>2010 US Equity Outlook: The Shape of Things to Come and Seven Trades

Seven questions on the shape of things to come
Our fundamental thesis remains that after a corporate over-contraction, the necessary expansion underway to meet existing demand will maintain pressures for a cyclical recovery into 2010. Enterprise spending and hiring will determine the speed of recovery and its sustainability. Instead of a detailed baseline and alternative scenarios, we discuss seven key questions:

Q1. After cost-cutting, how much upside remains for earnings? Significant.
Q2. How severe will a possible double-dip be? Is it priced in? Modest, a ‘W’ in growth rather than in the level of GDP; market is pricing in flat-to-down earnings.
Q3. Will monetary tightening derail the equity recovery? No. It should have only a temporary impact on US equities.
Q4. Will the dollar turn in 2010? Bad for US equities? We see the dollar rallying with US rates, but not ruling out upside for equities; energy is most vulnerable.
Q5. How are investors positioned after the massive rally? A large asset allocation underweight in equities persists; inflows will come only after rates turn up.
Q6. Will the financials outperform? We think so: current underperformance exceeds that in the Great Depression; they are cheapest on normalized earnings; and employment is a key driver of relative performance.
Q7. Will emerging markets continue to outperform the developed markets? Bulk of outperformance reflected multiple expansion not earnings growth; relative valuations have run up and so we prefer DM stocks with EM exposure over EM.

Revised targets, market & sector strategy
We revise up our EPS estimate for the S&P 500 in 2010 to $80.8 ($77.8) and our S&P 500 target to 1325 (1260). Across asset classes, we see the biggest upside for equities; but our sector allocations make us already overweight in a beta sense and so we stay fully allocated. Across sectors, our largest overweight remains the financials, and the largest underweight energy. We move health care from underweight to neutral as diminishing uncertainty about reform lifts multiples.

Seven trades for 2010
(i) Significant recovery upside but also downside risks: Best of both worlds basket, high-quality stocks cheap on normalized earnings;
(ii) M&A up cycle beginning: Buy acquisition targets;
(iii) Rising rates: Long brokers (XBD) and short REITs (IYR);
(iv) Stronger US dollar: Long retailers (RTH) and short energy (XLE);
(v) Overweight US versus emerging markets: Long US financials (XLF) and short EM financials;
(vi) Flows follow: Stay with value over growth;
(vii) Uncertainty to decline: Short S&P 500 12m forward volatility.

To read the full report: US EQUITY STRATEGY