JPM US Equity Outlook 2011

8/8/2019 JPM US Equity Outlook 2011

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North America Equity Research10 December 2010

2011 OutlookYE 2011 Target 1425; Raise '11E EPS to $94 from$91; Introduce '12E EPS of $102

US Equity Strategy

Thomas J Lee, CFAAC

(1-212) 622-6505

[email protected]

Daniel M McElligott(1-212) 622-5598

[email protected]

J.P. Morgan Securities LLC

See page 70 for analyst certification and important disclosures.J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm mhave a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making thinvestment decision.

Year-End 2011 S&P 500 Price Target: 14

S&P EPS EstimatesJPM Bottom

Strategy St

2010E $85.50 $84

2011E $94.45 +10% $95

2012E $102.00 +8% $108

Sector Weightings

Overweight: FinancialsIndustrialsEnergyMaterialsTechnologyDiscretionary

Neutral: HealthcareTelecom

Underweight: StaplesUtilities

Strategy View

Third year of expansion and third year ofpresidential cycle

Credit eases in 2011 and labor grows175k/month Sector rotation greatest in third year of bumarket; best window is 4-mo intervals

Favor Cyclicals early in 11 and Defensive

later in year Domestic Cyclicals over Intl

We see the S&P 500 delivering at least a 15% gain 2011, driven more by valuation

expansion (risk premium falling) than EPS beats. Our YE2011 S&P 500 target is

1425, based on 14x 2012E EPS of $102. History (see below) suggests an even stronger

20%-plus gain, and history also suggests there should be more rapid industry rotation

in 2011 (year 3) than any prior year. Thus, for the portfolio manager, 2011 represents

some daunting challengesa 15-20% bogey to beat along with even greater group

rotation than in 2010. Thus far, this market has been textbook in staging

leadership, and we introduce some tools in this report to target alpha generation.

US GDP growth is forecast to accelerate to 3.5% (4Q/4Q) from 2.6% in 2010 (see

Figure 9) aided by expansionary behavior by business and consumer, rehabilitation

of consumer balance sheets, and accommodative fiscal and monetary policy. We see

labor picking up, adding 175k/month. Inflation remains muted due to resource slack.

History strongly argues for an even stronger year in equities. This is the 3rd year

of a business expansion AND the 3rd year of a presidential term. There were only 5

periods (see Figure 10) in the 111 years of Dow history when both occurred and

markets rose in each instance posting an average gain of 21%. The risks of a bear

market in 2011 appear low given (i) low recession risk; (ii) low inflation;

(iii) positive real rates; and (iv) higher EY vs. BAA BY. These 4 items were key

determinants (of 20 we examined) of longer (vs. shorter) bull markets (Figure 14).

Finally, relative value should strongly support stocks in 2011. Equity risk premium

remains at 50-year high at 6.2% (see Figure 15) (our 14x assumes premium drops to

5.7%, well above 10-yr avg. of 3.56%). Moreover, forecast returns in 2011 for fixed

income markets are meaningfully weakerwith treasuries negative (see Figure 17),

high grade +2%against double-digit increases seen for commodities and equities.

Sector correlations historically have fallen to cycle lows during the 3rd year of a bull

market suggesting a drop in correlation from 90% (see Figure 21).

MARKET STRATEGY: GROUP LEADERSHIP LIKELY ROTATES MORE

RAPIDLY IN 2011, ARGUING FOR STAGING MARKETS. We compared the

price performance of 30 industries at each point in the bull market cycle (thus,

staging) and found top-quartile leadership shifted rapidly in Year 3 compared to

Years 1 and 2 (see Figure 26). This seems logical to us as a fall in correlation leads

to divergences and business cycle dynamics dominate. This bull market, as we

noted, has been a textbook example thus far. The top 8 groups which history

indicated should outperform in 2010 indeed outperformed by 1,000bp while the

expected worst 8 (based on history) underperformed by 400bp. For 2011, staging

analysis suggests best groups in the first 4 months of 2011 should be: Asset

Managers, Insurance, Construction Materials, Restaurants, Retail, Gaming,and oddly Telecom Services, and Utilities (see Figure 25).

18 IDEAS. We identified 18 names expected to outperform in early 2011, using the

following criteria: (i) top quartile of staging (above); (ii) top style factor of high-beta

which is attractive on institutional ownership and relative P/E (vs. LT avg.); and

(iii) rated OW. The tickers are: ODP, OZM, IVZ, ALL, NIHD, OMX, OC, LVS,

LTD, MW, AFL, GPI, BEN, PNK, HIG, M, MET, and AXP.


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Thomas J Lee, CFA(1-212) [email protected]

Table of Contents#1: Solid GDP Growth Expected in 2011 ................................3

#2: History Argues for 20%-Plus Year ....................................9

#3: Relative Return of Equities Should Outperform RiskyAssets......................................................................................13

Setting Target of 1425 ............................................................17

Market Strategy: Staging as Correlation Falls .....................19

Staging in 2011: The Year in 3 Phases..............................25

STOCKS: 18 Names for 1st Third of 2011 ............................29

Special: Still See Housing Bottom in 2011...........................31Risk: P/E Volatility ..................................................................35

Risk: Sovereign Concerns Real ............................................37

Risk: Municipal DebtBudget Deficits Helped by Recoveryin Revenue ..............................................................................39

2011 Sector Outlook...............................................................43

Basic Materials: Overweight..................................................45

Industrials: Overweight..........................................................47

Consumer Discretionary: Overweight ..................................49

Technology: Overweight........................................................51

Energy: Overweight................................................................53

Financials: Overweight ..........................................................55

Healthcare: Neutral.................................................................57

Telecom: Neutral ....................................................................59

Consumer Staples: Underweight ..........................................61

Utilities: Underweight.............................................................63

Appendix: Bull Market Metrics in Months 22-34 After Startof Bull Market ..........................................................................65


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#1: Solid GDP Growth Expected in 2011

J.P. Morgan Economic Outlook Above Consensus

J.P. Morgan economists see a fragile recovery but with enough cyclical lift to

overcome fiscal drags (see Figure 9) resulting in growth above Street consensus. This

above-consensus outlook is evident in Figure 1 and Figure 2.

What is notable is that J.P. Morgans US GDP forecasts are above Street consensus

in 1H (and below consensus in 4Q), while our Euro-area forecast calls for upside to

Consensus later in the year (2H).

The US forecast assumes passage of the compromise tax package offered by the

White House and Congress. What is notable in the compromise plan is the reduction

in Social Security withholding taxes. Previously, Kasman and team had expectedwithholding taxes to be a drag on income growth in 2011, but now they stand to

support income growth. Thus, our economics team sees GDP growth of 3.5-4.0% in

1H11, which is 110-130bp above that seen by Consensus.

Figure 1: JPM US GDP vs. Consensus

%q/q saar

2.50

3.50 4.00 3.503.00

JPM Consensus

0.30 . . .

-0.20

4Q10 1Q11 2Q11 3Q11 4Q11

Source: JPM Economics Research and Bloomberg.

Figure 2: JPM Euro GDP vs. Consensus

%oya saar

2.10 2.00

1.40 1.401.60

JPM

Consensus

0.10 0.100.20 0.30 0.30

4Q10 1Q11 2Q11 3Q11 4Q11 Source: JPM Economics Research and Bloomberg.

Washington Moving to the CenterBoosting Small Biz

The White House is moving to the center, which should provide a boost for business

confidence and, in our view, a particular boost to small/medium biz confidence. We

think small and medium business confidence has been hampered by bleak

fundamentals and tight credit, but also concerns about taxes, regulatory creep, and

the general anti-business sentiment from Washington.

Thus, we believe small and medium business confidence should improve in 2011,

which should engender hiring. Granted, this is circular (as hiring in the past has been

driven by better business conditions). But the point of this is that an improving

outlook from Washington, particularly towards the center, should at least help sustain

some of the improvements we are seeing in small and medium business conditions.

Consider the two charts below:

Upside seen in 1H

More upside seen in 2H


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The NFIB small business optimism index (see Figure 3) has nearly recovered tocycle highs as of October and, again, we see reasons for the rise to be sustained.

After all, this survey was completed before the mid-term elections and before therecent strengthening in labor market conditions.

In addition, NFIB hiring plans have similarly improved as shown in Figure 4 withthe employment index continuing its move above the zero line. Granted, we are

still a long way from reaching the 8.5 long-term level, but, by the same token,

this survey was taken as of October, before recent incremental improvements.

Figure 3: NFIB Small Business Optimism Improving

Business conditions

Source: Bloomberg.

Figure 4: NFIB Small Business Employment Plans Are Turning Positive

Hiring plans

Source: Bloomberg.

Consumer Balance SheetsCredit Better than Mortgages

Household balance sheet repair progressed substantially in the past few years. We

realize that debt reduction has been driven both by charge-offs as well as a higher

savings rate. Still, one needs to remember that a 5% savings rate equates to about

$550 billion annually in debt reduction.

Balance sheet repair can be seen most clearly in credit card balances, which havefallen 14% from a peak of $866 billion in 4Q08. Figure 5 shows that this credit

card reduction may have potentially overshot equilibrium, as the balance of

6.6% is below the 7.3% level seen at the start of the decade. An increase of 0.7%

(to get to 2000 levels) would represent $79.0 billion of incremental credit card

balances, or potential upside to spending in 2011.

On the other hand, mortgage debt likely has further to fall. At $8.7 trillion, itstands at 76.7% of Disposable Income (see Figure 6). While this is down from

85.5% at the peak in March 2008, it is well above the 50.1% at the start of the

decade and would need to fall a further $3.0 trillion to reach 50%. We actually do

not expect it to fall to 50% of disposable income, as low interest rates mitigate the

debt burden. But we do anticipate further declines in this balance.

ZERO line


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Figure 5: FIXED HEREConsumer Credit as % Disposable Income

% of Nominal Disposable Income

Source: Federal Reserve.

Figure 6: IN PROCESSMortgage Debt as % Disposable Income

% of Nominal Disposable Income

Source: Federal Reserve.

KEY TO REMEMBER, Excess Leverage in Housing IsConcentrated in 8% of Households

But, wait, isnt there too much mortgage debt? Arent many Americans underwater

in their mortgages? We think it is important to remember that only a fraction of US

households today have negative equity. Take a look at Figure 7 below. We have

stratified the homeowner market into: (i) Positive Equity; (ii) Borderline (Loan-to-

Value (LTV) between 100% and 130%); and (iii) Seriously Negative (LTV>130%).

The data was provided by our ABS team.

As shown below, 80mm households today have positive equity, including 32mm

with no mortgage. There are also another 38mm or so renters with no mortgage.There are 3.9mm households that are seriously delinquent, representing

$1.0 trillion in mortgages (negative equity is $372 billion).

Figure 7: Distribution of Mortgages Based on Loan-to-Value

Households in thousands, $ billions; from Matt Jozoff/John Sim, MBS Strategist

31,859

16,117

7,69911,022

8,0374,3822,4191,7281,8401,348589486400420242148303

HH with

NO

mortgage

200

# of Households

0

$1,693

$1,070

$1,965$1,620

$995

$578$417$401

$226$199$163$119$119$69$43$85

HHwith

NO

mortgage

200

Mortgage balance outstanding ($ billions)

Source: J.P. Morgan ABS/MBS Research.

SERIOUS NEG EQ (LTV > 130%)3.9mm Households

SERIOUS NEG EQ (LTV > 130%)$1.0 Trillion, $372 billion NEG EQUITY

POSITIVE EQUITY$7.3 Trillion

BORDERLINE6.0mm Homeowners

BORDERLINE$1.4 Trillion

POSITIVE EQUITY79mm Households


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Labor Tracking Like Jobless Recoveries of 91/01Suggesting 150-200k Jobs in 11

Kasman and team forecast payrolls to grow by 175k/month in 2011.

This would be consistent with the trajectory of labor markets during the jobless

recoveries of 91 and 01. As shown in Figure 8 below, the recovery in labor markets

looks a lot like the jobless recoveries of 91 and 01. In those precedent periods,

stronger hiring did not take place until 18 months after the labor market began to

growthink of it as a rolling start.

And similar dynamics are at work currently even if the drivers differbusinesseshave chosen to defer hiring, meeting rising demand with increased hours worked,

temporary hires, and eventually full-time hiring. What is different this cycle is

regulatory and tax uncertainty coupled with tight credit inhibiting hiring. But

eventually businesses should need to hire as shown in Figure 8 below.

Figure 8: 2011 Payrolls Should Grow 150-200k per Month, Similar to Past Jobless Recoveries of 1991/2001

Six-month average of monthly payroll gains (Private Payrolls)

1/10

2003

9/03

6/91

1991

-300

-200

-100

0

100

200

6/09 9/09 12/09 3/10 6/10 9/10 12/10 3/11 6/11 9/11 12/11

Monthly

inpriva

tepayroll(trailing6m

avg)

2011

2/03 5/03 8/03 11/03 2/04 5/04 8/04 11/04 2/05 5/05 8/05

11/90 2/91 5/91 8/91 11/91 2/92 5/92 8/92 11/92 2/93 5/931991

2003

2010

Source: J.P. Morgan and Bloomberg.

91/03 Jobs grew 150k-200k/ month

Date laborgrowth turnedpositive.


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Figure 9: J.P. Morgan Economic Forecast Summary

Saar

2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 2010 2011 2012 2010 2011 2012

Gross domestic product

Real GDP 1.7 2.5 2.5 3.5 4.0 3.5 3.0 2.6 3.5 3.0 2.8 3.1 3.0

Final sales 0.9 1.2 4.1 3.8 3.9 3.8 2.9 1.8 3.6 3.0 1.3 3.3 2.9

Domestic 4.3 2.9 2.7 3.3 3.7 4.1 3.3 2.8 3.6 3.0 1.9 3.4 3.1

Consumer spending 2.2 2.8 2.5 3.5 3.5 4.0 3.0 2.3 3.5 2.6 1.7 3.2 2.7

Business investment 17.2 10.3 7.0 7.8 10.6 11.5 10.1 10.5 10.0 8.9 5.7 9.6 9.7

Equipment 24.8 16.8 10.0 10.0 12.0 12.0 10.0 17.9 11.0 8.5 15.6 12.3 9.6

Structures -0.5 -5.8 -3.0 0.0 5.0 9.0 10.0 -7.0 5.9 10.0 -14.5 1.3 9.6

Residential investment 25.6 -27.5 5.0 10.0 20.0 15.0 10.0 -4.3 13.7 13.7 -2.9 6.7 13.1

Government 3.9 4.0 1.1 -0.6 -1.0 -1.0 -0.1 1.8 -0.7 -0.5 1.2 0.5 -0.5

Net exports ($bn, chained $2005) -449 -507 -467 -454 -453 -468 -487 - - - - - -

Exports (goods and services) 9.1 6.3 7.0 7.0 8.0 9.0 8.0 8.4 8.0 8.0 11.6 7.5 8.1

Imports (goods and services) 33.5 16.8 -2.0 3.0 6.0 10.0 10.0 14.2 7.2 6.7 13.5 7.2 8.2Inventories (ch $bn, chained $2005) 68.8 111.5 61.2 51.6 55.3 47.2 52.4 - - - - - -

Contribution to real GDP growth (% pts):

Domestic final sales 4.4 3.0 2.7 3.3 3.7 4.1 3.3 2.8 3.6 3.0 1.9 3.4 3.1

Housing 0.6 -0.8 0.1 0.2 0.4 0.3 0.2 -0.1 0.3 0.3 -0.1 0.1 0.3

Consumer Spending 1.5 2.0 1.8 2.5 2.5 2.8 2.1 1.6 2.4 1.8 1.2 2.2 1.9

Net exports -3.5 -1.8 1.3 0.5 0.2 -0.3 -0.5 -1.0 0.0 0.0 -0.6 -0.1 -0.2

Inventories 0.8 1.3 -1.6 -0.3 0.1 -0.3 0.1 0.8 -0.1 0.0 1.4 -0.2 0.0

Income and profits (NIPA basis)

Adjusted corp profits 12.7 11.5 8.0 8.0 10.0 8.0 7.0 19.2 8.2 5.5 29.8 9.0 5.9

Real disposable personal income 5.6 0.9 1.0 4.5 3.5 3.0 3.0 2.2 3.5 2.4 1.3 3.0 2.3

Saving rate1 6.2 5.8 5.4 5.7 5.7 5.4 5.4 - - - 5.7 5.6 5.2

Prices and labor cost

Consumer price index -0.7 1.5 2.3 1.8 1.0 1.1 1.1 1.1 1.2 1.3 1.6 1.4 1.2

Core 0.9 1.2 0.4 0.6 0.6 0.7 0.8 0.6 0.7 1.1 1.0 0.7 0.9Producer price index -0.5 0.9 4.0 1.0 0.7 0.8 1.3 3.2 0.9 1.4 4.1 1.4 1.3

Core 1.7 2.2 1.0 0.6 0.5 0.5 1.0 1.8 0.6 1.1 1.3 0.9 1.0

GDP chain-type price index 1.9 2.3 1.3 1.0 1.0 1.0 1.1 1.6 1.0 1.2 1.0 1.3 1.2

Core PCE deflator 1.0 0.8 0.5 0.6 0.6 0.7 0.8 0.9 0.7 1.0 1.4 0.7 0.9

S&P/C-S house price index (%oya) 3.6 -1.2 -2.1 -2.5 -1.0 1.0 2.0 -2.1 2.0 2.0 0.6 -0.1 2.0

Productivity -1.8 1.9 1.0 2.0 2.5 2.0 2.0 1.2 2.1 1.6 3.4 1.7 1.7

Other indicators

Housing starts (mn units, saar)1 0.602 0.584 0.550 0.600 0.650 0.675 0.700 - - - 0.588 0.656 0.781

Industrial production, mfg. 9.3 3.7 4.0 4.5 5.0 4.5 3.5 5.8 4.4 3.5 6.0 4.6 3.7

Capacity utilization, mfg. (%)1 71.6 72.3 73.0 73.7 74.4 75.0 75.5 - - - 71.7 74.6 76.2

Light vehicle sales (mn units, saar)1 11.3 11.6 12.2 12.4 12.6 12.8 12.9 - - - 11.5 12.7 13.2

Unemployment rate1 9.7 9.6 9.7 9.6 9.4 9.2 9.0 - - - 9.7 9.3 8.7

Nominal GDP 3.7 4.8 3.8 4.5 5.0 4.5 4.1 4.3 4.6 4.3 3.9 4.5 4.2

%q/q, saar %q4/q4 %y/y

Source: J.P. Morgan Economic Research.


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#2: History Argues for 20%-Plus Year

Markets Gained Each Time in the 3rd Year of ExpansionAND 3rd Year of Presidential Term

We have found substantial relevance in using historical analysis and cycle analysis as

key elements of framing our forecast. (Of course, the challenge is to explore the

differences in the current context.) We believe this provides us with a baseline

context to examine how market reaction is likely to evolve. Moreover, basic

decision-making instincts by investors are assumed to be similar over periods.

Based on 111 years of Dow history, 2011 looks to be an extremely favorable

combination of (i) 3rd year of an expansion and (ii) 3rd year of a presidential term:

This combination has only occurred 5 times since 1900 and the average returnhas been 20.6% with the market rising in each instance (see Figure 11).

On a standalone basis, performance of the Dow in the 3rd year of a Presidentialterm has been superior to that in other years (13.3% vs. 7.2% for all years). And,

of course, in such periods Senators are aiming for re-election as well. The

prevailing theory is that re-election dynamics drive fiscal spending. But it could

also be due to a President ultimately shifting toward the center.

And, on a standalone basis, performance in the 3rd year of an expansion hastypically been decent, with gains of 7.2% vs. declines of 6.7% seen during

recessions.

Figure 10: Annual Performance of S&P 500 During Expansion/Contraction and Presidential Cycles

Annual % change

AllYears

Contraction

Expansion

3rdYearof

Expansion

AllYears

Contraction

Expansion

3rdYearof

Expansion

AllYears

Contraction

Expansion

3rdYearof

Expansion

All Years 7.2% -6.7% 11.4% 7.2% 111 26 85 14 66% 42% 72% 71%

Presidential Election Years 8.2% 1.2% 11.1% 0.1% 28 8 20 5 71% 50% 80% 60%

Non-Presidential Election Years 6.8% -10.2% 11.5% 11.1% 83 18 65 9 63% 39% 69% 78%

3rd Year of Presidential Term 13.3% -13.9% 21.0% 20.6% 27 6 21 5 81% 33% 95% 100%

% Annual Gain Number of Instances % t imes Instances >=0%

Source: J.P. Morgan and FactSet.

Figure 11: Years that Were Both3rd Year of Presidential Term

and 3rd Year of ExpansionAnnual % change

41.4%

26.4%

18.9%

16.3%

0.0%

0% 20% 40% 60%

1935

2003

1963

1951

1947

during 2-yr of bear

market which

started in 05/46

Source: J.P. Morgan and FactSet.

Should it be any different in 2011? We dont think soThe naysayers will no doubt argue that it is different this time. Take the White

Housebecause of large deficits and midterm turmoil, skeptics are likely to argue

that there is little the White House can do in this 3rd year in terms of policy action.

But consider that split chambers of Congress and/or split Congress/White Househave been the norm in history, yet, 81% of the time the market has recorded

positive performance in the 3rd year of a Presidential term.

Wow Wow


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But Havent Half of All Bull Markets Ended by Year 3? Yes

There is another wrinkle in the historical analysis.

Of the 19 Bull markets that lasted at least 22 months (which is the current age of the

2009 bull market), 9 turned into bear markets before the 34th month (equivalent to

December 2011). In fact, 7 of the 9 would indicate an end to this bull market by

June 2011 (see below in Figure 12).

Figure 12: Duration of Bull Markets (Lasting at Least 22 Months)

Since 1900

1 1 2 2 2 4 510 11

21 22 24 27 28

34 38 39

7592

19191916197919761909196819051972198919511964 195519441959 193420041984 19231992

Lifespanbe

yondmonth22

Lifespan of bull beyond month 22

9 of 19 bull markets

did not last thru month

34


But even in those years the market gained 3% to 30% before peaking...Interestingly, as shown below in Figure 13, even in those 9 years in which a bear

market ensued (between months 22 and 34), intra-year gains ranged from 3% to 30%

(in 1909 and 1979, respectively).

Figure 13: Maximum % Gain from Month 22 to Month 34 (Best Intra-Year Gain)...

Since 1900, sorted by duration of bull market (see chart above)

5%9%

30%

4% 3%

11%

29%

11%

7%

14%10%

15%

19%

2%0%

13%

23%

7% 7%

0%

10%

20%

30%

40%

191919161979197619091968190519721989195119641955 19441959193420041984 19231992%G

ainMo22toPeakinMo22-34

9 of 19 bull markets did

not last thru month 34



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Analysis of Long vs. Short Bull Points to Longer Variety

We looked at 20 discrete metrics to understand what distinguishes a short vs.

long bull market (see Appendix and Figure 91 to Figure 94). Of these 20 metrics,we found 4 that had strong intuitive and explanatory powers for what distinguishes a

long vs. short bull market. Those are summarized in Figure 14:

Figure 14: Factors that Differentiate Longer vs. Shorter Bull Markets

As indicated

Time to next recession

40

16

Longer bull

markets

Short bulls (end

by 34th month)

Inflation

3.1%

7.8%

today

1.1%

Longer bull

markets

Short bulls (end by

34th month)

Real 10-year rates

1.7%

-1.1%

today

1.4%

Longer bull

markets

Short bulls (end

by 34th month)

S&P 500 EY vs. BAA Yields

1.6%

-0.6%

today

1.7%

Longer bull

markets

Short bulls (end

by 34th month)

Source: J.P. Morgan, Bloomberg, and FactSet.

#1: Time to next recessionForemost, it was the proximity to the next recession. Shorter bull markets saw a

recession start within 16 months. (In the current context, that would mean a recession

starting in 2012). On the other hand, longer bull markets saw a recession start only

within 40 months. This makes sense. Recessions bring bear markets. Bruce Kasman and team do not see a recession in 2012.

#2: Inflation was a big differentiatorInflation at Month 22 was a key differentiator as well. Shorter bull markets suffered

from higher inflation of around 8%, compared to longer bull markets with 3%

inflation. In our past work, we showed that inflation rates above 6% have driven P/E

compression, so this again is logical.

Inflation is running at about 1% today, again indicating a longer bull market.

#3: Real 10-year ratesReal 10-year rates (10-year less inflation) were POSITIVE during longer bull

markets whereas in Month 22 of shorter bull markets rates were negative. This is

somewhat less intuitive, but we think it speaks to rate-of-return opportunities for

businesses. Higher real rates imply positive expected returns for risky assets and

therefore capital investment.

Today, real rates, at positive 140bp, again clearly indicate a longer bull market.

#4: Equity relative value vs. BAA bond yieldsFinally, relative value was positive in longer bull markets with EY (1/P/E) higher

than bond yields (lowest investment grade). This again is intuitivestocks were

cheaper and therefore did well.

Today, EY is 170bp above the BAA bond yield.


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#3: Relative Return of Equities Should

Outperform Risky Assets

#1: 50-Year High in Equity Risk Premia...

Our global asset allocation team recently produced a 50-year time series of equity

risk premia shown below in Figure 15. They calculated these by comparing the

earnings yield of equities against the real yield on the 10-year, which is basically

the 10-year bond yield less inflation.

As shown below, the current equity risk premium of 620bp is the highest ever,higher even than that during the 1974 bear market trough and definitely well

above the level at which it settled at the 2002 bear market low.

This high risk premium obviously raises a few questions. Foremost is thatinvestors are showing little trust in equities, which may not be entirely surprising

given the awful performance of stocks over the past decade.

But it also may reflect a general fear of capital investment, both physical andfinancial. After all, many investors and companies still question the durability of

this recovery and thus have been reluctant to invest in longer-duration assets.

Equities, after all, are infinite-duration assets.

Figure 15: Equity Risk Premia

Calculated as Earnings Yield less Real 10Y Yield (10Y Less Inflation)

12/02

4.12

9/10

6.2112/74

5.56

10-year average

3.56

(2.0)

(1.0)

-

1.0

2.0

3.0

4.0

5.0

6.07.0

'57 '59 '62 '64 '67 '69 '72 '74 '77 '79 '82 '84 '87 '89 '92 '94 '97 '99 '02 '04 '07 '09

Equity Risk Premia 10-year average

Source: J.P. Morgan Global Asset Allocation Strategy.

The implication though is risk/reward for equities is attractiveThe key takeaway, in our view, is that risk/reward appears favorable for stocksthat

is, the margin for error is lower for equities when the equity risk premium is high.

Even if one were to argue that the equity risk premium has been rising, which hasbeen the case over the past decade, it is well above the 10-year average.


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#2: Equities Offer Attractive Return Potential vs. OtherRisky Assets

Equities did not outperform other risky assets in 2010 as shown in Figure 16 below.

In fact, most fixed income markets and commodities saw gains of 11-25%. Most of

these were above the 11.5% gain of the S&P 500 YTD (2.0% from dividends).

But 2011 forecast returns point to better relative performance for equitiesWe have compared our 2011 Target of 1425 for the S&P 500 to J.P. Morgans

projected returns for other risky assets. These are shown below in Figure 17.

The forecast return for Equities of 18.5% matches the expected return forcommodities (oil up 26% and commodities broadly up 19%) and is higher than

that for fixed income assets. Of this, the majority consists of capital gains (EPS

growth and P/E expansion) rather than dividend yield.

Our fixed income teams expect the rally in fixed income to end, with Treasuriesprojected to be flat (down 0.9%), high-grade returns a mere 2%, and high-yield

delivering an 8% total return. This is quite a contrast to 2010 when CMBS

returned 25% and high-yield 13%.

Figure 16: 2010 Comparative Returns for Risky Assets

% change, YTD as of 12/02/10

25.8

25.0

13.2

12.8

12.1

11.5

10

7.1

7.1

5.7

Gold (S&P GSCI)

CMBS (AAA)

High Yield

Emerging Markets Bonds

Treasury (10y)

Equities (S&P500)

Investment Grade Corporates

Commodities (JPMCCI)

Oil (S&P GSCI Brent)

MBS

Source: J.P. Morgan.

Figure 17: 2011 FORECASTED Comparative Returns of Risky Assets

% change

26.0

19.0

18.5

17.0

8.0

6.5

4.5

2.0

1.0

-0.9

Oil (S&P GSCI Brent)

Commodities (JPMCCI)

Equities (S&P500)

Gold (S&P GSCI)

High Yield

CMBS (AAA)

Emerging Markets Bonds

Investment Grade Corporates

MBS

Treasury (10y)

Source: J.P. Morgan estimates.

Fixed incomeforecasted returnsare substantiallymore modest thanthose for equitiesor commodities


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#3: JPM Client Survey Indicates Allocation into Equities

In J.P. Morgans Fixed Income Survey, investors were asked about expected changes

in portfolio allocation over the next six months (see US Fixed Income Markets 2011Outlook dated 11/24/10 by Srini Ramaswamy). The survey is broad-based, but this

particular question has only been asked this year. The survey was based on a clients

intended changes in asset allocation. If a respondent had a desire to add exposure,

they were asked to indicate +1, with -1 representing a desire to reduce exposure.

As shown below in Figure 18, respondents expressed the strongest desire to addexposure for Equities, followed by TIPS and Emerging Markets.

On the other end of the spectrum, respondents expressed modest preferences toreduce exposure to Non-Agency MBS and High-Yield.

Broadly, our interpretation is that macro funds and institutional managers are

likely to add to equity exposure in 2011Our takeaway is that institutional investors are likely to add to equity exposure in

2011. The nagging question remains whether retail investors will add to exposure.

What we do know is that retail investors tend to follow outperformance. Thus, ifthe outperformance of equities continues into 2011, we believe investors will

make a pronounced allocation into equities.

Figure 18: Client Survey Indicates Planned Move into EquitiesScale: +1 desire to add; -1 desire to reduce

-0.2 -0.1 -0.1-0.1

0.00.1 0.3 0.3

0.4 0.5

-0.2-0.5

0.0

0.5

1.0

Non-

Agy

MBS

High

Yield

CMBS Agy

debt

Agy

MBS

Dur'n

risk

ABS IG EM TIPS Equities

Source: J.P. Morgan Fixed Income Strategy.


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17



Setting Target of 1425

S&P 500 to Reach 1425 in 2011Debate Will Be on P/E

We believe the S&P 500 can reach 1425 in 2011 (see Figure 19). Consensus is

centered about 100 points lower with a top-down Strategist consensus (NI WGT

) of 1337. Michael Krauss, J.P. Morgan Technical Strategist, sees 1300-

1350. So, for reasons discussed in prior sections, we are more bullish than consensus

for 2011.

2011 should be more about valuation expansion rather than EPS upside...The composition of market return in 2010 was more about EPS upside, as top-down

forecasts rose about 7% in 2010 (2010E EPS started the year at $74 and is now $83).

For 2011, we see less potential for upward revisions to estimates, but rather see the

shift in market performance toward a decline in the risk premiumresulting in P/Eexpansion. Specifically, our target is based on the following:

Figure 19: Comparative S&P 500 Price Levels Based on EPS and P/E Ratios

Index level

Range of 2012 EPS.

Implied '12 GDP gth 2.25% 2.50% 2.75% 3.00% 3.25%

EPS $98.00 $100.00 $102.00 $104.00 $106.00

Applied

P/E

Implied Equity Risk

Premia YE '11

EY vs BAA

Yield

(EY less {10Y less

inflation})

12.5x 6.57% 2.02% 1,222 1,247 1,272 1,297 1,322

13.0x 6.26% 1.71% 1,271 1,297 1,323 1,349 1,375

13.5x 5.97% 1.42% 1,320 1,347 1,374 1,401 1,428

14.0x 5.71% 1.16% 1,369 1,397 1,425 1,453 1,481

14.5x 5.46% 0.91% 1,418 1,447 1,476 1,505 1,534

15.0x 5.23% 0.68% 1,467 1,497 1,527 1,557 1,587

15.5x 5.01% 0.46% 1,516 1,547 1,578 1,609 1,640 Source: J.P. Morgan estimates.

#1: Raise 2011E to $94 from $91 and New 2012E EPS of $102

The global cyclical recovery should enable S&P 500 companies to generate at least

high-single-digit EPS growth in 2011/2012. Our estimates are basically built around

2.5-3.0% GDP growth (in line with Kasmans US GDP view), but we see upside to

our 2011 estimates in the context of an accelerating cyclical outlook which ispossible if Europes sovereign issues do not damage the economy.

We are raising our 2011 EPS estimate to $94 from $91 (see details in Figure 20),principally reflecting higher anticipated EPS contributions from Financials and

Industrials.

Our 2012 EPS estimate of $102 anticipates that the prior EPS peak (in 2Q07 at$92) will be surpassed. This is consistent with prior earnings cycles.


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#2: Forward P/E Ratio Should Creep to 14.0x 2012E

While there are considerable countervailing forces acting on asset values (hence

P/E), we believe the primary drivers of P/E expansion will be:

1. Contracting relative value relationship of equities vs. corporate credit, in whichrisk premium for stocks narrows from record-high to normalized levels. As

shown in Figure 19, our target risk premium is 5.43%, down from 6.21%

currently (see Figure 15) but still well above 10-year average of 3.56%; and

2. Positive impact on asset prices from LSAP (Feds large-scale asset purchases, orQE2).

EPS Driven by Cyclicals

The drivers of earnings growth in 2011 and 2012 should basically be the

economically sensitive stocksCyclicals and near-Cyclicals account for $8 of the $9

in incremental EPS we forecast for 2011. We highlight forecasts by Sector in Figure20 below.

We are revising our 2011 EPS estimate up slightly to $94 (from $91) to reflectthe expected re-acceleration of the economic recovery in 2011. Our estimate of

$94 does implicitly assume meaningful GDP growth as the 4Q10E EPS run-rate

is $88 ($22 x 4 = $88).

We forecast that Financials will be the largest contributor of incremental EPSyear-over-year ($3.13) and report the fastest growth on a % basis.

Figure 20: S&P 500 EPS Forecast

$ per share

JPM Strategy Estimates

2011E EPS 2012E EPS

Strategy

Rating FY 2008 FY 2009

FY

2010E 1Q11E 2Q11E 3Q11E 4Q11E

FY

2011E $ chg % chg

Bottom-Up

Consensus FY 2012E $ chg % chg

Bottom-Up

Consensus

Cyclicals

Materials OW $2.57 $1.31 $2.40 $0.71 $0.78 $0.70 $0.65 $2.85 $0.45 19% $2.88 $2.93 $0.08 3% $3.13

Industrials OW 9.41 6.41 7.68 1.98 2.29 2.35 2.38 9.00 1.32 17% 9.23 9.62 0.62 7% 10.28

Discretionary OW 3.07 5.02 8.28 2.04 2.25 2.32 2.54 9.15 0.87 11% 9.33 10.45 1.30 14% 11.17

Technology OW 11.62 11.83 16.45 4.03 4.20 4.46 5.06 17.75 1.30 8% 18.56 19.43 1.68 9% 20.76

Near-Cyclicals

Energy OW $16.11 $6.81 $10.07 $2.63 $2.76 $2.88 $2.97 $11.25 $1.18 12% $11.07 $13.26 $2.01 18% $14.17

Financials OW (6.84) 4.91 13.37 3.59 4.13 4.21 4.58 16.50 3.13 23% 16.63 19.55 3.05 19% 20.89

DefensivesStaples UW $8.97 $9.20 $9.61 $2.33 $2.55 $2.62 $2.75 $10.25 $0.64 7% $10.41 $10.04 ($0.21) -2% $10.72

HealthCare N 11.10 11.17 11.77 3.06 3.08 3.06 2.99 12.20 0.43 4% 12.28 11.61 (0.59) -5% 12.40

Telecom N 2.91 2.25 2.18 0.58 0.61 0.61 0.60 2.40 0.22 10% 2.41 2.26 (0.14) -6% 2.41

Utilities UW 2.93 3.12 3.71 0.78 0.67 0.95 0.70 3.10 (0.61) -16% 3.08 2.85 (0.25) -8% 3.04

S&P 500 $61.85 $62.02 $85.52 $21.74 $23.33 $24.16 $25.22 $94.45 $8.93 10% $95.88 $102.00 $7.55 8% $108.97

S&P ex-Fin 68.69 57.11 72.15 18.15 19.20 19.95 20.65 77.95 5.80 8% 79.25 82.45 4.50 6% 88.08

Cyclicals $26.67 $24.56 $34.81 $8.77 $9.52 $9.82 $10.64 $38.75 $3.94 11% $40.00 $42.43 $3.68 10% $45.34

Defensives $25.91 $25.73 $27.27 $6.75 $6.91 $7.25 $7.04 $27.95 $0.68 2% $28.18 $26.75 ($1.20) -4% $28.58 Source: J.P. Morgan and FactSet.


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20



STAGING: Using Prior Bull Markets to Pick Groups Today

We have derived substantial insight with staging markets which is the basis for our

Circle of Life analysis, and we decided to further enhance this analysis by stagingprior bull markets across time. We also did similar work in our Guide to Stock

Bottoms Part I and Part II.

The idea here is that industry groups generally gain favor over time as a bull market

progresses, reflecting the combination of fundamental developments (earnings

power, employment, etc.) against changes in market behavior (valuation sensitivity

or M&A, etc.).

One can visually see such prior shifting of leadership in Figure 22 below indicating

the shifts in the composition of the top quartile of groups as bull markets aged:

Note, for instance, that in the Year -1 period (prior to market bottom), the leaderswere mostly Defensives (personal products, food, etc.).

But moving through Year 2 (now), leadership in the past has shifted more heavilyto Cyclicals.

Certainly this is the case today and we have compiled some analysis in thefollowing section discussing this.

Figure 22: Top Quartile Industry Groups as Bull Markets Aged

All bull markets since '74. Top quartile identified in DARK GREEN based on 6-month relative performanceAverage '74 to '02 YEAR -1 YEAR 1 YEAR 2 YEAR 3 YEAR 4

Date

Months into Bull market -11 -9 -7 -5 -3 -1 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49

S&P 500 % chg next 6-months (r (1) 3 (9) (16 ) (12 ) 5 19 17 11 7 7 9 8 6 1 3 3 6 5 2 1 (1) 3 7 8 7 8 7 4 4 7

Personal products 6 10 9 7 3 5 0 -2 -5 -4 1 2 5 0 2 1 1 -1 -1 0 -2 3 3 6 1 3 3 3 3 2 -1

Health Care Eq &Svcs 7 6 5 8 5 10 -1 -1 -4 -4 0 -4 -4 -7 -2 1 -4 -3 -2 5 5 7 6 10 1 4 2 7 0 -2 -4

Food & Beverages 6 9 8 8 2 4 -4 0 -3 0 3 3 3 1 3 3 -1 -1 -1 3 3 6 3 2 -1 5 5 9 2 0 -4

Homebuilders 6 10 9 7 3 5 0 -2 -5 -4 1 2 5 0 2 1 1 -1 -1 0 -2 3 3 6 1 3 3 3 3 2 -1

Biotech 18 0 8 7 18 32 28 31 18 15 -2 -10 -5 -8 -3 3 1 -12 0 6 25 23 32 44 20 33 24 19 -4 -18 -10

Pharma 4 6 5 6 5 6 -2 -4 -6 -3 -1 -2 -4 -6 -1 -3 -9 -12 -4 2 4 2 1 3 0 7 9 12 4 0 -5

Software 9 4 -3 -3 -1 8 16 7 5 3 7 2 -5 -9 -5 -1 4 -2 1 -5 -2 2 11 14 6 4 9 11 13 6 7

PC 5 3 0 -2 0 10 2 1 -6 3 1 1 -5 -6 -9 -8 -4 2 2 -3 -7 0 8 12 0 -7 -6 -2 4 3 6

Semis 12 8 -4 -9 -8 7 35 19 7 2 7 16 0 -4 -13 -3 7 9 4 -4 -2 -1 4 14 6 0 -7 -6 1 3 16

Telco Eq 3 4 0 -5 -8 -1 14 9 4 2 8 12 7 6 -2 3 5 9 11 4 2 0 -1 9 7 10 2 2 6 2 5

Chemicals 3 6 2 1 -1 -3 2 3 7 -2 4 2 4 -3 -5 -4 -3 -2 -1 -4 -5 -4 1 2 6 4 4 -2 1 3 8

Metals, Paper and Gold 3 -1 -1 -3 -1 -1 6 3 6 -1 2 3 6 1 -6 -4 -3 -1 -1 -3 -7 -5 1 3 7 2 5 -4 3 2 11

Asset Mgrs, Cons. Fin, etc -12 -15 -8 -10 10 41 62 42 21 14 3 6 -3 4 -13 0 2 6 0 -4 1 0 4 1 5 16 13 9 4 5 0 1

Banks 0 -4 -4 -6 1 4 7 6 4 2 -4 0 3 4 0 -4 0 3 3 1 -2 -2 0 4 9 10 7 1 -3 -4 -3

Construction Materials 2 5 -2 -5 -6 4 13 14 5 1 -1 2 5 1 0 -3 6 6 5 0 -2 0 1 6 5 3 0 -8 -5 -4 7

Auto &Auto Parts 2 7 0 -4 -8 -4 0 3 3 3 7 4 7 1 -3 -6 -1 2 1 -3 -5 -4 -5 -5 2 -2 -3 -10 -4 0 9

Hotels -5 -10 -11 -13 -7 11 24 24 11 14 8 10 12 19 8 1 5 3 10 7 2 -1 6 17 10 6 15 9 6 5 16

Gaming 23 31 20 1 -1 6 15 25 37 23 9 2 6 3 1 7 17 17 18 15 12 2 9 18 29 32 56 29 9 2 13

Insurance -4 -4 -3 -3 1 3 2 -2 0 -1 -2 2 2 1 2 6 6 4 3 4 5 5 4 4 2 2 0 0 0 0 -1

REITs -5 2 -2 -11 -9 1 17 16 0 1 8 8 1 -5 -3 3 5 -1 -5 0 1 4 1 17 15 14 6 1 -2 -3 1

Restaurants 4 11 1 -1 -7 -1 4 6 5 3 6 13 10 1 -2 5 8 5 -2 -3 5 6 8 8 6 8 2 2 0 0 -2

Telecom -7 -8 -3 6 8 4 -11 -12 -8 -4 -2 -1 3 1 7 7 8 3 0 1 4 0 -4 -6 -3 -1 -3 1 1 2 -5

Oil &Gas 1 -1 4 2 4 -7 -5 -6 -3 1 -6 -6 -3 5 8 6 3 3 3 7 7 3 -3 -8 -6 -7 -2 -3 2 0 6

E&P 3 -2 2 -6 -1 -8 0 -9 -4 -2 -6 -7 -7 4 8 11 3 -1 2 8 9 1 -4 -9 -7 -3 -2 -4 -7 -4 6

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

Retail 8 13 2 -2 -6 6 16 19 13 7 1 -3 -4 -5 -2 1 5 3 -1 -4 -3 1 2 9 4 4 0 0 -4 -4 -5

Transports 3 -1 -3 -4 -1 -1 2 -2 -1 -1 4 3 0 -1 0 1 2 3 7 1 2 1 6 5 7 2 1 -5 -2 0 2

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

Industrials 0 0 -1 -3 -3 -1 3 3 2 -1 0 1 2 2 0 0 1 1 5 2 0 -2 0 2 5 3 2 -3 -2 0 2

Media 0 -2 -1 -1 -3 2 3 6 -2 -7 -2 -2 1 -6 -5 -5 -3 -4 -3 -6 -2 -2 -1 -5 -3 3 6 3 1 1 2 Source: J.P. Morgan and Datastream.

1. Prior tomarketbottom,Defensivesled

2. But as bullmarket aged,leadershipshifted to other

groups in aconsistentmanner


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21



In 2010, Top-Quartile Groups Based on Staging MateriallyOutperformed...

So would staging have identified top groups in 2010?

We have compiled the data in Figure 23 below. We took the 30 largest industry

groups in the S&P 500 (weights of at least 2%) and stratified them by quartile based

on their historical outperformance in Year 2 of a bull market (roughly 2010).

The implied returns are those with the dashed lines around the columns. Forinstance, the top quartile (8 groups) would be expected to outperform by 650bp

(see Figure 24) based on their behavior during bull markets since 74.

The blue column shows the actual outperformance for each of these quartiles. Asnoted, the top quartile outperformed the S&P 500 by 1,030bp this year.

By contrast, the worst quartile underperformed by 400bp.

Overall, in 2010, each group performed roughly in line with expected performance

suggested by historical bull markets. In other words, interestingly, the market this

year has acted in very textbook manner.

Figure 23: Suggested Top Quartile (Based on Staging) Outperformed in 2010

% change relative to S&P 500

6.5

2.70.2

-2.2

10.3

3.9 3.8

-4.0

Quartile 1 Quartile 2 Quartile 3 Quartile 4

Relativeperf.vsS&P500

Predicted 2010 Actual 2010

Source: J.P. Morgan and Datastream.

To give some context on those groups, we have detailed these in Figure 24 below.

For instance, historical staging suggests that Consumer Cyclicals (Auto Parts,

Restaurants, Hotels, Gaming) should have led in 2010 and, as the actual shows

these sectors indeed outperformed.

The top 8 groups expected toperform well based on resultsin past bull markets did infact outperform by 1,030bp in

2010

The bottom 8 groupsunderperformed by400bp


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22



Figure 24: 2010 Comparative Performance: What History Would Suggest vs. What Happened

% change (next 6 months)

Good =Top quartile2010 stylized Actual 2010

(based on all bull markets since '73) 1H performance Bad = Bottom quartile

1H10 1H10 Comment

Asset Mgrs, Cons. Fin, etc Asset Mgrs, Cons. Fin, etc Financials did not stand out in 1H as

Banks Banks expected. Although history said REITs

Insurance Insurance should have been top quartile

REITs REITs

Chemicals Chemicals

Metals, Paper and Gold Metals, Paper and Gold Chemicals as expect but Metals better

Oil & Gas Oil & Gas Energy did badly in 1H10 as expected

E&P E&P

Semis Semis

Telco Eq Telco Eq

Construction Materials Construction Materials Corporate-capex plays were as expected

Transports Transports but Airlines rather than Transports outperform

Airlines Airlines in 1H10

Industrials Industrials

Software Software

PC PC

Auto & Auto Parts Auto & Auto Parts

Homebuilders Homebuilders

Restaurants Restaurants Consumer Cyclicals performed like

Retail Retail clockwork.

Hotels Hotels

Gaming Gaming

Media Media

Health Care Eq & Svcs Health Care Eq & Svcs

Biotech Biotech

Pharma Pharma Defensives did poorly as history suggested

Food & Beverages Food & Beverages framework in a near text-book format

Personal products Personal products

Telecom Telecom

Utes Utes Source: J.P. Morgan and Datastream.


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23



Analysis: How Do We Stage?

To do our staging analysis, we took multiple steps:

1. First, we examined the five bull markets since 1974 and looked at rolling six-month performance each month from Year -1 to Year +4, or six months in total.

2. Second, we identified the 30 largest industry groups (with at least a 2%weighting) and looked at the relative performance of each of these groups (vs.

S&P 500).

3. Third, we aggregated the performance of each of these groups to establish acomposite performance ranking at each point in the bull market.

4. Using quartiles identified, we now can determine at each month in the life cycleof a bull market what groups outperformed and underperformed.

We then stylized this information by indicating when a particular industry group

started outperforming (labeled Buy) and underperforming (labeled Sell) (see

Figure 26 and Figure 27).


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24




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Staging in 2011: The Year in 3 Phases

Historical analysis suggests that we should see substantial shifts in industry

leadership in 2011. Based on all bull markets since 1974 (5 in total), the groups

expected to outperform (top quartile) are shaded in Green below in Figure 25 and the

groups expected to underperform are italicized (bottom quartile).

Basically, in the first third of 2011, Consumer Cyclicals along with Insurance andAsset Managers are expected to lead.

As we move into the second third, enterprise/infrastructure Cyclicals should lead.

And by the final third of the year, there is likely to be a more pronounced shiftinto Defensives (Biotech, etc.)

Utilities, Insurance, and Gaming are expected to outperform consistently during

each phase of 2011. We will monitor this in our Circle of Life reports.

Figure 25: Groups Expected to Outperform in 2011 Based on Historical Staging

Top quartile is shaded green; Bottom quartile in italics and red

2011 stylized (based on all bull markets since '73)

1st third (~month 22) 2nd third (~month 26) 3rd third (~month 30)

Credit Sensitive Asset Mgrs, Cons. Fin, etc Asset Mgrs, Cons. Fin, etc Asset Mgrs, Cons. Fin, etc

Banks Banks Banks

Insurance Insurance Insurance

REITs REITs REITs

Resource & Chemicals Chemicals Chemicals

Commodity Metals, Paper and Gold Metals, Paper and Gold Metals, Paper and Gold

Producers Oil & Gas Oil & Gas Oil & Gas

E&P E&P E&P

Corporate Semis Semis Semis

Capex & Telco Eq Telco Eq Telco Eq

Infrastructure Construction Materials Construction Materials Construction Materials

Plays Transports Transports Transports

Airlines Airlines Airlines

Industrials Industrials Industrials

Software Software Software

PC PC PC

Auto & Auto Parts Auto & Auto Parts Auto & Auto Parts

Consumer Homebuilders Homebuilders Homebuilders

Cyclicals Restaurants Restaurants Restaurants

Retail Retail RetailHotels Hotels Hotels

Gaming Gaming Gaming

Media Media Media

Defensives Health Care Eq & Svcs Health Care Eq & Svcs Health Care Eq & Svcs

Biotech Biotech Biotech

Pharma Pharma Pharma

Food & Beverages Food & Beverages Food & Beverages

Personal products Personal products Personal products

Telecom Telecom Telecom

Utes Utes Utes Source: J.P. Morgan and Datastream.

1. Consumer Cyclicalsexpected to outperform inearly 2011, along withFinancials

2. Leadership isexpected to shift towardEnterprise/Capex Sensitives.It makes sense that domesticcyclicals would be expectedto gain

3. Defensives expected togain in the final thirdof 2011


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26



Stylized Sorting of Group Outperformance

We present the above analysis in a different format below, in which we show a

sequential ordering of groups based on their historical relative outperformance ateach point in a bull market cycle.

Figure 26: Historical Staging Stylized Timing of Group Outperformance (Buy Indicates Start of Outperformance)***

Based on Top Quartile performance at each month of bull market

Average '74 to '02 YEAR -1 YEAR 1 YEAR 2 YEAR 3 YEAR 4

Date


S&P 500 % chg next 6-months (rolling) (1) 3 (9) (16) (12) 5 19 17 11 7 7 9 8 6 1 3 3 6 5 2 1 (1) 3 7 8 7 8 7 4 4 7

Auto & Auto Parts BUY

Telecom BUY BUY

Oil & Gas BUY BUY BUY

E&P BUY BU

Utes BUY

Gaming BUY BUY

Hotels BUY BUY

Insurance BUY

Asset Mgrs, Cons. Fin, etc BUY BUY BUY

Banks BUY BUY BUY

Construction Materials BUY BUY

Transports BUY BUY

Health Care Eq & Svcs BUY BUY

Food & Beverages BUY BUY BUY BUY

Restaurants BUY BUY

Biotech BUY BUY

REITs BUY BUY

Retail BUY BUY BUY BUY

Software BUY BUY

Airlines BUY BUY BUY

Industrials BUY BUY BUY

PC BUY BUY BUY

Personal products BUY BUY BUY

Homebuilders BUY BUY BUY

Semis BUY BUY BUY BUY

Telco Eq BUY BUY BUY BUY

Chemicals BUY BUY BUY

Metals, Paper and Gold BUY BUY

Pharma BUY BUY

Media BUY BUY


*** Buy only indicates period in which specific group started to outperform in past bull markets, and does not indicate a J.P. Morgan Strategy sector rating or recommendation. For J.P. Morgan

Strategy sector ratings and analysis, please see 2011 Sector Outlook starting on page 43 of this report.

2011


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27



Stylized Sorting of Group Underperformance

We present the above analysis in a different format below. We show a sequential

ordering of groups based on their historical relative UNDERperformance at eachpoint in the bull market cycle.

Figure 27: Historical Staging Stylized Timing of Group Underperformance (Sell Indicates Start of Underperformance)***

Based on Bottom Quartile performance at each month of bull market

Average '74 to '02 YEAR -1 YEAR 1 YEAR 2 YEAR 3 YEAR 4

Date


S&P 500 % chg next 6-months (rolling) (1) 3 (9) (16) (12) 5 19 17 11 7 7 9 8 6 1 3 3 6 5 2 1 (1) 3 7 8 7 8 7 4 4 7

Pharma SEL SEL

Health Care Eq & Svcs SEL SEL

Media SEL SEL

Biotech SEL SELL SEL

PC SELL SEL

Software SEL

Semis SELL SEL SEL

Chemicals SELL

Metals, Paper and Gold SELL

Auto & Auto Parts SELL SELL

Hotels SEL SELL

Telecom SEL SEL SEL

Oil & Gas SEL SEL

E&P SELL SEL

Utes SEL SEL SEL

Insurance SEL SEL

Airlines SELL SELL SELL SEL

Construction Materials SEL SELL

Transports SELL SELL

Banks SEL SEL SELL SELL SEL

REITs SEL SEL

Retail SELL SEL

Gaming

Asset Mgrs, Cons. Fin, etc SEL SEL

Food & Beverages SEL SEL SEL

Restaurants SELL SEL

Industrials SELL SELL

Personal products SEL

Homebuilders SEL

Telco Eq SELL


*** Sell only indicates period in which specific group started to underperform in past bull markets, and does not indicate a J.P. Morgan Strategy sector rating or recommendation. For J.P. Morgan

Strategy sector ratings and analysis, please see 2011 Sector Outlook starting on page 43 of this report.

2011


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STOCKS: 18 Names for 1st Third of 2011

We decided to compile a list of ideas for the first third of 2011, based on our staging

conceptthat is, identify a group of stocks that is expected to outperform in the first

few months of 2011. Again, one of the changes in our thinking about 2011 is that we

believe there could be greater sector rotation than in past years. The criteria we used

are as follows:

In top quartile of industries for 2011, namely: Asset Managers, ConsumerFinance, Insurance, Construction Materials, Restaurants, Retail, Gaming,Telecom, and Utilities;

Style factor of High-Beta, as this style looks attractive on institutional ownershipand relatively cheaper vs. long-term valuations;

Upside implied by J.P. Morgan target price is at least 10%; and

Rated Overweight by J.P. Morgan.

The list of 18 stocks is shown in Figure 28 below. These stocks have an average P/E

(2011E) of only 13.4x and average implied upside of 21% to J.P. Morgan target

prices.

Figure 28: 18 Ideas Expected to Outperform in Early 2011

$ millions

JPM Coverage Sentiment EPS and Valuation

Name Sub-Industry Ticker

Current

Price

Market

Cap Beta

JPM

Rtg JPM Analyst

Target

Price

Implied

Upside

FC Mean

Rating

(1=buy,

5=sell)

Short

Int % of

Float

2011E

EPS

P/E

('11E) P/B1 Office Depot Inc. Specialty Stores ODP $5.03 $1,394 3.30 OW Horvers Christ $8.00 59% 2.90 6.7% $0.07 68.9x 1.72x

2 Och-Ziff Capital Management Asset Management & Custody BankOZM $14.12 $1,281 2.00 OW Worthington K $19.00 35% 1.90 5.7% $1.39 10.1x

3 INVESCO Ltd. Asset Management & Custody Bank IVZ $23.08 $10,664 1.75 OW Worthington K $30.50 32% 2.20 2.3% $1.71 13.5x 1.31x

4 Allstate Corp. Property & Casualty Insurance ALL $30.48 $16,404 1.49 OW Heimermann $40.00 31% 2.20 1.3% $3.88 7.9x 0.85x

5 NII Holdings Inc. Wireless Telecommunication Servic NIHD $41.34 $6,998 2.03 OW Baggio Andre $51.00 23% 1.90 3.1% $2.64 15.7x 2.21x

6 OfficeMax Inc. Specialty Stores OMX $18.07 $1,536 2.83 OW Horvers Christ $22.00 22% 2.20 10.2% $1.07 16.9x 2.85x

7 Owens Corning Building Products OC $28.77 $3,586 8.50 OW Rehaut Michae $34.50 20% 1.90 8.9% $2.16 13.3x 0.94x

8 Las Vegas Sands Corp. Casinos & Gaming LVS $46.04 $31,525 4.09 OW Greff Joseph $55.00 19% 2.00 10.5% $1.69 27.2x 5.18x

9 Limited Brands Inc. Apparel Retail LTD $31.10 $10,031 1.69 OW Tunick Brian $37.00 19% 2.40 3.0% $2.20 14.1x 4.89x

10 Men's Wearhouse Inc. Apparel Retail MW $23.65 $1,246 1.74 OW Tunick Brian $28.00 18% 2.20 9.5% $1.64 14.4x 1.26x

11 AFLAC Inc. Life & Health Insurance AFL $54.92 $25,882 1.75 OW Bhullar Jimmy $65.00 18% 2.10 1.2% $6.18 8.9x 2.32x

12 Group 1 Automotive Inc. Automotive Retail GPI $39.76 $943 1.76 OW Patel Himansh $46.00 16% 2.10 22.7% $3.22 12.3x 1.22x

13 Franklin Resources Inc. Asset Management & Custody BankBEN $118.92 $26,637 1.50 OW Worthington K $136.00 14% 2.20 1.8% $7.81 15.2x 3.45x

14 Pinnacle Entertainment Inc. Casinos & Gaming PNK $14.00 $860 1.94 OW Greff Joseph $16.00 14% 2.00 10.7% $0.17 83.3x 1.67x

15 Hartford Financial Services GrMulti-line Insurance HIG $25.00 $11,114 3.03 OW Bhullar Jimmy $28.00 12% 2.60 4.7% $3.68 6.8x 0.55x

16 Macy's Inc. Department Stores M $25.49 $10,794 1.82 OW Grom Charles $28.00 10% 2.00 4.3% $2.24 11.4x 2.20x

17 MetLife Inc. Life & Health Insurance MET $42.79 $42,159 1.80 OW Bhullar Jimmy $47.00 10% 1.80 2.2% $5.04 8.5x 0.84x

18 American Express Co. Consumer Finance AXP $45.63 $54,928 1.99 OW Shane Richard $50.00 10% 2.00 1.3% $3.75 12.2x 3.45x

Average 2.50 21% 2.14 6.1% 13.4x 1.72x Source: J.P. Morgan and FactSet.


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Special: Still See Housing Bottom in 2011

We still believe US housing markets are likely to see a bottom in mid-2011 (see

Positive on housing food chain dated 4/9/2010) sustained by household formation,

recovery in employment, tightening markets for housing (vacancy rates), and

gradually easing credit conditions.

A sustained recovery in housing provides upside to the GDP outlook. Eachincrement of 500k home starts (from the current 519k) adds 1.5% to GDP growth

and about 2mm jobs.

Thus, if US housing indeed starts to see a recovery in starts, this would addsubstantially to the upside potential for GDP forecasts.

Of course, there is an animal spirits element to the recovery in housing. After all,purchasing a home requires the buyer to accept a large liability and, thus,

expectations of future home prices are key. If one expects rising home prices, one

consequently has an incentive to acquire the liability.

Demand Forecast to Improve in 2011 Leading to GradualRise in Prices

Foremost, demand for housing is forecast to recover. Economists broadly see home

sales rising in 2011 (see Figure 29) with some variance between a 2% and 18% rise

in demand for existing homes (EHS). The drivers for this are noted above.

The gradual improvement in demand (existing homes, not new homes) should

stabilize home prices. The J.P. Morgan Securitized Products Group HPA (homeprice) forecasts are shown below in Figure 30. The relevant one is the Base

case and they see flat home prices in 2011 followed by gradual rises going

forward.

Figure 29: Economists Predict a Recovery in Housing Demand

From 2011 Global Housing Outlook by John Sim

Source: J.P. Morgan. From Home Price Monitor: 2011 Outlook by John Sim dated 11/24/2010.

Figure 30: J.P. Morgan SPG Sees Home Prices Flat in 2011

From 2011 Global Housing Outlook by John Sim

Source: J.P. Morgan. From Home Price Monitor: 2011 Outlook by John Sim dated

11/24/2010.


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Improvement in Employment Should Boost HouseholdFormation1.5mm in 2011 and 1.6mm in 2012

Equally important is a recovery in the labor markets. J.P. Morgan economists see the

US adding 175k per month in payrolls, a major step up from the 100k seen in 2010.

Historically, this bodes well for household formation. One can see below in Figure

31 that household formation varies with labor market conditions. Specifically, it has

plunged during recessions before recovering.

The pace of that recovery is illustrated in Figure 32 on the right. As one can see,Housing formed per net adult change meaningful accelerates as labor market

conditions improve. The result is that by Year +2 and +3 (which equates to 2011

and 2012), this ratio would be expect to rise from a low of 0.19 to 0.7 and this

implies a meaningful step up in demand.

For 2011 and 2012, moving to the average ratio of 0.7 times 2.6mm net new

adults implies 1.9mm-plus formed.

Figure 31: Household Formation vs. Employment Growth

Jobs and Households formed per net adult chg

0.160.22

0.16

0.470.27

0.540.42

0.10

0.30

0.50

0.70

0.90

1.10

1.30

1/59 1/63 1/67 1/71 1/75 1/79 1/83 1/87 1/91 1/95 1/99 1/03 1/07 1/11 1/15

H

H

form

ation

perN

etA

dultChg

(6,000)

(4,000)

(2,000)

0

2,000

4,000

Increase

in

Nonfarm

Payrolls

Recession Increase in Nonfarm Payrolls HHFormation per Net Adult chg


Figure 32: Following Labor Trough, HH FormationAccelerates

Jobs and Households formed per net adult chg

From trough HH Formed/ Net Adult chg

Year of Trough

in Ratio 0 1 2 3 4

1962 0.27 0.69 0.92 1.24 0.54 0.

1966 0.54 0.71 0.82 0.53 0.54 0.

1974 0.47 0.60 0.47 0.65 0.43 1.

1982 0.16 0.50 0.70 0.69 0.48 0.

1989 0.22 0.44 0.63 0.36 0.41 1.

1995 0.42 0.67 0.84 0.67 0.55 0.

b Avg All Years 0.35 0.60 0.73 0.69 0.49 0.2009 (today) 0.19 0.38

Implied HHs formed 2011e 2012e 2013e 20

a Incr. Adults 2.6mm 2.6mm 2.6mm 2.6m

b HH/adult (see above) 0.73 0.69 0.49 0.

a*b Implied HHs Formed 1.9mm 1.8mm 1.3mm 2.2m


Shadow Inventory Is Peaking

The J.P. Morgan Securitized Product Research (or SPG) team sees shadow inventory

of homes (homes delinquent, plus foreclosure plus REO) as peaking and gradually

dipping going forward (see Figure 33). But as has been apparent in the past fewyears, the pace at which these homes are liquidated plays a big role in home price

movements.

Their base case is for foreclosure liquidations to rise to 2.5mm in 2011 assuminga foreclosure rate of 10% and foreclosures becoming REO (real estate owned,

homes owned by banks) staying at roughly 3.5-4.0%.

In our view, a decline in shadow inventory sets the stage for home prices togradually bottom and that is the forecast of our SPG team which expects home

prices to bottom in 2011 before gradually rising.


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Figure 33: Shadow Inventory Is Peaking

Shadow is all delinquent, foreclosure, and REO loans (millions)

Source: J.P. Morgan. Loan Performance, MBA, and the 2011 Securitized ProductOutlook by Ed Reardon, John Sim, and team.

Figure 34: Liquidations of Foreclosures Are Peaking

Millions

Source: J.P. Morgan. From 2011 Securitized Product Outlook by Ed Reardon, John Sim,

and team.

Vacancy Rates of Housing Are Falling, While ApartmentRents Are Rising

Vacancy rates for both housing and rental use in the meantime are falling

meaningfully. In fact, we believe rental vacancy rates at 10.3% are essentially back

to equilibrium levels seen in the 2003-2004 period (see Figure 36).

But vacancy rates for US housing are still somewhat elevated at 2.5%. A tightermarket would see vacancy rates below 2%. The key for reducing vacancy rates

for US housing is the need for household formation (see above). Again, we see

that accelerating in 2011. The pushback is that one might say more households may become renters. This is

possible, but the issue, in our view, is the limited rental stock available.

Figure 35: Housing Vacancy Rates Are Declining

%

Source: Bloomberg.

Figure 36: Housing Vacancy Rates Are Declining

%

Source: Bloomberg.

Still high

Equilibrium


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Record Affordability, But Credit Needs to Ease

In the meantime, affordability of housing has improved greatly according to our SPG

team. As shown in Figure 37 below, given the combination of falling home price andlower interest rates, payments on a 30-year fixed-rate mortgage today are lower than

those using non-traditional lending products to purchase a home in 2006 and 2008. In

fact, compared to 2008, mortgage payments are 50% lower.

The movement in mortgage payments is illustrated in Figure 38 below whichshows that conforming mortgages (30-year fixed) have a lower payment now

than would ARMs originated in 2004 and prior. In other words, affordability is

very strong.

Figure 37: Affordability Is Better Today than During AnyBoom Time...

Forecasted payments

Source: J.P. Morgan. Loan Performance, MBA, and the 2011 Securitized

Product Outlook by Ed Reardon, John Sim, and team.

Figure 38: Conforming Loans Cheaper Than Option-ARMs of 5 Years Ago

Payment on a given mortgage product

Source: J.P. Morgan. Loan Performance, MBA, and the 2011 Securitized Product Outlook by Ed Reardon,

John Sim, and team. Assumes a $500K home in June 06, with Case-Shiller home price increases/declinesbefore and after. LTV ramps up from 70% to 80% during the boom and then back to 70%. Option ARM

assumes a minimum 1.5% teaser payment.


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Risk: P/E VolatilityExpect Higher Interest Rate and Dollar Volatility

Higher volatility in interest rates and the dollar should be all but certain in 2011, with

the resulting implication being higher P/E volatility (see Figure 39 and Figure 40).

The drivers of this are the combination of Fed monetary easing cycle (QE) against

the backdrop of rising sovereign debt sustainability (EU mostly) and diverging

cyclical momentum:

It should be no surprise that QE coupled with mounting sovereign debtsustainability questions are raising the volatility of interest rates. Similarly, given

the diverging global economic momentum (EM vs. developed), the Feds latest

easing cycle is driving debate about dollar intervention and competitive

devaluation.

Figure 39: Interest Volatility High...

Delivered volatility since 2005

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 1/10 7/10

DeliveredVolatility

5yr Avg +/- 1std dev

10yr Treasury Delivered Volatility (20Davg)

Trailing 5yr Avg


Figure 40: Dollar Volatility High...


0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 1/10 7/10

DeliveredVolatility

5yr Avg +/- 1std dev DXY Delivered Volatility (20D avg)

Trailing 5yr Avg


Higher interest rate and dollar volatility naturally produce higher P/E volNaturally, with higher interest rate and dollar volatility, we should expect higher P/E

volatility. Historical analysis indicates this has been the case (with 90% correlation).

Figure 41: High Rate Volatility Indicates Higher P/E Volatility


y = 0.3596x + 0.1101R2 = 0.9181

(0.60)

(0.40)

(0.20)

0.00

0.20

0.40

0.60

0.80

1.001.20

1.40

(2.00) (1.00) 0.00 1.00 2.00 3.00

10yr Treasury Yield Volatility # std dev from 5yr avg

P/E(NTM)Volatility#stddevfrom5yr

avg


Figure 42: Higher FX Volatility Indicates Higher P/E Volatility


y = 0.3058x + 0.0765

R2 = 0.9616

(0.60)

(0.40)

(0.20)

0.00

0.20

0.40

0.60

0.80

1.00

(1.60) (1.10) (0.60) (0.10) 0.40 0.90 1.40 1.90 2.40

DXY Volatility # std dev from 5yr avg

P/E(NTM)Volatility#stddevfrom5yr

avg



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Sufficient Funds to Meet Funding Requirements of Irelandand Portugal, and Spain, if Needed, Until 2013

Cumulatively, funds from the EFSF (European Financial Stability Fund), the IMF,

and EU balance of payments facility can provide 565bn of loans to Euro area

sovereigns. From Figure 44, which our European Rates Strategy team put together,

we can see that the cumulative estimated funding requirements of Ireland, Portugal,

and Spain are roughly 140bn below the funding capacity. Although we do

acknowledge concerns that there have only been opaque signs of these liquidity

arrangements being extended beyond 2013, we believe that the existing supports will

be sufficient to allow fiscal consolidation to proceed in the peripheral economies,

even if it only means creating a buffer away from harsher and more difficult

decisions of fiscal transfers, debt restructuring, and fiscal reform.

Figure 44: Ireland, Portugal, and Spain Require 23bn of Funding Until End 2013

Estimated funding requirements* until 2013 for Ireland, Portugal, and Spain

Source: J.P. Morgan European Rates Strategy.

* Excludes T-bills and bank recapitalization from funding requirements. The number for Ireland includes 3bn/yr of promissory notes.

**BoP is the 60bn Extended Balance of Payments facility agreed upon by the EU. The 565bn loans consists of 250bn from the IMF,

255bn from the EFSF, and 60bn from the Balance of Payments facility.

140bn buffer


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Risk: Municipal DebtBudget Deficits

Helped by Recovery in RevenueUS public indebtedness has come under elevated scrutiny in the recent months. If

municipalities begin to make widespread cuts to balance budgets, there would be

impacts on labor and capital spending. The city/state issue is arguably less about debt

given the relatively smaller debt burdens (see below).

Ultimately, though, this is a question of timing. If this does not become an issue in

2011, the US cyclical recovery should boost tax revenues making the overall impact

in future years smaller.

State Budget Deficits Largest Yet...But Revenue Growth

Expected to Help Bridge GapFrom our discussions with our Municipal Finance team, we believe that fears of the

so-called muni crisis are exaggerated and that states and, to a lesser extent, local

governments are able to, and committed to, meet their debt obligations. Although we

expect to see state budget gaps increasing, our Municipal Finance team does not view

this as a catalyst for an increase in muni default/liquidity risk although headline risks

likely will still persist.

In our earlier reports (see Post-Midterm Equity Strategy Call dated 11/3/10), we

discussed how the new Republican-controlled US House of Representatives likely

will herald in a new wave of fiscally conservative measures, which we believe will

reduce the likelihood of ARRA funding renewal. Consequently, FY2012 budget

deficits are expected to be larger than in previous years (ARRA contribution toclosing the gap expected to decrease from $59bn to $6bn).

Figure 45: Next Years Budget Gaps Should Be the Largest Yet

Total states' budget shortfalls, $ billion

Source: J.P. Morgan Municipal Finance Credit Research. Center on Budget and Policy Priorities analysis using data from US

Department of Health and Human Services, US Department of Education, Congressional Budget Office, and state budget documents.

$33bn increase instate responsibility


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There are several reasons why our Muni team remains constructive on the space:

States are constitutionally obligated to meet their debt obligations, whichsimply means that bondholders can sue state governments in the event of adefault. That, coupled with the risk of losing access to the public markets, should

be sufficient deterrent against default. Moreover, states are also constitutionally

obliged to balance their budgets.

State revenue growth has been rebounding, and is expected to continuerecovering into 2011. The best high-frequency gauge would be the weekly initial

jobless claims which J.P. Morgan Economists predict will grind down toward

400k, from which we would expect to see an acceleration in tax receipts six

months later.

Figure 46: State Taxes Are Rebounding

YoY change in real estate and local tax revenue, %

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

20102009200820072006

State Local

Source: US Census Bureau, J.P. Morgan Municipal Finance Credit Research.

Figure 47: And Should Continue to Recover Alongside Initial Jobless Claims

Quarterly state tax receipt growth (%); Weekly initial jobless claims (000s)

-10%

-5%

0%

5%

2006 2007 2008 2009 2010

Statetaxreceiptgrowt

200

300

400

500

600

700

Initialjoblessclaims

State tax receipts

Initial jobless claims

Source: US Census Bureau, US Bureau of Labor Statistics, J.P. Morgan Municipal Finance Credit

Research.

Expected improvements in thelabor markets are a leadingindicator of acceleration instate tax receipts (6mo delay)


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States Have Relatively Small Debt Levels and Are DistinctlyDifferent from Other Sovereigns...

Roever and team expect debt issuance to decline as debt becomes more taboo with

the Republican influence seen to dampen the marginal propensity to borrow. But

how much of this is actually relevant to the already much less indebted states and

local governments?

For starters, munis are distinct from other sovereigns in that they have limitedrollover riskthe debt is long-term, at a fixed rate, and is amortizing.

Moreover, there is much less of it around! States and local governments only owe10% of the total US public bonded debt (Figure 48). Pension and Healthcare

obligations remain daunting but even at current levels, they are estimated to be,

on average, solvent for the next 10 years and do not pose a 2011 risk.

Interest payments for debt obligations also only make up 5-6% of state budgets.

With significant resources, especially in the light of continuous revenue growth,the willingness of states to repay is also bolstered by their continued need for

capital.

Figure 48: Magnitude of State and Local Debt Is Small Relative to Federal Debt

$ in billions

Bonded Debt % of Total Debt

Federal 8,627.7 89.2%

State 373.3 3.9%

County 111.3 1.1%

School district 326.4 3.4%

City 238.0 2.5%

Total 9,676.6 100.0%

Source: J.P. Morgan Municipal Finance Credit Research.

States and localgovernments hold only10% of the total bondeddebt


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2011 Sector Outlook

Our Strategy Sector Overweights and Underweights are explored on the following

pages, as well as some discussion of the views of each of J.P. Morgans fundamental

equity analysts. Figure 49 below summarizes the views of our analysts on the

likelihood of his/her industry outperforming the market in 2011.

For our Strategy Sector ratings, in summary, our sector ratings are as follows:

Overweight: Materials, Industrials, Discretionary, Technology, Energy,andFinancials

Neutral: Telecom and HealthCare

Underweight: Staples and Utilities

Figure 49: J.P. Morgan Fundamental Analyst Conviction Levels on Likelihood of Industry Outperforming Market in 2011

HC = High Conviction, N = Neutral, LC = Low Conviction

CYCLICALS

Materials OW Industrials OW Discretionary OW Technology OW

Gold / Bridges HC Airlines / Baker HC Gaming / Greff HC Communications Equipment / Hall HC

Platinum/Palladium / Bridges HC Business Services / Steinerman HC Lodging / Greff HC LED (Alt Energy) / Blansett HC

Metals & Mining / Gambardella HC Airfreight/Surface Transport / Wadewitz HC Global QSR (Restaurants) / Ivankoe HC IT Hardware / Moskowitz HC

Chemicals / Zekauskas HC Machinery / Duignan N Homebuilders / Rehaut HC Electronic Mfg Services / OBrien HC

Coal / Bridges N Engineering & Construction / Levine N Broadlines & Department Stores / Grom HC Software Technology / Auty HC

Environmental Services / Levine N Food / Grom HC Applied and Emerging Tech / Coster HC

Aerospace & Defense / Nadol N Hardlines / Horvers HC Computer Svcs & IT Consulting / Huang HC

Electrical Equip & Multi-Industry / Tusa N Media / Khan HC SMid Semiconductors / Sur HC

Oil Tankers / Chappell LC Autos, Auto Parts & Tires / Patel HC Software / DiFucci N

Dry Bulk / Chappell LC Advertising & Marketing Svcs / Quadrani HC Enterprise Voice Equipment / OBrien N

Casual Dining (Restaurants) / Ivankoe N Solar Alt Energy) / Blansett LC

Building Products / Rehaut N Semiconductors / Danely LC

Specialty Retail / Tunick N Electronic Components / OBrien LC

Info Svcs/Radio/TV Broadcasting / Meltz N

Education Services / Steinerman N

Internet / Khan LC

NEAR-CYCLICALS

Energy OW Financials OW

Oil Services & Equipment / Anderson HC Life Insurance / Bhullar HC

Integrated Oil & Gas / Minyard HC Asset Managers / Worthington HC

Oil & Gas E&P / Allman N Large Cap Banks / Juneja HC

Energy MLPs / Liu N REITs / Michael Mueller / Paolone HC

Credit card / Shane N

Exchanges / Worthington N

Small/Mid Cap Banks / Alexopoulos N

Non-Life Insurance / Heimermann LC

DEFENSIVES

HealthCare N Telecom N Staples UW Utilities UW

Healthcare Tech & Distribution / Gill HC Tobacco / Maile HC Unregulated Utilities / Smith HC

SMid Biotechnology / Kasimov HC HH & Personal Care Products / Faucher N Regulated Utilities / Smith N

SMid Med/Life Sciences Tech / Peterson HC Packaged Food / Bivens LC

Managed Care / Rex HC Beverages / Faucher LC

Healthcare Facilities / Rex HC

Pharmaceuticals / Schott HC

Healthcare Information Tech / Rahim HC

Biotechnology / Meacham N

Medical Tech & Devices / Weinstein LC Source: J.P. Morgan.


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Figure 50: Sector Earnings Outlook and ValuationEarnings growth (2011) Valuation. (2012 P/E)

JPM

StrategyRating

JPM Est

EPSGrowth

Consensus

Est EPSGrowth

JPM vs.Consensus Comment

P/E(2012)

P/E (2012)

Relative toS&P 500 Comment

Cyclicals

Materials OW 18.8% 20.2% -144 bp Domestic materials like Paper, Construction

materials and Steels

15.2x 3.2x Valuatons less attractive

Industrials OW 17.2% 20.1% -295 bp Domestic cyclicals still more attractive 13.6x 1.6x Upside to P/E

Discretionary OW 10.5% 12.7% -222 bp 12.7x 0.7x Upside to P/E

Technology OW 7.9% 12.8% -491 bp See some risk to EPS growth due to Europe 12.2x 0.2x Upside to P/E

Near-Cyclicals

Energy OW 11.7% 9.9% 177 bp Above consensus due to higher Oil forecast 10.7x -1.3x See upside here

Financials OW 23.4% 24.4% -98 bp Fastest EPS growth in 2011 and largest

contributor to EPS gains

9.6x -2.4x Some P/E expansion possible

Defensives

HealthCare N 3.7% 4.3% -66 bp Weak EPS growth 11.4x -0.6x Upside to P/E as market trades higher

Telecom N 10.1% 10.5% -41 bp 16.2x 4.2x Expensive

Staples UW 6.7% 8.3% -165 bp Slower EPS 14.0x 2.0x and rel. higher valuatio

Utilities UW -16.4% -16.9% 51 bp 14.2x 2.2x P/E bit high

S&P 500 10.4% 12.1% -167 bp 12.0x Forecast P/E to reach 14x

S&P ex-Fin 8.0% 9

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JPM US Equity Outlook 2011

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