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March 2008
Exploiting the Gap Between Fundamental Reality
and Market Perception
NYU Stern School of Business March 25, 2008
Tobias M. Levkovich Managing Director, Chief U.S.
Equity Strategist tobias.levkovich_at_citi.com (212)
816-1623
Lorraine Schmitt, Associate [phone] Dan
Kaskawits, Associate [phone] Published
March 14, 2008
See Appendix A-1 for Analyst Certification and
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The Outlook

• We expect single-digit gains for the SP 500 in
  2008 and have a year-end target of 1,550.
• Sentiment is neutral, while proprietary valuation
  methods continue to be compelling, and earnings
  trends are still supportive.
• Large-cap likely to retain leadership over SMID.
• Volatility should continue with positive
  ramifications for IT names.
• Growth probably will outperform value, benefiting
  the Information Technology and Consumer
  Discretionary sectors.
• Preference for low expectation, attractively
  valued areas such as Retailers and Diversified
  Financials, over high expectation, unattractively
  valued Capital Goods and Materials.

Price Targets
SP 500 EPS Estimates
12008 SP 500 and DJIA targets established on
9/16/07. 22008 SP 500 and DJIA targets updated
on 1/22/08.
Source Citi Investment Research Economics and
Analysis
3
Credit Conditions Are Critical
Bank Tightening Standards and Capex
Bank Tightening Standards and Industrial
Production
Source Haver Analytics and Citi - U.S. Equity
Strategy
Source Haver Analytics and Citi - U.S. Equity
Strategy

• Current levels suggest a more challenging
  business environment.
• Recession risks are well in place.

4
Earnings
Profits and Employee Comp. as a of GDP
Source BEA and Citi Economic and Market Analysis

• National income margins are at 40-year highs
  not an easy hurdle to overcome, thereby
  generating forward earnings concerns.
• 70 of corporate costs is labor vs. only 7 for
  energy.

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Earnings
SP 500 and SP 500 GICS Sectors EPS Growth
Forecasts (Consensus vs. Citi)
Industrial Production and SP 500 EPS
Source Bloomberg, SP, and Citi Global Markets
Source Federal Reserve, Haver Analytics, and
Citi US Equity Strategy

• We are below consensus on 2008 EPS estimates as
  are many buy-side investors based on our client
  surveys.
• We are greater than the consensus on Energy and
  Health Care earnings.

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Earnings
Market Value Reflecting Implied EPS Growth
Source Haver Analytics and CIR - U.S. Equity
Strategy

• The implied growth rate on earnings is 20-25
  below its average pace of the past 20 years.
  When so little of future growth is being
  discounted, the SP 500 has typically rallied 17
  over the following 12-months.
• The past return environments occurred when
  margins were not at 40-year highs and inflation
  was not as muted, thus nominal EPS gains were
  arguably easier to achieve ruling out a 10
  move off of current market levels does not seem
  as farfetched to us.

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Valuation
P/Es, Interest Rates Risk Premium Analysis
Source Citi Investment Research - U.S. Equity
Strategy

• This approach indicates that stocks are 20
  undervalued.
• We believe the R-squared correlation of near
  0.71, between the trailing P/E and the 10-year
  Treasury and equity risk premium is rather
  compelling.
• Since 1961, when the actual trailing P/E was
  more than one standard deviation below the trend
  line P/E, the average 12-month appreciation was
  nearly 22.0.

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Sentiment
The Panic/Euphoria ModelSM
Source Citi Investment Research - U.S. Equity
Strategy

• Previous panic readings argue for potentially
  meaningful additional market gains in the next
  6-12 months with better than 90 historical
  probability.
• Has indicated 12-month average gains of roughly
  20 when in panic territory.
• Components NYSE short interest ratio, margin
  debt, Nasdaq daily volume as of NYSE volume, a
  composite average of Investors Intelligence and
  the American Association of Individual Investors
  bullishness data, retail money funds, the
  put/call ratio, CRB futures index, gasoline
  prices and the short interest ratio between
  public and member firms.

9
Real Estate Myths Unmasked
Personal Income Home Equity Extraction Vs.
Spending
Core Retail Sales and Wilshire 5000
Source Citi Economics and Market Analysis
Source Citi Economics Market Analysis

• The top quintile of American income earners
  account for roughly 40 of consumer spending and
  far more of discretionary spending.
• Looks like consumers dramatically underspent
  their real estate riches.

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Real Estate Facts
Household Net Equity In Real Estate
Household Net Worth (Ex-Real Estate)
Source Citi Investment Research - U.S. Equity
Strategy and FRB Flow of Funds
Source CIR - U.S. Equity Strategy and Haver
Analytics

• Home equity accounts for less than 21 of U.S.
  household net worth, not 75.

• Near record highs away from real estate.
• Over the past five years, only 3.1 trillion of
  the 18.7 trillion increase in net worth was due
  to real estate.

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Recession Risk
Stock Market Performance Around Recessions
Source Global Financial Database, Haver, and
Citi Investment Research US Equity Strategy

• Significant downside risk should a recession
  ensue.
• Unlikely to be as bad as average market decline,
  given the impact of the 1973-74 and 2000-02
  collapses.

12
Catalysts for Large-Cap Outperformance
Consumer Delinquencies Vs. Large/Small Performance
Pretax Corporate Profits Trends vs.
Small-Cap/Large-Cap Relative Performance
Source Haver Analytics, Bureau of Economic
Analysis (BEA), Russell, SP, and CIR Small/Mid
Cap US Equity Strategy
Source Haver and CIR Small/Mid Cap US Equity
Strategy
Credit Spreads Vs. Relative Performance
Volatility Vs. Relative Performance
Source Haver Analytics and CIR Small/Mid Cap US
Equity Strategy
Source Haver and CIR Small/Mid Cap US Equity
Strategy
13
Portfolio Positioning
Strategy Large Cap Industry Group Weightings

• Some controversial positioning views including
  Financials and industry groups linked to the
  global growth thesis.

Note Shading denotes most recent changes Source
Citi Investment Research - U.S. Equity Strategy
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Overweight Diversified Financials and Insurance
Insurance Valuation
Diversified Financials Valuation
Source FactSet and Citi US Equity Strategy
Source CIR US Equity Strategy and FactSet

• Alongside recent market turmoil, diversified
  financials and insurance valuation has become
  more attractive.

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Overweight Banks and Insurance
Banks Earnings Revisions
Insurance Earnings Revisions
Source FactSet and Citi US Equity Strategy
Source FactSet and Citi US Equity Strategy

• Banks earnings revisions are at all-time lows
  and may have bottomed.
• Insurance revisions now at previous lows.

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Capital Goods/Materials/Energy Equipment
Capital Goods Valuation
Energy Equipment Services Valuation
Source FactSet and CIR U.S. Equity Strategy
Source FactSet and CIR U.S. Equity Strategy

• Decoupling thesis to be tested in 2008.
• Valuation leaves little room for error amidst
  likely earnings problems.

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Materials and Capital Goods Trends
Materials
Capital Goods
Source Haver Analytics and CIR U.S. Equity
Strategy
Source Haver Analytics and CIR U.S. Equity
Strategy

• Deteriorating ISM data has typically been
  coincident with poor performance for Materials
  and Capital Goods stocks.

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Nasdaq and Homebuilders
August 2005
Now
Source Haver Analytics and CIR US Equity
Strategy
Source Haver Analytics and CIR US Equity
Strategy

• In 2005, Homebuilders were bubblicious.

• No longer the case.

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Tech, Housing, and Commodities
Homebuilders vs. Energy Equipment Services
Stocks
Nasdaq vs. Fertilizer Ag. Chemical Stocks
Source Haver Analytics and CIR US Equity
Strategy
Source Haver Analytics and CIR US Equity
Strategy

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