32% yoy in December 2009,
and preliminary evidence suggests that the pace of lending actually accelerated in
January, efforts to slow credit growth are quite welcome at this stage; we would argue that
a bigger risk is that the Chinese authorities tighten too little and need to start tightening
more aggressively later in the year just at the point when US growth is expected to slow.

Moreover, as our Asia economists have highlighted, a sudden withdrawal of lending is not
likely to translate into a sudden decrease in investment spending given that only about
10% of fixed asset investment in China is financed through the banking system.

In addition, many Chinese corporates have been “preemptively” borrowing over the past
year because they anticipated credit would be tightened. This has manifested itself in a
large increase in time deposits held at Chinese banks. As loan issuance is set to slow, this
money can now be put to work to finance new spending.

Of course, it is not just China that is tightening. Over the last couple of days, a number of
other EM central banks have either made tentative moves towards tightening or laid the
ground for such moves in the near future. In Brazil, the COPOM changed its statement to
suggest initiating a tightening cycle in April, but our economists believe that the risks to
this view are tilted towards an even earlier move in March. Meanwhile, in the Philippines,
the central bank raised the rediscount rate 50 bp. The latest news to support this trend
came from the Reserve Bank of India, which raised the Cash Reserve Ratio (CRR) 75 bp,
higher than market (and our economists’) expectations of a 50 bp hike. The hike will be
effective from the middle of February, and is expected to drain about half of the excess
liquidity that banks were parking at the RBI this week.

As the EM tightening cycle starts to come though, however, we continue to believe that in
all cases the moves seem appropriate given the strong growth in these countries.
Furthermore, when interest rates start to rise as a function of higher growth, the results
tend not to be negative for the equity market.

Greece and sovereign risk


In addition to China tightening, fears of a default by Greece have dominated markets
recently. The concerns are not so much focused on Greece itself (less than 3% of Eurozone
GDP), but on what happens if the stress spreads to large parts of Southern Europe with a
20%-30% share of Eurozone GDP. Such contagion is not our main scenario, but it remains
a prominent risk, the materialisation of which largely depends on the response by the
Greek government as well as its fellow Eurozone governments in the 8-10 weeks ahead.

The Greek problem is dealt with in more detail in an article by Erik Nielsen in the European
Economic Weekly, also published today: The Euro-zone challenge: Greece and contagion,
European Weekly Analyst, February 4, 2010.

Following years of insufficient policies, the present Greek government now faces both
liquidity and (potentially) solvency issues. We think it is likely that Greece will need

Goldman Sachs Global Economics, Commodities and Strategy Research 6


February 5, 2010 Portfolio Strategy: Strategy Matters

financial help from non-commercial sources during the next couple of months. How the
Greek government addresses its fundamental challenges, when and how the rest of the
Euro-zone change their public stance on financial support to Greece, and how other
governments address their own financing requirements will determine the extent of
further contagion to other peripheral Euro-zone countries. We believe that Ireland has
already put in place a solid start to the necessary adjustment process; that the latest fiscal
consolidation plans published by the Spanish government are credible given its
fundamentals, and that the Portuguese budget published last week is a beginning,
although more is likely to be needed here, in our economists view. Italy is in a more
comfortable position than the other Southern European countries because of stronger
balance sheets. If Greek spreads widen significantly as they seek to raise additional
financing, other peripheral sovereign debt may continue to trade in sympathy with Greek
assets, but fundamentals in terms of balance sheets and debt servicing profiles differ
significantly across the region, which means that the degree of potential solvency issues
facing Greece are not shared by other Euro-zone sovereigns.

Exhibit 10: Current financial situation in Euro-zone periphery

Spain Italy Greece Portugal Ireland


Current account deficit -6.1 -3.5 -11.9 -10.1 -3.0
(avg. last 4 quarters)
Budget deficit -11.4 -5.4 -12.7 -9.3 -11.6
(% of GDP)
Public debt 55.2 113.9 113.4 76.6 64.5
(% of GDP)
Public debt service in 2010* 4.7 14.1 11.6 2.5 6.2
(% of GDP)
* Includes long-term debt redemptions and interest payments

Source: National Treasury Offices, Eurostat, Goldman Sachs Research.

The current budget proposal


The Greek government had submitted its 2010-2013 stability programme to the
Commission on January 15, which envisages a decline in the budget deficit from 12.8% of
GDP last year to 8.7% of GDP this year, and down to 5.6% of GDP in 2011 and 2.8% of GDP
in 2012. The cut in the deficit was specified in detail only for 2010, including measures to
reduce tax evasion, eliminate tax exemptions and increase some excise duties. On the
back of these measures, as well as a modest 0.3% decline in GDP, the budget assumed
that tax collection would increase from just over 38% of GDP last year to 42% this
year. The expenditure side included a partial public sector hiring freeze, cuts in civil
servant allowances and a large cut in transfers to pensions. In a statement yesterday, the
Commission asked the government “to spell out the implementation calendar of these
measures within one month” (from the Ecofin’s expected formal approval on February 15)
The Commission also asked the government to clarify details of its structural reform
programme aimed at improving competitiveness in the medium term.

Funding risk
In summary, the Greek government is facing financing requirements of about €55 bn this
year, of which about half fall due between now and late May, including €17 bn in
amortisations of long-term debt. As far as we know, the government will need to raise €10-
15 bn for these needs before the end of May. In spite of the dramatic widening of Greek
spreads, European politicians have repeatedly ruled out any help to the Greek government

Goldman Sachs Global Economics, Commodities and Strategy Research 7


February 5, 2010 Portfolio Strategy: Strategy Matters

via loans or guarantees to help lower the borrowing costs. Instead, the emphasis has been
on still tougher fiscal measures by the government to help persuade investors to demand
lower spreads.

However, as our economists have argued in the past, we continue to believe that non-
commercial financing will become available to the Greek government this year in case
it should it prove too difficult to raise the needed financing in the commercial market.
If this were to be the case, we think the most likely scenario for such non-commercial
financing would be bilateral loans from fellow Eurozone member countries – coordinated
by the Commission – under the umbrella of Article 122, which says that such bilateral
loans may be made in exceptional circumstances. However, also in spite of the repeated
ruling out of IMF involvement, we believe that one cannot exclude the possibility of the
IMF increasing its involvement from its current technical assistance to a full-fledged
programme with financing and explicit conditionality.

Once Greece gets through May, the financing needs should ease to a monthly average of
about €3 bn to cover the deficit and short-term rollovers. We believe this will be
achievable, although it coincides with an expected path of the ECB gradually tightening
policy by driving the interbank EONIA rate higher towards 1%. However, starting next year,
the government faces annual amortizations of long-term debt of €25-30 bn a year until
2014, and monetary conditions are likely to gradually tighten. As public debt to GDP rises
towards 130%, the sustainability of Greek government debt becomes a potential concern
for the medium term.

Impact on the markets


The extent of market fears is evident in Greek CDS which jumped significantly in recent
days. As Exhibit 11 shows, the relative performance of Greek banks has moved in line with
Greek government debt spreads over German bunds. The market is making the
assumption that the sovereign risk is also ultimately a corporate risk.

Exhibit 11: Greek banks’ relative performance vs. sovereign spreads

110 0

50
100
100
90
150

80 200

250
70
300
60 FTSE Greek bank vs. FTSE Banks Europe (index to 100) 350
Spread Greek vs German 10yr bonds (RHS, inverted scale)
50 400
Aug-08 Oct-08 Dec-08 Feb-09 Apr-09 Jun-09 Aug-09 Oct-09 Dec-09 Feb-10

Source: Datastream, Goldman Sachs Global ECS Research.

Outside Greece, however, the direct impact of any Greek default on banks would likely be
relatively small.

Goldman Sachs Global Economics, Commodities and Strategy Research 8


February 5, 2010 Portfolio Strategy: Strategy Matters

Nonetheless, despite these stronger fundamentals in the other Southern European


economies, sovereign spreads are rising elsewhere too, particularly in Spain, Italy and
Portugal.

Exhibit 12: Evolution of European CDS

170 Spain, Italy & Portugal (average) 450


France & Germany (average) 400
150
Greece (RHS)
350
130
300
110
250
90
200
70
150
50
100
30 50

10 0
Feb-09 Mar-09 May-09 Jul-09 Aug-09 Oct-09 Dec-09 Jan-10

Source: Datastream, Goldman Sachs Global ECS Research.

However, as fears about fiscal sustainability spread, the main transition through the stock
markets is via domestic retail banks in other Southern European countries in particular.
Our banks team has already reflected this view on some of the domestic retail stocks in
Spain in particular. To reflect this, and provide a hedging opportunity, we have constructed
a basket of domestic retail bank stocks in Southern Europe, or a ‘Club Med Banks Basket’,
Bloomberg ticker: GSSTMEDB. This basket’s performance relative to the market tracks CDS
spreads very closely. We believe there is further downside risk to this basket in the short
term.

Exhibit 13: GSSTMEDB Constituents Exhibit 14: GSSTMEDB relative to the DJ Stoxx 600 and
Greek CDS

140 0
GSSTM EDB Greek CDS (RHS, Inverted)
RIC Ticker Bloomberg Company Name Country Weights
50
ACBr.AT ALPHA GA Alpha Bank Greece 6.3%
130
EFGr.AT EUROB GA EFG Eurobank Greece 6.3% 100
NBGr.AT ETE GA National Bank of Greece Greece 6.3%
BOPr.AT TPEIR GA Bank of Piraeus Greece 6.3% 120 150
BBVA.MC BBVA SQ BBVA Spain 6.3%
BKT.MC BKT SQ Bankinter Spain 6.3% 200
POP.MC POP SQ Banco Popular Espanol Spain 6.3% 110
SABE.MC SAB SQ Banco Sabadell Spain 6.3% 250
PAS.MC PAS SQ Banco Pastor Spain 6.3%
ISP.MI ISP IM Intesa Sanpaolo Italy 6.3% 100 300
BMPS.MI BMPS IM Banca Monte dei Paschi di Siena Italy 6.3%
UBI.MI UBI IM UBI Banca Italy 6.3% 350
BAPO.MI BP IM Banco Popolare Italy 6.3% 90
BBPI.LS BPI PL Banco BPI S/A Portugal 6.3% 400
BCP.LS BCP PL Banco Commercial Portugues S/A Portugal 6.3%
BES.LS BES PL Banco Espirito Santo S/A Portugal 6.3%
80 450
Feb-09 A pr-09 Jun-09 A ug-09 Oct-09 Dec-09

Source: Goldman Sachs Global ECS Research. Source: Goldman Sachs Global ECS Research.

Goldman Sachs Global Economics, Commodities and Strategy Research 9


February 5, 2010 Portfolio Strategy: Strategy Matters

From ‘Hope’ to ‘Growth’… again


We argued in The Equity Market Cycle Part I; Identifying the phases, October 22, 2009, that
the market cycle tends to be split into four distinct periods characterised by different
returns and drivers. The ‘Hope’ phase – the initial recovery from a bear market low tends to
be dramatic (with average annualised returns of about 50%). This rise starts when earnings
are still falling and the economy is often in recession (but the second derivative of growth
starts to slow); this is the phase that we believe has been in place over the past ten months.
The second phase of the cycle, the ‘Growth’ phase is a much longer period (typically
averaging around 33 months compared with the ten months of the ‘Hope’ phase) and the
average annualised returns tend to be lower – around 11%.

We have also noted that the transition between ‘Hope’ and ‘Growth’ is often associated
with the market being trapped in a trading range. The recent sell-off and trading range
since last September, from a historical perspective, is not that unusual. As investors start
to question the quality or sustainability of the recovery that they have started to
discount, the momentum of growth starts to slow, or concerns about monetary
tightening increase, the market often hits an ‘air pocket’.
The very strong rebound from the March 2003 lows to March 2004 was, for example,
followed by the market being stuck in a trading range that lasted until September of that
year. Our assumption had been that the consolidation in most markets since last
September was reflective of this kind of transition. We thought wrongly, however, that the
modest positioning in the market at the end of last year, coupled with strong profit growth
for 4Q, would be enough to propel the markets higher at the start of this year. While the
profit and economic recovery do seem to be emerging in the way that we had hoped for,
the fears surrounding monetary tightening in China, as well as sovereign risks in Greece
have overshadowed these fundamentals. With a starting point of fairly fragile confidence –
and a widespread view that the recovery is purely a function of one-off inventory
adjustments and aggressive policy action, it has not taken much to trigger a sell-off.

Risk off as market follows 2004 analogy


The 2004 period serves as a useful template to analyse current conditions. Following a
50% rise in a virtual straight line from March 2003 to March 2004, the equity market had a
correction of around 8% through to August 11, 2004, and then recovered to previous levels
by September.

There were a number of possible triggers for that correction, but among them were fears
of monetary tightening in China and the US. The Chinese authorities raised the reserve
requirement ratio to 7.5% from 7% in April – this compares with the rise from 15.5% to 16%
recently. In addition, the two-year swap rate in the US started to rise in anticipation of the
increase in Fed funds rates in April 2004. Indeed, if we overlay the recent recovery with the
one from the 2003 trough, we can see some similarities. This time, however, the fade and
correction seem to have come somewhat earlier in the cycle.

Goldman Sachs Global Economics, Commodities and Strategy Research 10


February 5, 2010 Portfolio Strategy: Strategy Matters

Exhibit 15: The European market has evolved in a similar fashion to 2002
X axis shows number of days since January

400 330

January 2008 January 2002 (RHS) 310


350 290

270
300
250

230
250
210

200 190

170

150 150
0 60 120 180 240 300 360 420 480 540 600 660 720 780

Source: Datastream, Goldman Sachs Global ECS Research.

The way the market ‘traded’ in the 2004 setback is not very different from the reaction over
the past couple of weeks. In the initial ‘Hope’ phase, when the market recovery was very
sharp, the reactions were very similar in both periods. All stocks went up together,
although the highest decile of returns were particularly strong (mainly rewarding high
leverage companies).

Exhibit 16: Return by decile 2003 Exhibit 17: Return by decile 2009
March 2003 to March 2004 March 2009 to December 2009

200% 240%

200%
160%
160%
Returns per decile Returns per decile
120%
120%

80%
80%
40%
40%
0%

0% -40%
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

Source: Datastream, Goldman Sachs Global ECS Research. Source: Datastream, Goldman Sachs Global ECS Research.

In the correction/consolidation phase that followed, the market was more selective, with
some stocks falling as others rose – very similar to what we have seen since the start of
this year.

Goldman Sachs Global Economics, Commodities and Strategy Research 11


February 5, 2010 Portfolio Strategy: Strategy Matters

Exhibit 18: Return by decile 2004 Exhibit 19: Return by decile 2010 YTD
March 2004 to September 2004

40% 18%

14%
20% 10%

6%
0% 2%

-2%

-20% Returns per decile -6%


Returns per decile
-10%

-40% -14%
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

Source: Datastream, Goldman Sachs Global ECS Research. Source: Datastream, Goldman Sachs Global ECS Research.

From a sector perspective, the transition patterns were also similar. In the initial ‘Hope’
phase, the market rewarded cyclicals at the expense of defensive sectors. In the March
2004 to September 2004 period, the market did not reverse and reward defensive sectors
at the expense of cyclicals; rather, the best performers then were a mix of defensive and
cyclical sectors. The same thing has happened since early this year.

Exhibit 20: Return by sector from March 2003 to March Exhibit 21: Return by sector from March 2009 to end of
2004 2009

100% 150%
Cyclical
80% 120% Cyclical

60% 90%

40% 60%

20% 30%

0% 0%
PHHG

PH/H Gds

Telecom
Real Estate

Health Care
Con & Mat
Cons & Mat

Real Est
Inds Gds

Telecoms

Chemicals

Oil & Gas

Oil & Gas


Chemicals
Retail

Financial

Retail
Insurance
Media

Healthcare

Insurance

Media
Basic Res.
Trav & Leis

Trav & Leis


Technology

Banks

Basic Res

Utilities

Food & Bev

Banks

Fin. Svs
Inds

Food & Bev


Technology

Utilities
Auto &
Autos

Source: Datastream, Goldman Sachs Global ECS Research. Source: Datastream, Goldman Sachs Global ECS Research.

Goldman Sachs Global Economics, Commodities and Strategy Research 12


February 5, 2010 Portfolio Strategy: Strategy Matters

Exhibit 22: Return by sector from March 2004 to Exhibit 23: Return by sector in 2010 ytd
September 2004

20% 8%
Cyclical
10% 4%
Cyclical
0% 0%

-10% -4%

-20% -8%

-30% -12%

PH/H Gds
Health Care

Telecom
Real Est

Con & Mat


IndsGds

Oil & Gas


Retail

Chemicals
Media
Insurance

Basic Res.
Technology
Trav & Leis

Food&Bev

Utilities
Fin. Svs

Banks
PHHG

Autos
Cons & Mat
Real Est
Oil & Gas

Inds Gds
Chemicals

Telecoms
Retail

Financial
Healthcare

Insurance
Media
Utilities

Basic Res

Trav & Leis


Banks

Food & Bev

Technology
Autos

Source: Datastream, Goldman Sachs Global ECS Research. Source: Datastream, Goldman Sachs Global ECS Research.

While the drivers are clearly different this time around, we believe that the market fears are
those that occur naturally following a very sharp rebound from a deep bear market. Once
the focus on the exogenous risks of Greece and China fades, as it did following the Balkan
or Dubai crisis, for example, we believe investors will focus again on the underlying value
in the market and the improvement in profitability.

In the meantime, we believe that fears will continue to weigh on the Spanish market in
particular, and reiterate our underweight position in IBEX, recommended in Strategy
Matters: A guide to selecting countries in European equities, published January 15, 2010.
We also reiterate our overweight position in the FTSE, to reflect looser financial conditions
in the UK, and the DAX, to benefit from potential further weakness in the euro.

Equity Basket Disclosure


The Equities Division of the firm has previously introduced the basket of securities
discussed in this report. The Equity Analyst may have been consulted as to the
composition of the basket prior to its launch. However, the views expressed in this
research and its timing were not shared with the Equities Division. Note: The ability to
trade this basket will depend upon market conditions, including liquidity and borrow
constraints at the time of trade.

Goldman Sachs Global Economics, Commodities and Strategy Research 13


February 5, 2010 Portfolio Strategy: Strategy Matters

Reg AC
We, Peter Oppenheimer, Christian Mueller-Glissmann, CFA, Gerald Moser, Anders Nielsen and Matthieu Walterspiler, hereby certify that all of the
views expressed in this report accurately reflect our personal views about the subject company or companies and its or their securities. We also
certify that no part of our compensation was, is or will be, directly or indirectly, related to the specific recommendations or views expressed in this
report.

Goldman Sachs Disclosures

Disclosures required by United States laws and regulations


See company-specific regulatory disclosures above for any of the following disclosures required as to companies referred to in this report: manager
or co-manager in a pending transaction; 1% or other ownership; compensation for certain services; types of client relationships; managed/co-
managed public offerings in prior periods; directorships; for equity securities, market making and/or specialist role. Goldman Sachs usually makes a
market in fixed income securities of issuers discussed in this report and usually deals as a principal in these securities.
The following are additional required disclosures: Ownership and material conflicts of interest: Goldman Sachs policy prohibits its analysts,
professionals reporting to analysts and members of their households from owning securities of any company in the analyst's area of coverage.
Analyst compensation: Analysts are paid in part based on the profitability of Goldman Sachs, which includes investment banking revenues. Analyst
as officer or director: Goldman Sachs policy prohibits its analysts, persons reporting to analysts or members of their households from serving as
an officer, director, advisory board member or employee of any company in the analyst's area of coverage. Non-U.S. Analysts: Non-U.S. analysts
may not be associated persons of Goldman Sachs & Co. and therefore may not be subject to NASD Rule 2711/NYSE Rules 472 restrictions on
communications with subject company, public appearances and trading securities held by the analysts.

Additional disclosures required under the laws and regulations of jurisdictions other than the United States
The following disclosures are those required by the jurisdiction indicated, except to the extent already made above pursuant to United States laws
and regulations. Australia: This research, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian
Corporations Act. Canada: Goldman Sachs & Co. has approved of, and agreed to take responsibility for, this research in Canada if and to the extent it
relates to equity securities of Canadian issuers. Analysts may conduct site visits but are prohibited from accepting payment or reimbursement by the
company of travel expenses for such visits. Hong Kong: Further information on the securities of covered companies referred to in this research may
be obtained on request from Goldman Sachs (Asia) L.L.C. India: Further information on the subject company or companies referred to in this
research may be obtained from Goldman Sachs (India) Securities Private Limited; Japan: See below. Korea: Further information on the subject
company or companies referred to in this research may be obtained from Goldman Sachs (Asia) L.L.C., Seoul Branch. Russia: Research reports
distributed in the Russian Federation are not advertising as defined in the Russian legislation, but are information and analysis not having product
promotion as their main purpose and do not provide appraisal within the meaning of the Russian legislation on appraisal activity. Singapore:
Further information on the covered companies referred to in this research may be obtained from Goldman Sachs (Singapore) Pte. (Company
Number: 198602165W). Taiwan: This material is for reference only and must not be reprinted without permission. Investors should carefully
consider their own investment risk. Investment results are the responsibility of the individual investor. United Kingdom: Persons who would be
categorized as retail clients in the United Kingdom, as such term is defined in the rules of the Financial Services Authority, should read this research
in conjunction with prior Goldman Sachs research on the covered companies referred to herein and should refer to the risk warnings that have been
sent to them by Goldman Sachs International. A copy of these risks warnings, and a glossary of certain financial terms used in this report, are
available from Goldman Sachs International on request.
European Union: Disclosure information in relation to Article 4 (1) (d) and Article 6 (2) of the European Commission Directive 2003/126/EC is
available at http://www.gs.com/client_services/global_investment_research/europeanpolicy.html which states the European Policy for Managing
Conflicts of Interest in Connection with Investment Research.
Japan: Goldman Sachs Japan Co., Ltd. is a Financial Instrument Dealer under the Financial Instrument and Exchange Law, registered with the Kanto
Financial Bureau (Registration No. 69), and is a member of Japan Securities Dealers Association (JSDA) and Financial Futures Association of Japan
(FFAJ). Sales and purchase of equities are subject to commission pre-determined with clients plus consumption tax. See company-specific
disclosures as to any applicable disclosures required by Japanese stock exchanges, the Japanese Securities Dealers Association or the Japanese
Securities Finance Company.

Ratings, coverage groups and views and related definitions


Buy (B), Neutral (N), Sell (S) -Analysts recommend stocks as Buys or Sells for inclusion on various regional Investment Lists. Being assigned a Buy
or Sell on an Investment List is determined by a stock's return potential relative to its coverage group as described below. Any stock not assigned as
a Buy or a Sell on an Investment List is deemed Neutral. Each regional Investment Review Committee manages various regional Investment Lists to
a global guideline of 25%-35% of stocks as Buy and 10%-15% of stocks as Sell; however, the distribution of Buys and Sells in any particular coverage
group may vary as determined by the regional Investment Review Committee. Regional Conviction Buy and Sell lists represent investment
recommendations focused on either the size of the potential return or the likelihood of the realization of the return.
Return potential represents the price differential between the current share price and the price target expected during the time horizon associated
with the price target. Price targets are required for all covered stocks. The return potential, price target and associated time horizon are stated in
each report adding or reiterating an Investment List membership.
Coverage groups and views: A list of all stocks in each coverage group is available by primary analyst, stock and coverage group at
http://www.gs.com/research/hedge.html. The analyst assigns one of the following coverage views which represents the analyst's investment outlook
on the coverage group relative to the group's historical fundamentals and/or valuation. Attractive (A). The investment outlook over the following 12

Goldman Sachs Global Economics, Commodities and Strategy Research 14


February 5, 2010 Portfolio Strategy: Strategy Matters

months is favorable relative to the coverage group's historical fundamentals and/or valuation. Neutral (N). The investment outlook over the
following 12 months is neutral relative to the coverage group's historical fundamentals and/or valuation. Cautious (C). The investment outlook over
the following 12 months is unfavorable relative to the coverage group's historical fundamentals and/or valuation.
Not Rated (NR). The investment rating and target price have been removed pursuant to Goldman Sachs policy when Goldman Sachs is acting in an
advisory capacity in a merger or strategic transaction involving this company and in certain other circumstances. Rating Suspended (RS). Goldman
Sachs Research has suspended the investment rating and price target for this stock, because there is not a sufficient fundamental basis for
determining an investment rating or target. The previous investment rating and price target, if any, are no longer in effect for this stock and should
not be relied upon. Coverage Suspended (CS). Goldman Sachs has suspended coverage of this company. Not Covered (NC). Goldman Sachs does
not cover this company. Not Available or Not Applicable (NA). The information is not available for display or is not applicable. Not Meaningful
(NM). The information is not meaningful and is therefore excluded.

Global product; distributing entities


The Global Investment Research Division of Goldman Sachs produces and distributes research products for clients of Goldman Sachs, and pursuant
to certain contractual arrangements, on a global basis. Analysts based in Goldman Sachs offices around the world produce equity research on
industries and companies, and research on macroeconomics, currencies, commodities and portfolio strategy. This research is disseminated in
Australia by Goldman Sachs JBWere Pty Ltd (ABN 21 006 797 897) on behalf of Goldman Sachs; in Canada by Goldman Sachs & Co. regarding
Canadian equities and by Goldman Sachs & Co. (all other research); in Hong Kong by Goldman Sachs (Asia) L.L.C.; in India by Goldman Sachs
(India) Securities Private Ltd.; in Japan by Goldman Sachs Japan Co., Ltd.; in the Republic of Korea by Goldman Sachs (Asia) L.L.C., Seoul Branch; in
New Zealand by Goldman Sachs JBWere (NZ) Limited on behalf of Goldman Sachs; in Russia by OOO Goldman Sachs; in Singapore by Goldman
Sachs (Singapore) Pte. (Company Number: 198602165W); and in the United States of America by Goldman Sachs & Co. Goldman Sachs
International has approved this research in connection with its distribution in the United Kingdom and European Union.
European Union: Goldman Sachs International, authorized and regulated by the Financial Services Authority, has approved this research in
connection with its distribution in the European Union and United Kingdom; Goldman Sachs & Co. oHG, regulated by the Bundesanstalt für
Finanzdienstleistungsaufsicht, may also distribute research in Germany.

General disclosures
This research is for our clients only. Other than disclosures relating to Goldman Sachs, this research is based on current public information that we
consider reliable, but we do not represent it is accurate or complete, and it should not be relied on as such. We seek to update our research as
appropriate, but various regulations may prevent us from doing so. Other than certain industry reports published on a periodic basis, the large
majority of reports are published at irregular intervals as appropriate in the analyst's judgment.
Goldman Sachs conducts a global full-service, integrated investment banking, investment management, and brokerage business. We have
investment banking and other business relationships with a substantial percentage of the companies covered by our Global Investment Research
Division. Goldman Sachs & Co., the United States broker dealer, is a member of SIPC (http://www.sipc.org).
Our salespeople, traders, and other professionals may provide oral or written market commentary or trading strategies to our clients and our
proprietary trading desks that reflect opinions that are contrary to the opinions expressed in this research. Our asset management area, our
proprietary trading desks and investing businesses may make investment decisions that are inconsistent with the recommendations or views
expressed in this research.
We and our affiliates, officers, directors, and employees, excluding equity and credit analysts, will from time to time have long or short positions in,
act as principal in, and buy or sell, the securities or derivatives, if any, referred to in this research.
This research is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be
illegal. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of
individual clients. Clients should consider whether any advice or recommendation in this research is suitable for their particular circumstances and,
if appropriate, seek professional advice, including tax advice. The price and value of investments referred to in this research and the income from
them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may
occur. Fluctuations in exchange rates could have adverse effects on the value or price of, or income derived from, certain investments.
Certain transactions, including those involving futures, options, and other derivatives, give rise to substantial risk and are not suitable for all
investors. Investors should review current options disclosure documents which are available from Goldman Sachs sales representatives or at
http://www.theocc.com/publications/risks/riskchap1.jsp. Transactions cost may be significant in option strategies calling for multiple purchase and
sales of options such as spreads. Supporting documentation will be supplied upon request.
Our research is disseminated primarily electronically, and, in some cases, in printed form. Electronic research is simultaneously available to all
clients.
Disclosure information is also available at http://www.gs.com/research/hedge.html or from Research Compliance, One New York Plaza, New York,
NY 10004.
Copyright 2010 The Goldman Sachs Group, Inc.
No part of this material may be (i) copied, photocopied or duplicated in any form by any means or (ii) redistributed without the prior
written consent of The Goldman Sachs Group, Inc.

Gao Hua Securities Disclosures

General disclosures
This research is disseminated in China by Gao Hua Securities.

Goldman Sachs Global Economics, Commodities and Strategy Research 15


February 5, 2010 Portfolio Strategy: Strategy Matters

This research is for our clients only. This research is based on current public information that we consider reliable, but we do not represent it is
accurate or complete, and it should not be relied on as such. We seek to update our research as appropriate, but various regulations may prevent us
from doing so. Other than certain industry reports published on a periodic basis, the large majority of reports are published at irregular intervals as
appropriate in the analyst's judgment.
Goldman Sachs Gao Hua, an affiliate of Gao Hua Securities, conducts an investment banking business. Gao Hua Securities, Goldman Sachs Gao
Hua and their affiliates have investment banking and other business relationships with a substantial percentage of the companies referred to in this
document.
Our salespeople, traders, and other professionals may provide oral or written market commentary or trading strategies to our clients and our
proprietary trading desks that reflect opinions that are contrary to the opinions expressed in this research. Our proprietary trading desks and
investing businesses may make investment decisions that are inconsistent with the recommendations or views expressed in this research.
Gao Hua Securities and its affiliates, officers, directors, and employees, excluding equity and credit analysts, will from time to time have long or
short positions in, act as principal in, and buy or sell, the securities or derivatives, if any, referred to in this research.
This research is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be
illegal. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of
individual clients. Clients should consider whether any advice or recommendation in this research is suitable for their particular circumstances and,
if appropriate, seek professional advice, including tax advice. The price and value of investments referred to in this research and the income from
them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may
occur. Fluctuations in exchange rates could have adverse effects on the value or price of, or income derived from, certain investments.
Certain transactions, including those involving futures, options, and other derivatives, give rise to substantial risk and are not suitable for all
investors. Investors should review current options disclosure documents which are available from Gao Hua sales representatives or at
http://www.theocc.com/publications/risks/riskchap1.jsp. Transactions cost may be significant in option strategies calling for multiple purchase and
sales of options such as spreads. Supporting documentation will be supplied upon request.
Copyright 2010 Beijing Gao Hua Securities Company Limited
No part of this material may be (i) copied, photocopied or duplicated in any form by any means or (ii) redistributed without the prior
written consent of Beijing Gao Hua Securities Company Limited.

Goldman Sachs Global Economics, Commodities and Strategy Research 16