October 15, 2010

United States: Portfolio Strategy

US Equity Views
Updating our price targets as investors focus on 2011
S&P 500 has surged 12% in the past 7 weeks. We expect the
market will rise another 2% to reach our year-end 2010 target
of 1200. We anticipate a flat return to stocks during 1Q 2011
as economic recovery remains fragile. Despite QE2, firms will
spend only after CEO confidence improves. Our 12-month
target of 1275 (up from 1250) reflects a 9% price return.
3-Month: 2% upside to 1200 based on conditional return profile
Immediate near-term positives include 3Q earnings season, mid-term David J. Kostin
(212) 902-6781 david.kostin@gs.com
Congressional elections on November 2nd, and FOMC meeting on Nov 3rd. Goldman Sachs & Co.
Our 2% forecast return ranks in the 51th percentile of 3-month returns since
1950, conditional on a trailing 1-month return in the 0% to 5% range. Stuart Kaiser, CFA
(212) 357-6308 stuart.kaiser@gs.com
Goldman Sachs & Co.
6-Month: The economy is not the market and QE2 is not a panacea
Most investors we meet believe the Fed’s goal of reflating the economy Amanda Sneider, CFA
will drive stock prices higher. QE2 should eventually stimulate economic (212) 357-9860 amanda.sneider@gs.com
growth but earnings impact will be minimal. Firms will spend cash slowly Goldman Sachs & Co.
given spare capacity, desire to preserve margins, and low CEO confidence.
Yi Zhang
(212) 357-6003 yi.g.zhang@gs.com
12-Month: Our DDM-based valuation suggests fair value of 1275 Goldman Sachs & Co.
We expect the cost of equity will decline during the course of 2011 as risk
aversion recedes and investors turn to the economic prospects for 2012.

Path of the S&P 500: Our 3-month, 6-month and 12-month price targets
1,400

1,300 S&P 500 Forecasts 1275

1200 1200
1,200

1,100 12-Month
(+9%)
3-Month 6-Month
1,000
(+2%) (+2%)

900

800

700

600
Sep-09

Sep-10

Sep-11
Mar-09

Jun-09

Mar-10

Jun-10

Mar-11

Jun-11
Dec-08

Dec-09

Dec-10

Dec-11

Source: Compustat and Goldman Sachs Global ECS Research.

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
October 15, 2010 United States: Portfolio Strategy

Updating our 3-month, 6-month, 12-month S&P 500 price targets

The S&P 500 has surged 12% in seven weeks and now trades at 13.4x our NTM EPS
estimates, in-line with the 35-year average since 1975.
In our view, three unrelated items combined to push US share prices higher:
 September’s batch of positive macroeconomic data surprised to the upside for the first
time in five months. The Goldman Sachs aggregate monthly US-MAP score measuring
the magnitude and relevance of economic data hit the highest level since June 2009;

 Polls indicate the November 2nd mid-term Congressional elections will likely see
Republicans gain control of the US House of Representatives and narrow the current
Democratic majority in the US Senate. A divided government may reduce the policy
and regulatory uncertainty that many business leaders claim has hindered capital
spending decision-making; and

 Comments from various Fed officials made it increasingly clear that the Fed intends to
initiate a second round of quantitative easing (QE2) following the upcoming FOMC
meeting on November 2nd and 3rd. Ten-year US Treasury yields have dropped 20 bp in
four weeks to 2.57%. For context, yields peaked this year at 4.0% in early April.

We expect the S&P 500 will rise another 2% to reach our year-end 2010 target of 1200.
We anticipate US equities will trade sideways during 1Q 2011 as economic uncertainty
remains high. Our revised 12-month price target of 1275 (from 1250) reflects a potential
price return of 9% from current levels. The cost of equity should decline slightly as 2011
progresses and investors turn their attention to the economic growth prospects for 2012.

Risks to our view include a jump in management confidence leading to acceleration in

capital spending; a decision by individual investors or pension funds to re-allocate assets
from bonds to domestic equities; a rise in trade protectionism; a US municipal finance
crisis, another European sovereign credit market dislocation, and a protracted economic
slowdown in emerging markets generally and China in particular.

Exhibit 1: S&P 500 EPS should near prior peak in 2011 but index level will be below Oct ‘07
as of October 14, 2010
1,700 110
09-Oct-07
24-Mar-00 New Peak = 1565
Peak = 1527 2011 EPS 100
near
1,500 prior peak
$89 90
S&P 500
Price
1,300 1275 12-mo 80
Target
1200
S&P 500 Price

Jun-07
S&P 500 EPS

Peak EPS = $91 6 mo 70

Year-end
1,100 2010
Sep-00
Peak EPS = $57 Current 60
Mar-04
SPX
New Peak EPS
1160
900 50

40

700
S&P 500
EPS Goldman Sachs
09-Mar-09 Forecasts 30
Low = 678

500 20
Dec-96

Dec-97

Dec-98

Dec-99

Dec-00

Dec-01

Dec-02

Dec-03

Dec-04

Dec-05

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

Dec-11

Dec-12

Dec-13

Source: Compustat and Goldman Sachs Global ECS Research.

Goldman Sachs Global Economics, Commodities and Strategy Research 2

October 15, 2010 United States: Portfolio Strategy

Maintaining our 2010 year-end price target of 1200

Our interim price forecasts reflect our view of the likely path toward our 12-month
DDM-based estimate of fair value for the S&P 500. Our three- month target is the most
market-driven of our price targets.

We maintain our year-end 2010 target of 1200, reflecting a 2% expected return over
the next three months. Options currently imply a 46% probability the S&P 500 will reach
our 3-month target, suggesting we are more bullish about a recovery than market
expectations. A 3-month return of 2% would rank in the 51th percentile of 3-month returns
since 1950, conditional on a trailing 1-month return in the 0% to 5% range that we have just
experienced.

Exhibit 2: Distribution of 3-month S&P 500 returns implied by options market, as of October 14, 2010

16 %
Goldman Sachs
14 % 3-Month Forecast: +2%
Distribution of 3-month S&P 500
returns implied by options market Option implied
12 %
Probability Distribution

probability: 46%
10 %

8%

6%

4%

2%

0%
< (30)% (24)% (18)% (12)% (6)% 0% 6% 12 % > 18 %
3-Month Returns

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

Exhibit 3: Distribution of S&P 500 forward 3-month returns conditional on trailing 1-month returns since 1950

Distribution of Following 3-Month Returns

(15)% to (10)% to (5)% to 0% to 5% to 10% to
< (15)% (10)% (5)% 0% 5% 10% 15% > 15%
Trailing 1-Month Returns

< (15)% 3% 10 % 10 % 15 % 30 % 13 % 3% 16 %

(15)% to (10)% 5 4 7 17 18 21 14 15

(10)% to (5)% 5 7 9 17 27 20 10 6
(5)% to 0% 2 3 8 22 31 22 8 3

0% to 5% 1 3 9 22 33 23 7 2

5% to 10% 2 4 9 20 27 26 11 2

10% to 15% 0 2 6 26 26 24 16 2

> 15% 0 0 11 5 30 16 30 8

Source: Compustat and Goldman Sachs Global ECS Research.

Goldman Sachs Global Economics, Commodities and Strategy Research 3

October 15, 2010 United States: Portfolio Strategy

Three topics will drive US equities over the next several months
1. Earnings season (October 18th-November 5th). The crescendo of quarterly reporting
season is upon us and 395 companies in the S&P 500 (78% of the equity cap) will report 3Q
earnings results in the next three weeks (Oct 18th to Nov 5th). As we discussed in our
October 8th report, 3Q 2010 Earnings season preview: We expect positive EPS surprises,
current bottom-up consensus expects 3Q earnings to be below 2Q actual results for the
overall S&P 500 and for six of the 10 sectors (see Exhibit 4).

US economic activity during 3Q was positive, albeit below trend, making it unlikely
that S&P 500 earnings will decline sequentially from 2Q to 3Q. Current consensus
expects 3Q 2010 revenues (ex Financials and Utilities) will rise by 6% year/year while EPS
for the same cohort of companies increases by 19% (30% for the entire S&P 500 including
Financials and Utilities) (see Exhibit 5).

Exhibit 4: Strong 2Q EPS did not flow through to 3Q

as of October 13, 2010
24
2010 S&P 500 Consensus EPS by Quarter
22 4QE $22

2Q $21

20 3QE $21

1Q $19
18

16
31-Jan

31-May
28-Feb

30-Jun

31-Jul
31-Dec

31-Dec
30-Sep

30-Nov
31-Oct
31-Mar

31-Aug
30-Apr

Source: First Call, Compustat, and Goldman Sachs Global ECS Research

Exhibit 5: S&P 500 Bottom-up consensus estimates for 3Q 2010; as of October 13, 2010
3QE 2010 Bottom-up Consensus
Sales Margin EPS
Growth Change Growth
$/Share yoy Level yoy $/Share yoy
Info Tech $24 14 % 16.0 % 340 bp $3.85 44 %
Industrials 27 8 7.3 137 2.01 33
Materials 9 8 6.7 120 0.59 32
Energy 35 20 7.1 90 2.46 37
Consumer Discretionary 30 3 6.1 78 1.85 18
Consumer Staples 34 (0) 6.7 (8) 2.24 (1)
Health Care 30 (1) 9.3 (26) 2.78 (4)
Telecom Services 8 (1) 6.4 (28) 0.52 (6)
Financials NM NM NM NM 3.20 195
Utilities NM NM NM NM 1.04 3
S&P 500 $20.53 30 %
ex. Financials and Utilities $197 6% 8.3 % 88 bp 16.29 19

Source: Compustat, FirstCall, I/B/E/S and Goldman Sachs Global ECS Research.

Goldman Sachs Global Economics, Commodities and Strategy Research 4

October 15, 2010 United States: Portfolio Strategy

2. Mid-term elections (November 2nd). All elections have consequences, but the stakes
seem especially high this cycle. Many portfolio managers view the prospect of a divided
Congress as positive for equities in terms of reduced legislative uncertainty. Simply put,
investors believe gridlock is good for equity markets.

A change of control election in the House and/or Senate has generally been
associated with positive returns during the subsequent 12 months. The average gain
in the S&P 500 during the 12 months following the six Congressional change of control
elections since 1950 (including two Presidential election years) equals 11% with minimum
and maximum returns of -4% and 33%, respectively (see Exhibit 6). Historically, the S&P
500 has generated positive 12-month returns following all 15 mid-term elections since 1949.
Returns ranged from 3% to 33% with an average of 18%.

According to RealClearPolitics.com, an independent political web site that aggregates

polling data, Republicans seem likely to gain control of the House of Representatives
while Democrats appear likely to retain their majority in the US Senate.
Polls as of October 13, 2010 show 211 seats in the House of Representatives as safe or
leaning Republican, 185 seats as safe or leaning Democratic, with 39 seats considered
“toss- ups.” Majority in the 435-seat House requires 218 votes and 38 of the 39 toss-up
seats are currently held by Democrats. RealClearPolitics.com shows 48 seats in the US
Senate as safely Democratic or not up for election (including 2 independents who caucus
with the Democrats), 46 seats as safely Republican or not up, with 6 seats considered
“toss-ups.” All six “toss-up” seats are currently held by Democrats.

We recognize that many investors believe a divided government is good for

equity markets. However, clarity is needed in areas such as tax policy. The 2001-
2003 tax cuts will sunset on December 31, 2010 and capital gains, dividend and estate taxes
will all increase sharply if Congress takes no action during the truncated lame duck session
following the election. For additional details see US Economics Analyst: Thoughts on the
Midterm Election (October 8, 2010).

Exhibit 6: Congressional change of control has happened six times since 1950
as of September 29, 2010
60
Controlling Party
50 House of Rep. Senate 1 Year
Year Old New Old New Return
Percentage Change vs. Election

40 33%
1952 D R D R 0.1 %
1954 R D R D 33.0
30 1980 D D D R (4.4)
1986 D D R D 3.2
20 1994 D R D R 24.7
11%
2006 R D R D 10.3
10

0
-4%
(10)

(20)
Congressional
(30) S&P 500 (1951 - 2007) Change of Control
Average % Change Election
(40)
-12 -9 -6 -3 0 +3 +6 +9 +12
Months from Election
Source: Compustat and Goldman Sachs Global ECS Research.

Goldman Sachs Global Economics, Commodities and Strategy Research 5

October 15, 2010 United States: Portfolio Strategy

3. Quantitative Easing (November 3rd). The widely held consensus view of both buy- and
sell-side economists is that the Fed will initiate a second round of quantitative easing (QE2)
following the November 2nd-3rd FOMC meeting. Various estimates exist regarding the
specific size and form of the asset purchase program. Although it will probably start
smaller, our US Economics Research group believes Fed purchases of US Treasuries will
cumulate to $1.0 trillion or more.

The decision to begin QE2 represents an explicit acknowledgement by the Fed that US
economic growth remains extremely weak and unemployment is likely to remain much
higher than its policy mandate. Given public statements by Fed officials that inflation is
also running below its target, the Fed’s upcoming QE2 initiative is a dramatic attempt to
create inflation—or at least inflation expectations – and rouse the economy from its torpor.

Reflecting on the client meetings we have hosted during the past few weeks, most
investors’ are optimistic regarding the market impact of the Fed’s actions. These investors
believe the market will continue to rally even after the Fed’s announcement next month.

There is friction between macro and micro investors’ interpretation of the impact of
QE on equities. In the broadest terms the affirmative macro case for QE2 rests on
easier financial conditions and the goal of asset price inflation. The skeptical micro
view is that additional easing is an acknowledgement of the weak US growth outlook
and will not drive earnings meaningfully higher in the near-term. We discuss these
views in more detail below.

Equities and QE2: The Macro Affirmative

We boil equity investors’ bull case for QE down to four points (1) the positive
relationship between easier financial conditions and equity returns; (2) reduced risk of
double-dip recession in 2011; (3) support for prices of long-dated assets; and (4) lower
rates making equities more attractive in relative terms.
Our Global Markets team has highlighted an easing in Financial Conditions (FCI) since early
August that has been most pronounced in OECD countries, particularly the US and UK.
Although the mechanics of easing may be “unconventional” in this case the impact should
be similar and include a weaker USD, reflationary pressure on equities, and lower average
global interest rates. Easing FCI should also help reduce the risk of another US recession,
as our US Economists estimate $1 trillion of asset purchases could create a potential boost
to real GDP growth of about ½ percentage point, using historical rules of thumb.

The difference between the current case (QE2) and QE1 is that policy is more focused on
longer duration assets this time, which may mean a more direct impact on equities and
foreign bonds in addition to domestic credit products. Even if the impact on equities is
second order, lower long-term interest rates should serve to increase the relative
attractiveness of equities versus credit products with the potential (albeit impossible to
estimate) to motivate portfolio reallocation. Both support of long-dated asset prices and
asset allocation would argue for multiple expansion in US equities. Outside of the points
we have highlighted, investors are also discussing the positive wealth effect from asset
price inflation, a weaker USD, and increased corporate investment.

Recent equity performance and our own analysis show that Fed security purchases
are positive for equity prices, all else equal. Our own 2011 S&P 500 earnings estimate
already reflects QE to some degree, as $1 trillion of asset purchases is an element of our
US Economics 2011 real GDP forecast of 1.8%. Together that implies that QE2 might push
multiples higher but would not have the real impact on the growth outlook or S&P 500
earnings necessary to make equity markets attractive to incremental buyers.

Goldman Sachs Global Economics, Commodities and Strategy Research 6

October 15, 2010 United States: Portfolio Strategy

Exhibit 7: US Financial Conditions have eased further Exhibit 8: S&P earnings yield is at a large premium to 10-
since July to a 5-year low year Treasury bonds

102 8
S&P 500 earnings yield - 10-year Treasury yield
101 6
US Financial Conditions Index

100

Yield premium (%)

4
99
2
98
0
97

96 -2

95 -4

Dec-76

Dec-79

Dec-82

Dec-85

Dec-88

Dec-91

Dec-94

Dec-97

Dec-00

Dec-03

Dec-06

Dec-09
Jun-06

Jun-07

Jun-08

Jun-09

Jun-10
Dec-05

Dec-06

Dec-07

Dec-08

Dec-09

Source: Goldman Sachs Global ECS Research Dec-10 Source: Factset, Compustat and Goldman Sachs Global ECS Research

Our rough estimate is that $1 trillion of QE2 could drive 8% to 10% of upside for US
equities but that much of that move may have already occurred. Using the impact on
financial conditions and asset prices of the first round of QE as a guide, our US Economics
team estimates that an announcement of $1 trillion of QE2 could move the S&P 500 8%
higher with additional upside to 10% in the ensuing month. They believe the market began
anticipating QE2 in early August in response to FOMC announcements and media reports
at the time. See US Economics Daily: QE2: How Much Has Been Priced In? October 7, 2010
https://360.gs.com/gs/portal/home/fdh/?st=1&d=9793063

As a complement to that work we analyzed the impact on weekly equity returns since 2003
from weekly changes in (1) AMG mutual fund flows (including ETFs); (2) aggregate US
MAP scores; and (3) securities held on the Fed’s balance sheet. This framework suggests a
9.5% tailwind for the S&P 500 assuming $25 billion of securities purchases per week for 40
weeks ($100 billion per month or $1 trillion of total purchases) all else equal. That time
frame is likely conservative as our economists believe larger purchases over a shorter time
may have more impact. While that conclusion is quite encouraging it comes with three
important caveats. First, there is a great deal of uncertainty around this framework and the
3 factor model has an r-square of only 0.12. Second, the S&P 500 has outperformed this
framework by 750 bp since the start of August so much of the impact may already be
priced in, consistent with our Economists’ work. Third, QE2 will not occur in a vacuum and
we estimate the positive impact from $25 bn of security purchases would be offset by a
MAP score of -9 or $1.6 bn in AMG mutual fund outflows (all numbers weekly).

Over time we believe QE2 will be positive for US equities through reduced economic
uncertainty and price support (multiple expansion and lower interest rates). However,
a meaningful amount is already reflected in recent S&P 500 performance and our take on
investor expectations. Moderately below consensus reported economic data could also
offset security purchases.

Goldman Sachs Global Economics, Commodities and Strategy Research 7

October 15, 2010 United States: Portfolio Strategy

Exhibit 9: Since first discussion of QE2, Gold and SPX appreciated while USD depreciated
as of October 13, 2010

20
August 3
Fed discussions of Gold
15 additional easing
first become public

% return since August 3rd

10

S&P 500
5
Barclays 7-10 Year
Bond Fund
0

(5)
USD/EUR

(10)

Oct-10
Jul-10

Aug-10

Sep-10

Nov-10
Jun-10

Source: IDC via FactSet and Goldman Sachs Global ECS Research

Equities and QE2: The Micro Skeptic

Micro investors’ skepticism regarding QE rests on four points: (1) QE2 is confirmation
of a weak US real GDP growth outlook with significant downside risks; (2) rates and
credit spreads are already low, muting the impact of more easing; (3) the monetary
policy shift will have minimal near-term impact on 2011 S&P 500 earnings growth:
and (4) stock market P/E multiples are already in line with previous periods when real
interest rates were in the 1%-2% range similar to today.
As detailed above, the QE2-driven low interest rate environment should attract buyers to
risky assets (such as equities). Those interest rates – if kept low enough for long enough –
will eventually create inflation, boost nominal GDP and increase sales (which are correlated
with GDP). Earnings forecasts should then rise assuming there is no erosion in corporate
profit margins. The prospect that margins may also rise would represent a tailwind for EPS
and could arguably lead to a P/E expansion resulting in higher share prices.

However, we believe it is important to separate the economic analysis of QE2 from

the potential equity market impact. Our US economics research colleagues have
published extensively on many aspects of how QE2 may work. We focus below on
potential equity market implications which are clouded by low corporate and consumer
confidence and already high margins that may limit the impact of QE.

Corporations have not taken advantage of already low rates due to low confidence.
QE2 will effectively penalize individuals and companies for holding cash because yields
across the term structure will remain extraordinarily low for an extended period of time. At
some point companies should begin to engage in capital spending. Even if the forecast
return from a given project is low, it most likely will exceed the yield on cash, which
currently hovers just above zero and will stay unchanged for an extended period. That said
rates and spreads are low now and comments from corporate managements suggest they
are holding off on hiring and capital spending due to high macro uncertainty.

Goldman Sachs Global Economics, Commodities and Strategy Research 8

October 15, 2010 United States: Portfolio Strategy

Mergers motivated by low rates are unlikely to contribute to domestic economic

growth. Low interest rates and a receptive corporate bond issuance market have led to an
uptick in both friendly and unsolicited M&A activity. Mergers certainly represent one way
for US companies to reduce the $1.0 trillion of cash on their balance sheets (excluding
Financials). But mergers are unlikely to contribute to domestic economic growth given
most business combinations are justified or rationalized on the basis of anticipated cost
savings. Accretion – or “synergy” in management consultant parlance – typically involves
job cuts and unfortunately works at cross purposes with policymakers’ goal of reducing the
current 9.6% unemployment rate in the US.

Further upside to corporate margins may be limited given near record levels for many
industries. Managements are reluctant to slash margins and investors have come to
expect and reward steady improvements in operating efficiency. Given that Goldman
Sachs Economics forecasts 1.8% GDP growth in 2011 vs. a consensus estimate of 2.5%, we
continue to recommend our low vs. high operating leverage trade. Our intuition is that as
consensus GDP forecasts downshift closer to our expectation then sales growth forecasts
will have to be reduced accordingly. Firms with low operating leverage should be less
susceptible to negative EPS revisions relative to companies with high operating leverage.
Our preferred implementation is via our Bloomberg baskets (GSTHOPLO vs. GSTHOPHI).

QE2 is unlikely to meaningfully boost company earnings above our current forecasts.
Firms may be able to borrow at historically low interest rates, but excess capacity exists
across many industries so the prospect that “cheap” money abounds will not necessarily
spark a new round of capital spending. While equities may benefit from reduced downside
risk (if recession probabilities are lowered by QE) our earnings estimates already
incorporate some degree of QE and a ½ percentage point increase to US real GDP growth
will not significantly change our S&P 500 earnings outlook.

If QE2 won’t meaningfully boost earnings (although it should over time as GDP
growth improves) then the transmission mechanism to higher stock prices must
come via another route. The bullish argument that QE2 will raise the price of risky assets
rests on the notion that lower interest rates will reduce the cost of equity and applying a
lower discount rate in a DDM will raise the present value of future earnings and dividends
and thereby boost the current fair value of stocks.

Exhibit 17 shows the sensitivity of 12-month forecast fair value levels of the S&P 500
to a variety of cost of equity assumptions and long-term core inflation rates. Many of
the other variables in our DDM will remain nearly unchanged over the next year including
the real growth rate and the terminal EPS growth.

We agree with the theoretical argument above that a lower cost of equity raises the
fair value of stocks. However, as a practical matter a lower cost of equity is simply
another way of saying that stocks should trade at a higher P/E multiple.

The link between QE and P/E: Money Flow

Positive money flow will be needed to expand S&P 500 P/E multiples above its
current level of 13.4x, slightly above with its 35-year average. At a minimum a firm bid
must exist from the marginal buyer such as hedge funds and retail investors. In our view,
the lack of money flow into domestic equities represents the key obstacle to US stocks
trading substantially above their long-term average following the 30% P/E multiple
expansion in 2009. Exhibit 10 shows the ownership of US equities since 1952.

Individual investors own more than 50% of US stocks. Direct share ownership totals
33% and indirect ownership via mutual funds accounts for another 21%. In response to the
dislocation in equity markets during the past two years individuals have consistently
reduced their holdings of actively managed domestic equity mutual funds. Since the start

Goldman Sachs Global Economics, Commodities and Strategy Research 9

October 15, 2010 United States: Portfolio Strategy

of 2009, more than $1.0 trillion has been withdrawn from money market mutual funds.
None of the assets was re-directed to domestic equities. Instead, 60% was invested in bond
mutual funds, with 6% allocated to international stocks. Additional proceeds may have
been used to reduce debt or fund living expenses.

Looking ahead, money often follows performance. Therefore, a sustained uptrend in

stocks could lead to net inflows. In terms of QE2, if the Fed pushes interest rates lower
across the yield curve individual investors might shift their allocation again, this time
moving from bonds to stocks. Given the assets involved, such a move could have dramatic
impact on share prices. ETFs will likely continue to take market share.

We expect pension funds and government retirement funds are likely to at least
maintain their roughly 17% ownership share of the domestic equity market. But given
how significantly underfunded many pension plans are, a situation which is only
exacerbated by QE2, these funds should arguably increase their equity exposure and
reduce their bond allocation. In aggregate these organizations could have a dramatic
impact on the overall index level should CIOs choose to adjust long-term asset allocation.

The third ownership category worth highlighting is companies themselves where

total cash positions, cash/asset ratios, and free cash flow yields stand at or near all-
time highs. Firms in the S&P 500 hold cash equivalent to roughly 12% of the equity cap of
the market. Managements faced with the prospect of extremely low yields on their short to
intermediate term cash, but reluctant to fund new capital spending projects, could decide
to buyback shares. Although repurchase would have a positive impact on share prices, it
would not drive economic growth.

Exhibit 10: Ownership of US equity market: Individuals and pension funds own 71% of the equity market
as of June 30, 2010

100%

90%
Ownership of
US Corporate Equity Market
80% Households 33%

70% 54%

60%
Mutual Funds 21%
50%

Pension Funds 9%
40%
Government Retirement 17%
30% Funds 8%
International Investors 12%
20%
Hedge Funds 3%
10% ETFs 3%

0% Other 9%
1946
1949
1952
1955
1958
1961
1964
1967
1970
1973
1976
1979
1982
1985
1988
1991
1994
1997
2000
2003
2006
2009

Source: Federal Reserve, LionShare and Goldman Sachs Global ECS Research.

Goldman Sachs Global Economics, Commodities and Strategy Research 10

October 15, 2010 United States: Portfolio Strategy

Exhibit 11: Annual Net flows into mutual funds

as of October 6, 2010

800

637 Mutual Fund Flows

-$204 billion $ billions
600

Money Money
Market Market -$339 billion
400
375

255
200 Bonds
$ billions

US
27 US
Equity
Equity
0
Bonds US Money Bonds
Equity (40) Market
(69)
(200) (151) Money
Market

(400) +$514 billion

(539) (525)
(600)
2008 2009 2010 YTD

Source: Haver Analytics, ICI and Goldman Sachs Global ECS Research.

Goldman Sachs Global Economics, Commodities and Strategy Research 11

October 15, 2010 United States: Portfolio Strategy

Economic risks serve as a headwind for the S&P 500 in early 2011
Our US Economics team expects GDP will grow at a 1½%-2% rate through the middle
of next year and the unemployment rate will rise to 10% (see Exhibits 12 and 13). The
reason is that “short-cycle” factors such as the inventory cycle and the impulse from fiscal
policy are likely to continue deteriorating through early 2011, keeping GDP growth very
sluggish. (See “The Risk of Recession: Concentrated over the Next 6-9 Months,” US Daily
Comment, September 23, 2010).

The base case outlook is the US avoids slipping back into a recession. However, the
recession scenario also has significant probability of perhaps 25%-30%. As noted earlier, it
is still possible that all of the 2001-2003 and 2009 tax cuts will expire if Congress fails to
agree on a bipartisan “deal” during the lame duck session. We estimate that full expiration
would result in a further hit to GDP growth in early 2011 of nearly 2 percentage points
(annualized) relative to the baseline scenario that assumes extension of the lower- and
middle-income tax cuts.

Exhibit 12: GS US Economics quarterly GDP forecasts Exhibit 13: Our US Economists forecast an average 2011
unemployment rate of 10%
12
US GDP Growth (qoq annualized %)

4.0 %
11 Unemployment Rate Goldman Sachs
3.5 %
Goldman Sachs
Unemployment Rate (%)
10
3.0 % Economics Consensus 9
2.5 % Consensus
8
2.0 % 3.7 7
1.5 % 3.0 6
2.5
1.0 % 2.0 5
1.7 1.5 1.5 1.5 4
0.5 %
3
0.0 %
Q1A Q2A Q3E Q4E Q1E Q2E Q3E Q4E 2
Jan-00

Jan-02

Jan-04

Jan-06

Jan-08

Jan-10

Jan-12

Jan-14
2010 2011

Source: Bloomberg and Goldman Sachs Global ECS Research. Source: Bureau of Labor Statistics and Goldman Sachs Global ECS Research.

US MAP: macroeconomic data and equity returns

The relationship between US-MAP scores and S&P 500 returns shows that reported
economic data is important to the equity market. MAP combines the relevance and the
level of “surprise” vs. consensus forecasts in reported economic indicators to provide an
estimate of the overall importance of a given data point. Relevance is based on the impact
on the 2-year Treasury yield while surprise measures reported data against median
consensus expectations. See US Economics Analyst, June 18, 20101 for more detail on the
US-MAP methodology.

An accumulation of macro data that is persistently above/below expectations is meaningful

for the equity market. We find the monthly aggregate of US-MAP scores (a measure of the
cumulative impact of economic data between ISM reports) has explained 26% of monthly
S&P 500 returns since 2008 and nearly 50% when 2 outlier months (Dec-08 and Jul-10) are
dropped from the data. Removing those data points is arbitrary, but US ISM troughed in
Dec-08 while Jul-10 combined strong S&P 500 earnings with very weak macro data, partly
explaining divergence in those cases. The relationship was weaker from 2001 to 2008 (r^2

1
Goldman Sachs Global ECS Research: US Economics Analyst, June 18, 2010.
https://360.gs.com/gs/portal/?st=1&action=action.binary&d=9247611&r=34&fn=/document.pdf

Goldman Sachs Global Economics, Commodities and Strategy Research 12

October 15, 2010 United States: Portfolio Strategy

of 0.11) showing the market’s macro bent (note: MAP scores before 18-Jun-10 are raw
scores without US Economics judgmental adjustments).

US-MAP is tracking at -11 in October while the S&P 500 is up 2.5%. September MAP was
+39, the strongest month for reported economic data relative to consensus expectations
since June 2009. Strong data last month also ended four months of sequentially weaker
data that significantly lowered investor expectations. Looking ahead we see the potential
for US-MAP readings to again turn negative. Our US Economists expect the two MAP
inputs with the highest relevance scores (US ISM and non-farm payrolls) to weaken into
year-end. If realized that outlook would be negative for US equities and consistent with our
more defensive sector weights.

Exhibit 14: US-MAP Index of macro surprises versus S&P 500

as of October 15, 2010

60 15
US-MAP (LHS)
Monthly total MAP score

Monthly S&P 500 return (%)

40 10

20 5

0 0

(20) (5)

(40) Oct (10)

S&P 500 return (RHS) 2010
(60) (11) (15)

(80) (20)
Jul-09

Jul-10
May-09

May-10
Jan-09

Jan-10
Sep-09

Nov-09

Sep-10

Nov-10
Mar-09

Mar-10

Source: Goldman Sachs Global ECS Research.

Goldman Sachs Global Economics, Commodities and Strategy Research 13

October 15, 2010 United States: Portfolio Strategy

Our dividend discount model anchors our 12-month price target

The DDM is our preferred method to gauge the long-term valuation of the S&P 500. A
sluggish economic backdrop is not an environment conducive to either rapid earnings
growth or P/E multiple expansion. We expect neither development during the next year.
Instead, a second derivative improvement in economic data will be the most likely catalyst
for investors to look past the interim economic slowdown anticipated during the next 6
months.

Goldman Sachs Economics believe the rates of change of GDP and employment are
likely to improve as we move past early/mid-2011 and into 2012, provided the
economy doesn’t return to recession in the near term. Beyond early 2011, the impulse
of short-cycle factors such as inventories and fiscal policy to GDP growth is no longer likely
to deteriorate (i.e. it will not get worse in a second-derivative sense, although it will likely
remain negative). Meanwhile, the slow-motion improvement in areas such as excess
housing supply and bank credit quality is likely to continue. This should add up to a
gradual acceleration in growth to a trend or slightly above-trend pace by late 2011 and
going into 2012 (see US Economics Daily: More Q&A on the Outlook, October 4, 2010).

Our DDM implies a 12-month forward fair value for the S&P 500 of 1275, or 9% above
the current index level. Key inputs in our DDM appear in Exhibit 15. We expect the cost of
equity, which incorporates our ERP assumption, to decline to 8.1% by September 2011.

The S&P 500 currently trades at a NTM P/E ratio of 13.4x using our top-down EPS
estimates. Our model implies that the price improvement during the next 12 months will
be a function of declining cost of equity rather than P/E multiple expansion (see Exhibit 16).

Exhibit 15: DDM assumptions

as of October 14, 2010
3 Month 6 Month 12 Month
Assumptions
Assumed long-term EPS growth rate
Real growth rate 2.5% 2.5% 2.5%
Nominal growth rate 2.1 2.1 2.1
10 year US Treasury 2.5 2.5 3.0
Equity risk premium 5.7 5.7 5.1
Cost of Equity (risk free rate + ERP) 8.2% 8.2% 8.1%

Calculation of DCF value

Terminal year multiple 16.5 x 16.3 x 16.6 x
PV of terminal year value 825 819 880
PV of dividends years 1-20 375 381 395
PV of terminal year value + PV of dividends 1200 1200 1275

S&P 500 DDM Fair Value 1200 1200 1275

Current S&P 500 Price 1174
Premium / (Discount) to Current 2% 2% 9%
Note: Terminal multiple calculated as 1 / (cost of equity – long term inflation).

Source: Goldman Sachs Global ECS Research.

Goldman Sachs Global Economics, Commodities and Strategy Research 14

October 15, 2010 United States: Portfolio Strategy

Exhibit 16: S&P 500 Cost of Equity = ERP + 10 Year Treasury Yield
as of October 5, 2010

18

16 Forecast
14

12

10
Cost of
8 Equity
6
ERP
4
10 Year
2 US Treasury
Yield
0
Dec-81

Dec-86

Dec-91

Dec-96

Dec-01

Dec-06

Dec-11

Dec-16
Note: We estimate the equity risk premium (ERP) using our DDM framework to model expected future cash flows. We solve for the cost of equity that implies the
market is at ‘fair value’ and then deduct the10-year US Treasury.

Source: IDC via FactSet and Goldman Sachs Global ECS Research.

Sensitivity of DDM to cost of equity and inflation

The dividend discount model is most sensitive to the cost of equity and the rate of
long-term inflation. Exhibit 17 shows the range of forward 12-month fair values based on
various assumptions of cost of equity and inflation. A 10 bp change in either input adjusts
the forward 12-month fair value by approximately 30 points.

Exhibit 17: 12-Month forward DDM Fair Value sensitivity to cost of equity and long-term inflation assumptions

12-Month Forward Fair Value

12-Month Forward Cost of Equity

1,275 7.6 % 7.7 % 7.8 % 7.9 % 8.0 % 8.1 % 8.2 % 8.3 % 8.4 % 8.5 % 8.6 %
1.5 % 1264 1231 1199 1169 1139 1111 1084 1057 1032 1007 984
1.6 1295 1260 1227 1196 1165 1136 1108 1080 1054 1029 1005
Long-term core inflation

1.7 1326 1291 1257 1224 1192 1162 1132 1104 1077 1051 1026
1.8 1359 1322 1287 1253 1220 1188 1158 1129 1101 1074 1048
1.9 1394 1355 1318 1283 1249 1216 1185 1155 1126 1098 1071
2.0 1429 1389 1351 1314 1279 1245 1213 1181 1151 1122 1094
2.1 1466 1425 1385 1347 1310 1275 1241 1209 1178 1148 1119
2.2 1505 1461 1420 1381 1343 1306 1271 1237 1205 1174 1144
2.3 1545 1500 1457 1416 1376 1338 1302 1267 1234 1202 1171
2.4 1587 1540 1495 1452 1411 1372 1334 1298 1263 1230 1198
2.5 1630 1582 1535 1490 1448 1407 1368 1330 1294 1259 1226
2.6 1676 1625 1577 1530 1486 1443 1402 1363 1326 1290 1256
2.7 1724 1671 1620 1572 1525 1481 1439 1398 1359 1322 1286

Source: Goldman Sachs Global ECS Research.

Goldman Sachs Global Economics, Commodities and Strategy Research 15

October 15, 2010 United States: Portfolio Strategy

Exhibit 18: We expect no P/E expansion during the next 12 months

as of October 14, 2010

17

P/E (NTM)
Target
16 Year-end 2010
P/E
15

14 Bottom-up 13.4x
Consensus
P/E
P/E Multiple

13 13.5x
13.4x 13.3x
12
11.5x Current
11 top-down
P/E

10
SPX
9 Trough

8
Mar-08

Jun-08

Mar-09

Jun-09

Mar-10

Jun-10

Mar-11

Jun-11
Sep-08

Dec-08

Sep-09

Dec-09

Sep-10

Dec-10

Sep-11

Dec-11
Source: Compustat, I/B/E/S and Goldman Sachs Global ECS Research.

Exhibit 19: Consensus NTM P/E over time

as of October 14, 2010

30

25
P/E (NTM)
20 Bottom-up
Consensus Current
Long-term P/E Bottom-up
P/E Multiple

average Consensus
15 13.0x 13.3x

10

0
Dec-76

Dec-79

Dec-82

Dec-85

Dec-88

Dec-91

Dec-94

Dec-97

Dec-00

Dec-03

Dec-06

Dec-09

Dec-12

Dec-15

Source: Compustat, I/B/E/S and Goldman Sachs Global ECS Research.

Goldman Sachs Global Economics, Commodities and Strategy Research 16

October 15, 2010 United States: Portfolio Strategy

Appendix A: Triangulation of three valuation approaches

Our traditional valuation framework for the S&P 500 incorporates three different
analyses. The dividend discount model (DDM) represents one element of our three-
pronged approach to estimating fair value for the S&P 500. We also use a mean reversion
of P/E multiples and various versions of the Fed model.

We place a greater emphasis on the results of our DDM compared with the other
valuation approaches. Our DDM implies a 2010 year-end fair value for the S&P 500 of
1200, 2% above the current level of the S&P 500.

The Fed model (a macro or top-down approach) suggests the S&P 500 trades 20%
below fair value. Today’s unusually low interest rate environment explains why this
method shows the market to be so undervalued. The P/E multiple mean reversion method
(a micro or bottom-up approach) implies the undervaluation of the S&P 500 is almost 25%.

Exhibit 20: Triangulation of three approaches

as of October 14, 2010

Year-end 2010 S&P 500 Fair Value

Upside / (Downside)
Goldman Sachs From Current
Methodology Top-down S&P 500 Level

US Portfolio Strategy DDM 1200 2%

Fed model 1410 20 %

US Treasury 10 Year Yield 1410 20
BBB Corporate 10 Year Yield 1410 20
10 Year TIPS Yield 1410 20

Reversion of P/E to 10-yr avg 1440 23 %

Avg Fair Value (using 3 approaches) 1350 15 %

Note: Valuation based on pre-provision and write-down earnings estimates

Source: Goldman Sachs Global ECS Research.

The Fed model suggests the S&P 500 is 20% below fair value. The Fed Model approach
at its core compares the S&P 500 earnings yield (inverse of P/E using NTM earnings) with
the 10-year Treasury yield. The rationale for the model is that investors ultimately choose
whether to invest in equities or bonds, and that the yield differential of the two assets
should be roughly comparable over time. We calculate the S&P 500 upside or downside to
fair value by assuming the yield spread reverts to the 10-year trailing average spread with a
price change by the S&P 500 that closes half the gap.

We base our Fed Model valuation on an average of three versions of the model: the
traditional model comparing S&P 500 earnings yield to 10-year Treasury yield, one which
substitutes 10-year BBB corporate bond yields, and a third that uses TIPs. The current yield
gap is extremely wide by historical standards. Mean reversion of the yield spread
relationship suggests 20% upside to S&P 500 and an implied P/E of 15.9x.

Goldman Sachs Global Economics, Commodities and Strategy Research 17

October 15, 2010 United States: Portfolio Strategy

Exhibit 21: 10-year Treasury yield near all-time low Exhibit 22: Fed Model implies P/E of 15.9X
as of October 14, 2010 as of October 14, 2010

14 % 600 bp
10-year Treasury yield 10-year Treasury yield
1987
12 %
and S&P 500 earnings yield Consensus 400 bp less S&P 500 earnings yield Rolling 10-year

Yield Spread (10 yr yield - S&P 500 E/P)

Bottom-up
average
Earnings Yield
10 % 200 bp

0 bp
Yields

8% 2000

(200) bp
6%

(400) bp
4%
US Treasury
10-Year Yield (600) bp
2%
1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012
(800) bp

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012
Source: First Call, Compustat and Goldman Sachs Global ECS Research. Source: First Call, Compustat and Goldman Sachs Global ECS Research.

Current P/E valuation is low relative to the average historical multiple in tame
inflation environments. On a cyclically-adjusted basis, the S&P 500 trades at 17.1x trailing
10-year average EPS, slightly above the 80-year average of 16.7x.

Exhibit 23: On a cyclically-adjusted basis, S&P 500 P/E valuation is near 80-year average
as of October 14, 2010

45

40
Cyclically Adjusted
35
S&P 500 P/E Ratio
(10-year average trailing EPS)
Cyclically-Adjusted P/E

30

25
Current
(14-Oct)
20 80 year 17.1x
avg = 16.7x
15

10
9-Mar-09
5 9.9x
1932 16-Aug-82
5.1x 6.2x
0
Dec-27
Dec-30
Dec-33
Dec-36
Dec-39
Dec-42
Dec-45
Dec-48
Dec-51
Dec-54
Dec-57
Dec-60
Dec-63
Dec-66
Dec-69
Dec-72
Dec-75
Dec-78
Dec-81
Dec-84
Dec-87
Dec-90
Dec-93
Dec-96
Dec-99
Dec-02
Dec-05
Dec-08
Dec-11
Dec-14

Source: Compustat, Robert Shiller, and Goldman Sachs Global ECS Research.

Goldman Sachs Global Economics, Commodities and Strategy Research 18

October 15, 2010 United States: Portfolio Strategy

Exhibit 24: Average S&P 500 Forward P/E by Inflation Bands

as of October 13, 2010

20x
Average S&P 500 Forward P/E
17.1x by Inflation Bands, 1976-2010
15.6x
14.7x 14.3x
15x

Average NTM P/E

10.6x
10.1x
10x
8.0x
6.8x 6.7x 6.5x

5x

11 53 105 93 56 24 27 6 6 35
mo

0x
1% & 1% to 2% to 3% to 4% to 5% to 6% to 7% to 8% to 9% &
below 2% 3% 4% 5% 6% 7% 8% 9% above
Headline CPI Band

Source: FactSet and Goldman Sachs Global ECS Research.

Exhibit 25: Average S&P 500 Forward P/E by Real 10-Yr Bands
as of October 13, 2010

20x
Average S&P 500 Forward P/E
by Real 10 Yr Rate Bands, 1976-2010
16.0x 16.0x

15x
13.6x
12.8x
Average NTM P/E

10.8x
10.1x
10x
7.7x 7.5x 7.7x
7.3x

5x

63 66 58 92 63 25 16 16 9 4
mo

0x
1% & 1% to 2% to 3% to 4% to 5% to 6% to 7% to 8% to 9% &
below 2% 3% 4% 5% 6% 7% 8% 9% above
US Ten Year Yield minus Headline CPI Band

Source: FactSet and Goldman Sachs Global ECS Research.

Goldman Sachs Global Economics, Commodities and Strategy Research 19

October 15, 2010 United States: Portfolio Strategy

Exhibit 26: The Bottom Line

Our key forecasts for the S&P 500 index, recommended sector positioning and top thematic trade ideas;
Price targets as of October 15, 2010 and pricing as of October 14, 2010

S&P 500 Index Forecasts

S&P 500 Price Targets Current Level 3 Month 6 Month 12 Month
1174 1200 (+2%) 1200 (+2%) 1275 (+9%)
S&P 500 EPS estimates 2008A 2009A 2010E 2011E
GS Portfolio Strategy top-down $50 $57 $81 $89
Growth (% year/year) (40) 15 43 10
Recommended Sector Positioning
Recommended GS Overweight / S&P 500 Total Return GS Alpha
S&P 500 Sector Positioning Underweight (a) Weight 2010 YTD

Information Technology 300 bp 19% 3% (10)bp

Consumer Staples Overweight 200 11 10 (1)
Telecom Services 100 3 12 (4)

Energy 0 11 4 (17)
Financials 0 16 2 0
Industrials Neutral 0 11 18 3
Materials 0 4 8 (11)
Utilities 0 4 6 5

Consumer Discretionary (300) 10 17 (22)

Underweight
Health Care (300) 12 1 19
S&P 500 0 bp 100% 7% (37)bp
Thematic Trade Recommendations
Initiation
Our best trade ideas: Portfolio Strategy thematic baskets (b) Date Return
BUY Low Operating Leverage (GSTHOPLO); SELL High Operating Leverage (GSTHOPHI)
See US Equity Views: Adjusting S&P 500 earnings forecasts and price targets (9-Aug-10). 9-Aug-10 (3.9)%
BUY High Dividend Growth (GSTHDIVG); SELL S&P 500
See US Equity Views: Adjusting S&P 500 earnings forecasts and price targets (9-Aug-10). 9-Aug-10 0.3 %
BUY High Sharpe Ratio Basket (GSTHSHRP); SELL S&P 500
See 2010 Outlook: Cyclical start; defensive finish (7-Dec-09). 7-Dec-09 9.1 %
BUY BRICs Sales Basket (GSTHBRIC); SELL S&P 500
See Portfolio Passport: Coming to America (5-Nov-08). 4-May-09 15.2 %

(a) Sector weightings last rebalanced on 14-Sep-10. (b) US Portfolio Strategy baskets may be found on Bloomberg by typing <GSSU5>. The Bloomberg page provides
real-time basket performance and current basket constituents. To obtain access to our baskets on Bloomberg, please contact your Goldman Sachs salesperson. The
ability to trade these baskets will depend upon market conditions, including liquidity and borrow constraints at the time of trade.

Source: FactSet and Goldman Sachs Global ECS Research.

Goldman Sachs Global Economics, Commodities and Strategy Research 20

October 15, 2010 United States: Portfolio Strategy

Disclosures
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 21

October 15, 2010 United States: Portfolio Strategy

Reg AC
We, David J. Kostin, Stuart Kaiser, CFA, Amanda Sneider, CFA and Yi Zhang, 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.

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Goldman Sachs Global Economics, Commodities and Strategy Research 22

October 15, 2010 United States: Portfolio Strategy

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Goldman Sachs Global Economics, Commodities and Strategy Research 23