>GLOBAL STRATEGY (MORGAN STANLEY)

Mid-Cycle Valuations – Finding the “Value” in Global Cyclicals
Mid-Cycle Earnings: What Looks Cheap and Where

• The rally in global equity markets has seen the Global cyclical sectors (Discretionary, Industrials, Materials and Information Technology) rise 77% from the low set on March 9th, outperforming Global defensive sectors by 40%. The rally has been largely driven by multiple expansion, with the forward P/E of the MSCI World index up 40% for the cyclical sectors, in comparison to forecast earnings which are up 13% over the same period.

• We think the multiple expansion phase of the cycle is now largely over (see our report titled “Global Equity Strategy: A Rally, But One to Sell Into”). Consequently, our focus is now on how quickly earnings can ramp up to support further price performance and how stocks are priced on a return to more trend-like earnings. This is particularly important for Materials, Industrials and Consumer Discretionary, where arguably year-ahead earnings are likely to be below trend. Technology is different: current consensus forecasts expect the IT sector to reach a new earnings peak in 2010.

• We create estimates of trend earnings for the major regions: the US, Europe, Asia ex-Japan, and Japan. (This is based on work by Toby Walker, our Australian Equity Strategist. See his note “Who Continues to Look Cheap on Mid-cycle Value”, dated October 1, 2009). Based on the past four cycles (73-75, 80-83, 90-91, 00-02), earnings take an average of two years to recover to mid-cycle levels (see page 10). Consensus expects this cycle to be different. In the current cycle, consensus expects earnings to trough in 2009 and get back to the 2007 cycle peak in 2010. We believe this is highly optimistic, and history supports this view. Our base case calls for earnings to bottom in 2009, with a return to mid-cycle ROE’s by 2011.

• Our analysis suggests that Japanese cyclicals are trading at the largest discount to mid-cycle earnings, followed by Europe. The cyclical sectors in the US are the least attractive at only 9.4% below their trend earnings valuation despite having to wait until 2011/12 before reaching this earnings level.

• Among the sectors, Industrials and Materials are most attractive in Japan, Consumer Discretionary is most attractive in Asia Pacific ex-Japan, and Technology is the best value in
Europe. None of the US cyclical sectors show strongly on a trend earnings valuation basis, which fits with the relative performance of US over rest-of-world cyclicals since markets bottomed in early March.

To see the full report: GLOBAL STRATEGY