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North America Equity Research14 December 2010
U.S. Year Ahead 2011Stronger Growth Emerging
Contents
Macro............................................................
Capital Goods / Industrials...........................
Consumer ....................................................
Energy .........................................................
Financial ......................................................
Health Care..................................................
Materials ......................................................
Media & Telecom.........................................
Technology ..................................................
For a complete list of contributors,please see Table of Contents on page 4.
Bloomberg JPUS2011
Bloomberg subscribers can use the tickerJPUS2011 to access tracking information ona basket created by the J.P. MorganDelta One desk to leverage the themesdiscussed in this report. For information onJPUS2011, please contact your J.P. Morgansalesperson or the Delta One desk.
See page 110 for analyst certification and important disclosures, including non-US analyst disclosures.J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware thathe firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a singfactor in making their investment decision.
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J.P. Morgan Securities LLC Equity Research 383 Madison Avenue, New York, NY 101793
December 14, 2010
Dear Investor,
The U.S. economy has lifted from its bout of midyear weakness and, after a long
summer vacation following its retreat in May and June, the U.S. equity market steadily
advanced in September and October. After a pause in November, the S&P 500 hit a
new high for the year on December 10, and looks to end the year more than 10%
higher than at its start, the best performance among the developed markets on a
regional basis.
While economic fragility and uncertainty were key characteristics of equity sentiment
and performance over the course of 2010, somewhat stronger growth should emerge
in 2011 with Fed and fiscal support. J.P. Morgans baseline economic forecast calls forthe U.S. economy to gradually accelerate from growth averaging only about 2% in the
middle two quarters of 2010 to above-trend growth through 2011 and 2012. Our
economists expect inflation to hold below 1% in 2011 and do not look for a Fed rate
hike until 2013.
Consequently, we remain constructive on U.S. equities. Tom Lee, J.P. Morgans Chief
U.S. Equity Strategist, expects the S&P 500 to advance at least 15% in 2011, driven
more by valuation expansion than upside to estimates. Amid considerable
countervailing forces on asset values, we believe the equity market risk premium will
contract from a 50-year high toward more normalized levels, despite likely more rapid
industry rotation than seen over the past two years.
We designed this report as a sector-by-sector guide to equity investing in the United
States for the upcoming year. We asked our analyst teams to identify key drivers of
sector stock prices and to present their best investment ideas, framed by commentary
from our economists, strategists, as well as derivatives and accounting experts. One of
the most common themes was the need for investors to be selective, given notable
risks both to the upside as well as downside.
As always, we aim to provide analysis that proves helpful in your investment decision-
making process and hope you find this report useful.
Noelle Grainger
Head of U.S. Equity Research
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Table of Contents
Macro
Economics (Robert Mellman) .......................................................................................7
Equity Strategy (Thomas J Lee, CFA) ........................................................................11
Equity Technical Strategy (Michael Krauss) ...............................................................17
Accounting & Valuation (Dane Mott, CFA, CPA) ........................................................21
Equity Derivatives (Marko Kolanovic) .........................................................................26
Delta One Strategy (Marko Kolanovic) .......................................................................33
Capital Goods / Industrials
Aerospace & Defense (Joseph B. Nadol III) ...............................................................39
Airfreight & Surface Transportation (Thomas R. Wadewitz) .......................................40
Electrical Equipment & Multi-Industry (C. Stephen Tusa, Jr CFA)..............................41
Engineering & Construction (Scott Levine).................................................................42
Environmental Services (Scott Levine).......................................................................43
Machinery (Ann Duignan)...........................................................................................44
Marine Transportation (Jonathan B Chappell, CFA)...................................................45
Consumer
Airlines (Jamie Baker) ................................................................................................47
Autos & Auto Parts (Himanshu Patel, CFA) ...............................................................48
Beverages (John Faucher) .........................................................................................49
Gaming & Lodging (Joseph Greff) ..............................................................................50
Homebuilding & Building Products (Michael Rehaut, CFA) ........................................51
Household & Personal Care Products (John Faucher)...............................................52
Packaged Food (Terry Bivens)...................................................................................53
Restaurants (John Ivankoe) .......................................................................................54
Retailing Broadlines & Department Stores (Charles Grom, CFA, CPA) ..................55
Retailing Food (Charles Grom, CFA, CPA) .............................................................56
Retailing Hardlines (Christopher Horvers, CFA) ......................................................57
Retailing Specialty (Brian J. Tunick) ........................................................................58
Tobacco (Rae Maile) ..................................................................................................59
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Energy
Electric Utilities & Independent Power Producers (Andrew Smith) .............................61
Energy MLPs (Xin Liu, CFA) ......................................................................................62
Integrated Oil & Gas (Katherine Lucas Minyard) ........................................................63
Oil & Gas Exploration & Production (Joseph Allman, CFA)........................................64
Oil Services & Equipment (J. David Anderson, PE, CFA) ..........................................65
Financials
Asset Managers (Kenneth B. Worthington, CFA) .......................................................67
Banks Large Cap & Trust and Processors (Vivek Juneja).......................................68
Banks Mid- and Small Cap (Steven Alexopoulos, CFA) ..........................................69Exchanges (Kenneth B. Worthington, CFA) ...............................................................70
Insurance Life (Jimmy S. Bhullar, CFA)...................................................................71
Insurance Non-Life (Matthew G Heimermann) ........................................................72
REITs / Real Estate Services (Michael W. Mueller, CFA / Anthony Paolone, CFA) ...73
Health Care
Biotechnology (Geoffrey Meacham, Ph.D.) ................................................................75
SMid Biotechnology (Cory Kasimov) ..........................................................................76
Healthcare Technology & Distribution (Lisa C. Gill)....................................................77
Healthcare Information Technology (Atif Rahim) ........................................................78
Managed Care (John Rex) .........................................................................................79
Medical Technology & Devices (Michael Weinstein) ..................................................80
SMid Medical & Life Sciences Technology (Tycho W. Peterson) ...............................81
Pharmaceuticals Major(Chris Schott, CFA) ............................................................82
Pharmaceuticals Specialty (Chris Schott, CFA) ......................................................83
Materials
Chemicals Specialty, Commodity & Agricultural (Jeffrey J. Zekauskas)..................85
Coal (John Bridges CFA, ACSM) ...............................................................................86
Gold (John Bridges CFA, ACSM) ...............................................................................87
Metals & Mining (Michael F. Gambardella).................................................................88
Platinum & Palladium (John Bridges CFA, ACSM).....................................................89
Silver(John Bridges CFA, ACSM)..............................................................................90
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Media & Telecommunications
Advertising & Marketing Services (Alexia S. Quadrani)..............................................91
Entertainment (Imran Khan) .......................................................................................92
Information Services / Radio & TV Broadcasting (Michael A. Meltz, CFA) .................93
Technology
Alternative Energy (Christopher Blansett) ..................................................................95
Applied & Emerging Technologies (Paul Coster, CFA) ..............................................96
Business & Education Services (Andrew C. Steinerman)...........................................97
Communications Equipment & Data Networking (Rod Hall, CFA)..............................98
Communications Infrastructure Technology (Steven J. OBrien) ................................99Computer Services & IT Consulting (Tien-tsin Huang, CFA)....................................100
IT Hardware (Mark Moskowitz).................................................................................101
Semiconductors (Christopher Danely)......................................................................102
SMid Semiconductors (Harlan Sur) ..........................................................................103
Software (John DiFucci) ...........................................................................................104
Software Technology (Sterling Auty, CFA) ...............................................................105
Disclosures...............................................................................................................110
Note: Unless otherwise noted, all stock prices and coverage lists in this report are as
of the close on December 7, 2010, and target prices for December 2011.
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Economics
Fiscal Policy Helping to Lift Growth into 2011
With important adjustments behind us, as well as Fed and fiscal support,growth should turn somewhat stronger in 2011
The forecast calls for real GDP to accelerate from 2.6% growth in 2010 to3.5% in 2010 (4Q/4Q)
Core inflation should hold below 1% through 2011; the Fed Funds rateexpected to stay near zero until 2013, but the Feds asset purchase program
will likely end in June
Economic recovery is not healthunemployment rate to end 2011 at 9.0%;fiscal deficit to widen even more
The forecast looks for the U.S. economy to gradually accelerate from growthaveraging only about 2% in the middle two quarters of 2010 to above-trend growth
through 2011 and 2012. The economy has been held back over the past few years by
important adjustments in the aftermath of the credit crisis and extended recession.
Business has been reluctant to hire while it rebuilt profit margins and shored up
corporate finances; households cut back on spending while they raised their saving
rate; and homebuilding activity has dropped to extreme lows with associated declines
in output and employment. With these adjustments largely behind us, growth should
turn somewhat stronger. And the latest readings on most economic indicators,
including consumer spending, tend to indicate that the economy is lifting from a bout
of weakness in the middle of 2010. Swings in the financial markets over the past few
monthsespecially rising stock pricestend to increase confidence that the upturn
in growth will continue.
Until recently it seemed that modest acceleration in growth now under way would
meet substantial headwinds in the form of tighter fiscal policy that would hold back
growth in early 2011. But the recent agreement on tax policy between the Obama
Administration and Congressional Republicans has replaced restraint with fiscal
stimulus, notably the $120 billion reduction in employee payroll. (The forecast had
already incorporated the continuation of the Bush tax cuts and the renewal of
emergency unemployment benefits.) While the tax agreement has not yet been
passed by Congress, it seems very likely that it will be passed in something close to
its current form soon. As the recent turn to stronger growth is reinforced by the tax
cuts, real GDP growth should reach 3.5% in 1Q11 and 4.0% in the second quarter.
Growth is forecast to slow to 3.0% in 4Q10 as households and business anticipate the
hit to disposable income in early 2012 when payroll taxes revert to their higher level.
Core inflation has fallen below 1% over the past year as measured by either the core
CPI or the core PCE price index. High unemployment in labor markets, high vacancy
rates in real estate, and relatively low operating rates in manufacturing should
continue to hold core inflation below 1% in 2011. Energy and food prices are
expected to increase, but even headline inflation should average only 1.2%.
Robert Mellman
(1-212) 834-5517
JPMorgan Chase Bank NA
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The economy is likely to end 2011 with core inflation below 1.0%, the
unemployment rate at about 9.0%, and real GDP growth moderating to 3.0%.
Against this backdrop, the Fed will likely keep official rates close to zero, and the
forecast does not look for a Fed rate hike until early 2013. The Feds asset purchase
program is expected to run through June and then expire as currently planned.
The baseline forecast may look comforting against the brutal backdrop of the past
few years. The economy looks to enjoy stronger growth, declining unemployment,
and continued increases in profit margins. But the economic recovery will not bring
economic health. Even a shift to the solid growth in the forecast is apt to bring the
unemployment rate down at a pace of only about 3/4% per year. Thus, the
unemployment rate, now 9.8%, likely will remain highly elevated for years to come.
And the boost to growth from lower taxes comes at the expense of a larger budget
deficit, now forecast to be $1.5 trillion, or nearly 10% of GDP, in 2011. The forecast
looks for the federal fiscal deficit to narrow after 2011, but the decline will not come
quickly and fiscal challenges at both the federal and state and local levels will be
with us for the foreseeable future.
A turn to stronger growth brings with it upside risks to the baseline forecast as
business and households turn more optimistic. But the baseline forecast will remain
subject to visible downside risks too, and the expansion may well continue to feel
fragile. Contagion effects of Euro-area fiscal problems could rock the U.S. equity
markets. Core inflation probably will hold below 1.0% through 2011, raising obvious
concerns that a downside shock could push the economy into outright deflation. The
reality of an unprecedented number of long-term unemployed brings concerns about
prospects for an increase in the number of long-term unemployable. And what looks
to be a period of sustained strong corporate profits and high unemployment might
give rise to a political environment that is increasingly hostile to the market
economy. In short, improved economic growth and declining unemployment should
mark a welcome change in the economic landscape, but they are not likely to be a
panacea that will eliminate current problems and tensions.
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Table 1: U.S. Economic Forecast%ch saar, except as noted
1H11 2H11 2011 2012
(4Q/4Q) (4Q/4Q)
Real GDP 3.75 3.25 3.50 3.00
Real domestic final sales 3.50 3.70 3.60 3.00
Core PCE price index 0.6 0.7 0.7 1.0
Unemployment rate (%, eop) 9.4 9.0 9.0 8.6
Fed funds rate (%, eop) 0.13 0.13 0.13 0.13 Source: J.P. Morgan.
Figure 1: Real GDP and Core PCE Price Index%ch saar, both scales
-9
-6
-3
0
3
6
0
1
2
3
05 06 07 08 09 10 11 12
ForecastReal GDP
Core PCE price index
Source: J.P. Morgan.
Figure 2: Unemployment Rate and Federal Budget, with Forecast
4
6
8
10
-12
-9
-6
-3
0
3
Percent, annual av g Percent of GDP, annual av g
90 95 00 05 10
Unemployment rate
Budget balance
Source: J.P. Morgan.
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Table 2: J.P. Morgan U.S. Forecast
2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 2010 2011 2012 2010 2011 2012Gross 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 8.2
Inventories (ch $bn, chained $2005) 68.8 111.5 61.2 51.6 55.3 47.2 52.4 - - - - - -Contribution to real GDP growth (% pts):
Domestic final sales 4.4 3.0 2.7 3.3 3.7 4.1 3.3 2.8 3.6 3.0 1.9 3.4 3.1
Net exports -3.5 -1.8 1.3 0.5 0.2 -0.3 -0.5 -1.0 0.0 0.0 -0.6 -0.1 -0.2
Inventories 0.8 1.3 -1.6 -0.3 0.1 -0.3 0.1 0.8 -0.1 0.0 1.4 -0.2 0.0
Income and profits (NIPA basis)
Adjusted corp profits 12.7 11.5 8.0 8.0 10.0 8.0 7.0 19.2 8.2 5.5 29.8 9.0 5.9
Real disposable personal income 5.6 0.9 1.0 4.5 3.5 3.0 3.0 2.2 3.5 2.4 1.3 3.0 2.3
Saving rate1 6.2 5.8 5.4 5.7 5.7 5.4 5.4 - - - 5.7 5.6 5.2
Prices and labor cost
Consumer price index -0.7 1.5 2.3 1.8 1.0 1.1 1.1 1.1 1.2 1.3 1.6 1.4 1.2
Core 0.9 1.2 0.4 0.6 0.6 0.7 0.8 0.6 0.7 1.1 1.0 0.7 0.9
Producer price index -0.5 0.9 4.0 1.0 0.7 0.8 1.3 3.2 0.9 1.4 4.1 1.4 1.3
Core 1.7 2.2 1.0 0.6 0.5 0.5 1.0 1.8 0.6 1.1 1.3 0.9 1.0
GDP chain-type price index 1.9 2.3 1.3 1.0 1.0 1.0 1.1 1.6 1.0 1.2 1.0 1.3 1.2Core PCE deflator 1.0 0.8 0.5 0.6 0.6 0.7 0.8 0.9 0.7 1.0 1.4 0.7 0.9
S&P/C-S house price index (%oya) 3.6 -1.2 -2.1 -2.5 -1.0 1.0 2.0 -2.1 2.0 2.0 0.6 -0.1 2.0
Productivity -1.8 1.9 1.0 2.0 2.5 2.0 2.0 1.2 2.1 1.6 3.4 1.7 1.7
Other indicators
Housing starts (mn units, saar)1 0.602 0.584 0.550 0.600 0.650 0.675 0.700 - - - 0.588 0.656 0.781
Industrial production, mfg. 9.3 3.7 4.0 4.5 5.0 4.5 3.5 5.8 4.4 3.5 6.0 4.6 3.7
Capacity utilization, mfg. (%)1 71.6 72.3 73.0 73.7 74.4 75.0 75.5 - - - 71.7 74.6 76.2
Light vehicle sales (mn units, saar)1 11.3 11.6 12.2 12.4 12.6 12.8 12.9 - - - 11.5 12.7 13.2
Unemployment rate1 9.7 9.6 9.7 9.6 9.4 9.2 9.0 - - - 9.7 9.3 8.8
Nominal GDP 3.7 4.8 3.8 4.5 5.0 4.5 4.1 4.3 4.6 4.3 3.9 4.5 4.2
Current account balance ($bn)1 -123.3 -135.6 -137.7 -140.8 -143.6 -148.4 -157.3 - - - -505.7 -590.1 -665.6
% of GDP -3.4 -3.7 -3.7 -3.7 -3.8 -3.9 -4.0 - - - -3.4 -3.9 -4.2
Federal budget balance ($bn)1 - - - - - - - - - - -1294.2 -1500.0 -1200.0
% of GDP - - - - - - - - - - -8.8 -9.8 -7.51. Entries are average level for the period. Federal balance figures are for fiscal years.
%q/q, saar %q4/q4 %y/y
Source: J.P. Morgan.
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Equity Strategy
YE 2011 Target 1425; Raise 11E EPS to $94 from $91; 12E EPS of $102
S&P 500 to Reach 1425 in 2011Debate Will Be on P/E
We see the S&P 500 delivering at least a 15% gain in 2011, driven more by valuation
expansion (risk premium falling) than EPS beats. Our YE2011 target for the
S&P 500 is 1425, based on 14x 2012E EPS of $102.
We have increased our 2011 EPS estimate for the S&P 500 to $94 (from $91),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.
Amid considerable countervailing forces on asset values, we believe P/Eexpansion will be driven primarily by i) contracting relative value relationship of
equities vs. corporate credit, in which risk premium for stocks narrows fromrecord-high toward normalized levels, and ii) positive impact on asset prices from
Feds large-scale asset purchases (QE2). As such, our target risk premium is
5.7%, down from 6.2% currently but still well above the ten-year average of
3.56%.
Figure 3: 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.
History suggests an even stronger 20%-plus gain, and that there should be more rapid
industry rotation in 2011 (year 3) than any prior year in this bull market. Thus, for
the portfolio manager, 2011 represents some daunting challengesa 15-20%
bogey to beat along with the prospect for even greater group rotation than in 2010.
Thus far, this market has been textbook in staging leadership, and in our
2011 Outlook piece, we introduce some tools to help target alpha generation.
Three Reasons to Be Constructive in 2011
#1: Solid GDP growth expected in 2011
U.S. GDP growth is forecast to accelerate to 3.5% (4Q/4Q) from 2.6% in 2010 aided
by expansionary behavior by business and consumer, rehabilitation of consumer
balance sheets, and accommodative fiscal and monetary policy.
Thomas J Lee, CFA AC
(1-212) 622-6505
Daniel M McElligott(1-212) 622-5598
daniel.m.mcelligott @jpmorgan.com
J.P. Morgan Securities LLC
Bloomberg JPMA TLEE
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We see labor picking up, adding 175k/month. Inflation remains muted due to
resource slack.
#2: History argues for 20%-plus year in equities
This year represents the third year of a business expansion AND the third year of a
Presidential term. There were only five periods in the 111 years of Dow history whenboth occurred and markets rose in each instance, posting an average gain of 21%
(Figure 4 and Figure 5).
Figure 4: 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 % times Instances >=0%
Source: J.P. Morgan and FactSet.
Figure 5: Years that Were Both 3rd Yr.of Pres. Term & 3rd Yr. of Expansion
Annual % 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.
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 four items
were key determinants (of 20 we examined) of longer (vs. shorter) bull markets.
#3: Relative return of equities should outperform other risky assets
Finally, relative value should strongly support stocks in 2011. Equity risk premium
remains at a 50-year high at 6.2% (our 14x assumes premium drops to 5.7%, well
above ten-year average of 3.56%). Moreover, forecast returns in 2011 for fixed
income markets are meaningfully weakerwith treasuries flat, high grade +2%,
against double-digit increases seen for commodities and equities.
Market Strategy: Staging as Correlation Falls
Sector correlations historically have fallen to cycle lows during the third year of a
bull market, suggesting a drop in correlation from current 90%.
Group leadership likely rotates more rapidly in 2011, arguing for staging
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. This seems logical to us as a fall in correlation leads to
divergences and business cycle dynamics dominate.
Staging would have identified top groups in 2010. This bull market has been a
textbook example thus far. The top eight groups which history indicated should
outperform in 2010 indeed outperformed by 1,000bp while the expected worst eight
(based on history) underperformed by 400bp.
Wow Wow
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Figure 6: Suggested Top Quartile (Based on Staging) Outperformed in 2010
% change relative to S&P 500
6.5
2.7
0.2
-2.2
10.3
3.9 3.8
-4.0
Quartile 1 Quartile 2 Quartile 3 Quartile 4
Relativeperf.vsS&
P
500
Predicted 2010 Actual 2010
Source: J.P. Morgan and Datastream.
For 2011, staging analysis suggests the best groups in the first four months of 2011
should be: Asset Managers, Insurance, Construction Materials, Restaurants,
Retail, Gaming, and interestingly Telecom Services and Utilities.
Figure 7: 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 Retail
Hotels 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.
The top 8 groups expected toperform well based on resultsin past bull markets did infact outperform by 1,030bp in2010.
The bottom 8 groupsunderperformed by400bp.
1. Consumer Cyclicalsexpected to outperform inearly 2011, along withFinancials.
2. The leadership isexpected to shift towardEnterprise/CapexSensitives. It makes sensethat domestic cyclicalswould be expected togain
3. Defensives expected togain in the final third of2011
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Sector Strategy2011 Outlook
We explore our Strategy Sector Overweights and Underweights in detail in our 2011
Outlook report. A summary is provided below:
Overweight Materials: The global synchronized expansion has fueled a recovery in demand
for many global commodities. The Feds QE is essentially another easing cycle
with a resulting weakening of the U.S. dollar (being a byproduct) and, thus,
boosting the outlook for these commodity producers.
Industrials: Industrials typically prove attractive during most of a bull marketcycle but we believe valuation sensitivity or at a minimum, GARP traits, will
matter in 2011. We still recommend exposure but realize a lot more good news
has been priced in here.
Discretionary: History suggests that in early 2011, investors should still want toown consumer cyclicals. And given our expectation of a strengthened consumer,
coupled with rising employment and repaired balance sheets, there could be
upside to estimates as well.
Technology: Group is not expensive but fiscal austerity in Europe and U.S.states/towns will pose a risk to tech spending. We remain Overweight due to
strong balance sheets coupled with potential upside in U.S. visibility as the U.S.
economy accelerates.
Energy: In the short term we see strong fundamental trends and positive outlookdriving outperformance for the sector. That said, group is very sensitive to the
price of oil and other commodities and to the perception about the durability of
the global economic expansion.
Financials: Historical staging favors banks and insurance in 2011. This sector isalso the largest contributor to expected EPS growth and should be the fastest
grower in 2011.
Neutral
Healthcare: Healthcare is not getting sickergroup could look more attractivelater in 2011 once we get closer to seeing full impact of healthcare reform and
move toward the other side of the valley for several segments.
Telecom: Potentially overcapitalized as the number of scale players suggestspricing pressure while intermodal threats challenge volumes and share.
Underweight
Staples: Fundamental outlook is mixed, but generally positive, with offsettingeffects from slowly rising demand but also rising cost pressures.
Utilities: We remain Underweight and see little reason to put fresh money towork in the sector given slower EPS growth. However, as the bull market
matures, valuations should become more attractive at some point.
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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. Figure 8below highlights our J.P. Morgan
Strategy forecasts for earnings growth in 2011-2012, as well as P/E (2012) multiplesfor each sector.
Figure 8: Sector Earnings Outlook and ValuationEarnings growth (2011) Valuation. (2012 P/E)
JPM
Strategy
Rating
JPM Est
EPS
Growth
Consensus
Est EPS
Growth
JPM vs.
Consensus Comment
P/E
(2012)
P/E (2012)
Relative to
S&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% 9.8% -180 bp 12.6x
Cyclicals 11.3% 14.9% -360 bp EPS gains driven by Cyclicals 12.8x 0.8x P/E should be 15x-16x
Defensives 2.5% 3.3% -83 bp 13.1x 1.1x
Cylicals vs. Defensives 883 bp 1159 bp -277 bp -0.3x -0.3x
Source: J.P. Morgan and FactSet.
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Top Stock Ideas from J.P. Morgan Fundamental Analysts
Table 3 lists the 67 top picks of our J.P. Morgan Fundamental Analysts for 2011.
These stocks have an average upside of 22% to current prices.
Table 3: Top Stock Ideas from J.P. Morgan Fundamental AnalystsPriced as of 12/10/2010, sorted by Implied Upside
Ticker Name
JPM
Rtg
Current
Price
Market
Cap
Target
Price
Implied
Upside Ticker Name
JPM
Rtg
Current
Price
Market
Cap
Target
Price
Implied
Upside
1 NRG NRG Energy Inc. OW $18.70 $4,623 $33.00 76% 35 TUP Tupperware Brands Corp. OW $47.87 $3,023 $57.00 19%
2 DNDN Dendreon Corp. OW $37.65 $5,434 $66.00 75% 36 UPS Uni ted Parcel Service Inc. OW $72.89 $53,130 $86.00 18%
3 ITRI Itron Inc. OW $55.89 $2,258 $95.00 70% 37 LIFE Life Technologies Corp. OW $52.76 $9,852 $62.00 18%
4 AMR AMR Corp. OW $7.97 $2,656 $13.50 69% 38 SMG Scotts Miracle-Gro Co. OW $50.92 $3,391 $59.00 16%
5 KGC Kinross Gold Corp. OW $18.44 $20,890 $27.00 46% 39 AFL AFLAC Inc. OW $56.12 $26,447 $65.00 16%
6 COL Rockwell Collins Inc. OW $58.19 $9,127 $83.00 43% 40 ICE Interconti nentalExchange I OW $117.55 $8,599 $136.00 16%
7 WFC Wells Fargo & Co. OW $30.27 $158,880 $43.00 42% 41 CTSH Cognizant Technology Sol OW $70.31 $21,338 $80.00 14%
8 PFE Pfizer Inc. OW $17.02 $136,329 $24.00 41% 42 DRI Darden Restaurants Inc. OW $49.48 $6,849 $56.00 13%
9 WCRX Warner Chilcott Plc OW $21.31 $5,380 $30.00 41% 43 NTAP NetApp Inc. OW $54.15 $19,571 $61.00 13%10 MDRX Allscripts Healthcare Soluti OW $18.25 $3,415 $25.00 37% 44 MW Men's Wearhouse Inc. OW $24.88 $1,314 $28.00 13%
11 DVN Devon Energy Corp. OW $73.29 $31,654 $100.00 36% 45 COST Costco Wholesale Corp. OW $71.25 $30,804 $80.00 12%
12 LEN Lennar Corp. (Cl A) OW $17.69 $2,718 $24.00 36% 46 CA CA Inc. OW $24.14 $12,351 $27.00 12%
13 BVMF3.SA BM&F Bovespa S/A Bolsa OW $12.55 $25,652 $17.00 35% 47 YUM Yum! Brands Inc. OW $50.26 $23,551 $56.00 11%
14 IPG Interpublic Group Of Cos. OW $11.11 $5,430 $15.00 35% 48 CBI Chicago Bridge & Iron Co. OW $32.52 $3,226 $36.00 11%
15 IVZ INVESCO Ltd. OW $23.23 $10,734 $30.50 31% 49 X United States Steel Corp. OW $53.61 $7,699 $59.00 10%
16 KFT Kraft Foods Inc. OW $30.75 $53,713 $40.00 30% 50 VLCCF Knightsbridge Tankers Ltd. OW $22.82 $543 $25.00 10%
17 ALL Allstate Corp. OW $30.94 $16,651 $40.00 29% 51 CNX Consol Energy Inc. OW $43.99 $9,935 $48.00 9%
18 NXY.TO Nexen Inc. OW $21.76 $11,425 $28.00 29% 52 MCD McDonald's Corp. OW $77.56 $81,943 $84.00 8%
19 STJ St. Jude Medical Inc. OW $40.85 $13,993 $52.00 27% 53 HOT Starwood Hotels & Resorts OW $61.23 $11,673 $66.00 8%
20 ESRX Express Scripts Inc. OW $54.76 $28,815 $69.00 26% 54 JBL Jabil Circuit Inc. OW $16.71 $3,640 $18.00 8%
21 RHI Robert Half International In OW $30.20 $4,444 $38.00 26% 55 HAR Harman International Indus OW $48.37 $3,365 $52.00 8%
22 C Citigroup Inc. OW $4.77 $138,567 $6.00 26% 56 QCOM QUALCOMM Inc. OW $49.48 $80,040 $53.00 7%
23 SWC Stillwater Mining Co. OW $20.07 $1,965 $25.00 25% 57 JWA John Wiley & Sons Inc. (Cl OW $45.79 $2,344 $49.00 7%
24 PEP PepsiCo Inc. OW $64.90 $102,856 $80.00 23% 58 CREE Cree Inc. OW $72.05 $7,815 $77.00 7%25 BBBB Blackboard Inc. OW $42.36 $1,457 $52.00 23% 59 IR Ingersoll-Rand Plc OW $44.41 $14,389 $47.00 6%
26 MRVL Marvell Technology Group OW $19.56 $12,723 $24.00 23% 60 EPD Enterprise Products Partne OW $40.70 $33,983 $42.00 3%
27 VIAB Viacom Inc. (Cl B) OW $39.54 $21,991 $48.50 23% 61 ETN Eaton Corp. OW $98.91 $16,647 $102.00 3%
28 BIN IESI-BFC Ltd. OW $22.91 $2,528 $28.00 22% 62 ENTR Entropic Communications I OW $11.75 $987 $12.00 2%
29 HAL Halliburton Co. OW $40.22 $36,581 $49.00 22% 63 WFMI Whole Foods Market Inc. OW $49.49 $8,559 $50.00 1%
30 MBFI MB Financial Inc. OW $16.43 $886 $20.00 22% 64 UDR UDR Inc. OW $22.86 $4,164 $23.00 1%
31 WLP WellPoint Inc. OW $57.68 $22,703 $70.00 21% 65 SLW Silver Wheaton Corp. OW $38.51 $13,338 $36.00 -7%
32 OMX OfficeMax Inc. OW $18.14 $1,542 $22.00 21% 66 LLTC Linear Technology Corp. OW $34.62 $7,804 $31.00 -10%
33 OC Owens Corning OW $28.75 $3,584 $34.50 20% 67 RAI Reynolds American Inc. OW $32.22 $18,786
34 GILD Gilead Sciences Inc. OW $37.61 $30,534 $45.00 20% Average 22% Source: J.P. Morgan and FactSet.
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Equity Technical Strategy
U.S. Equity 2011 Technical Outlook
S&P 500 targets 1300-1350 in 2011, which should complete this bull cyclefrom 666 in March 2009
Shorter term, buy pullbacks now to 1155-1175; we see an 1130 floor; favornew highs to the 1240-1248 dual Head and Shoulders targets by the end of
January, then some correction
In 2011, we expect the S&P 500 to see a 1300-1350 range high and a 1100-1130 range low
Our preferred trajectory suggests a rally to the range highs around mid-year, and then a correction toward the range lows in 2H
This scenario suggests that a five-wave advance from the 2010 low and aconservative three-wave advance from the 2009 bottom would both complete
around 1300-1350
Most favored S&P 500 sectors are: Consumer Discretionary, Energy,Industrials, Technology
S&P 500 Index Outlook
Our Equity forecast from the 2010 Outlookwas a lot better than our incorrect Bond
outlook. For the S&P 500 index, we had suggested that 2010 would see a trading
range year between 950 on the downside and 1150/1200 on the upside. Our best case
upside target was 1229-1240. In our2010 Outlooktrading theme section, we
suggested entering S&P 500 core longs toward the 950-1000 range low territory,
then exit core longs in the 1200-1240 upper ceiling area.
The S&P 500 did accommodate our views this year. The market did trade sideways
throughout 2010 and formed an actual range of1011 (July low) to 1220 (April high)/
1227 (November high). Effectively, our2010 Outlooktrading theme outlook
captured both ends of this years entire S&P 500 range. In addition, during the year
in ourUS Equity Technical Strategist, we turned bearish just before the April 26 top,
and then shifted bullish very close to the July 1 bottom. Into the November high, we
targeted a 1229-1248 peak, missing by 2 points at the 1227 actual high prior to the
recent 4.4% decline. The 1248 area marks the May-September Head and Shoulders
bottom breakout target above 1130 (see figure below).
Michael Krauss
(1-212) 834-5103
David Cohen, CFA
(1-212) 622-5338
J.P. Morgan Securities LLC
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Figure 9: S&P 500 Index 1240-1248 Dual Head and Shoulders Bottom ObjectivesS&P 500 IndexWeekly bars
Source: J.P. Morgan.
The 1229 and 1240 levels have indeed been important barriers throughout 2010, as
referenced in last years Outlook. The 1229 level marks a 61.8% retracement of the
major bear market from the 1576 October 2007 all-time high, down to the 666
March 2009 bottom. The 1240 level is the 2008-2009 Head and Shoulders bottom
rally target (see figure above). The April and November S&P 500 peaks stopped just
below these levels. However, the basing activity this year above 950-1000 and
Octobers important monthly momentum buy signal (see figure below) suggest that
this barrier will be exceeded on the third time up to this zone.
Figure 10: S&P 500 Index Technical Roadmap for 2011S&P 500 IndexMonthly bars
Source: J.P. Morgan.
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In 2011, we expect the S&P 500 to see a 1300-1350 range high and an 1100-1130
range low (see following figure). Our preferred trajectory suggests a bit more
pullback now, a rally to the range highs around mid-year, and then a correction
toward the range lows in 2H (see above figure). This scenario suggests that a five-
wave advance from the 2010 low and a conservative three-wave advance from the
2009 bottom would both complete around 1300-1350. The rally completion wouldthen produce a steep correction in 2H 2011 that either: (a) retests this years
1220/1227 highs; (b) deepens further toward 1130-1140, thereby equating with the
209 point April-July decline; or (3) tests 1100, retracing 38.2% of the entire 2009-
2011 bull market.
Figure 11: S&P 500 Index Targets 1300-1350 in 2011S&P 500 IndexWeekly bars
Source: J.P. Morgan.
We expect some more consolidation now. In the days/weeks ahead, the correction
unfolding from the 1227 November 5 high targets 1155-1175 and assumes an 1130
floor. Indeed the market has held twice at 1173 in the past week. We expect to see
buyers on this weakness. The 1155-1175 targets include a 38.2% retracement from
the 1040 August 27 low and mid-October congestion. The 1130 interim floor marks
the top end of the June-August range and August low 50% retracement (see above
figure). From these supports, we expect new highs early in 2011, in line with New
Year seasonality.
Amid our preferred risk-on environment as evidenced by monthly momentum
signals (bullish Equities and bearish Treasuries), we anticipate that the S&P 500 will
reach 1229 October 2007 61.8% retracement, and the 1240-1248 dual Head and
Shoulders bottom targets by the end of January 2011. We would book half of1155-1175 longs in that 1229-1248 zone.
In 1H2011, we see the S&P 500 peaking for the year around 1300-1350. This
confluence area includes: 1290/1307 Elliott fifth-wave targets from the July low,
1297 where the rally from the July low is equal to the March to June 2009 rally,
1313 August 2008 pre-Lehman bankruptcy high, 1327 May 2006 high,
1333 a double from the March 2009 low, and 1353 where the rally from the July
low is 0.618 as long as the entire March 2009 to April 2010 rally. Just above here,
1364-1373 saw three significant monthly lows in March 2007, August 2007, and
May 2008. While unexpected, 1430 would be the measured move above the April to
July range.
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If the 1100 area is violated to the downside, our worst-case scenario would retarget
this years 1011 low and the 950-1000 longer-term floor. Interestingly, if the
1350 area does mark a 2011 S&P 500 peak, then this years 1011 low would mark an
exact 50% retracement of the entire 666 to 1350 cyclical bull market! Finally,
repeating the last sentence of the 2010 Outlook, We do not expect the 666 cycle low
breaking, absent a global depression.
Trading Themes
S&P 500: Buy pullbacks toward 1155-1175. Risk closes below 1130. Take half
profits in the 1229-1248 zone in December/January. Exit core longs in the 1300-1350
target zone, and go short for a move to 1150-1200.
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Accounting & Valuation
Coming into Focus: Tax Legislation and New Accounting Standards in View
When hope is not an option: looking for compromise on tax legislation
On November 15, Congress began its lame duck session following the mid-term
elections that gave Republicans control of the House and narrowed the Democratic
majority in the Senate beginning in the 112th Congress. Congressional Democratic
leaders remain in control of both chambers through year-end 2010 and have set a
laundry list of tax priorities for resolution during the lame duck session. At the top of
the list is addressing the expiring 2001 and 2003 Bush-era tax cuts. Other priorities
include patching the individual alternative minimum tax (AMT) for 2010, dealing
with the estate tax before it reverts to pre-2001 levels in 2011, and extending
retroactively temporary tax incentives that expired at the beginning of 2010.
A framework for compromise emerges
On December 7, President Obama announced a framework for an agreement betweenthe White House and Congressional Republicans on a broad tax package. Reaction
from lawmakers that were not part of the negotiations will ultimately determine the
fate of the agreement between the President and Republican Congressional leaders.
Said differently, Democratic Congressional leaders will have to sign off on any
agreement before it can move forward in the House or the Senate.
It is worth noting that, on December 9, the House Democratic caucus rejected the
proposed framework in a symbolic vote. The caucus vote is non-binding; it is also
likely not a clear indicator of the direction (yay or nay) that House Democrats will
ultimately vote. However, the private vote is a signal that significant uncertainty
remains as to the specific details of the final legislationthat is, changes to the
compromise framework may be required to guarantee the necessary vote count for
passage.
In accordance with the proposed compromise, President Obama and Republican
Congressional leaders have tentatively agreed to:
Extend the Bush-era tax cuts for the next two years (i.e., FY 2011 and FY 2012)forall individual taxpayers.
Maintain the current maximum 15% tax rate on net capital gains and dividendsfor two years (i.e., FY 2011 and FY 2012).
Extend other income tax relief enacted in 2001 and 2003 including marriagepenalty relief, the 10% bracket, and the enhanced child credit.
Patch the alternative minimum tax (AMT) for FY 2011 and FY 2012.
Reinstate the estate tax for two years with a top rate of 35% and a maximumexemption amount of $5 million.
Include a 2% employee-side payroll tax cut for workers. Under the plan, theSocial Security payroll tax on individual wages would be lowered to 4.2% in
2011, from the current 6.2% rate. Social Security taxes apply only to the first
$106,800 in wages; the benefit for high earners tops out at approximately $2,100.
The employer share of Social Security taxes would not be affected.
Extend unemployment insurance benefits through the end of FY 2011.
Dane Mott, CFA, CPAAC
(1-415) 315-5905
Amy Schmidt
(1-415) 315-6705
J.P. Morgan Securities LLC
Bloomberg JPMA MOTT
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Tax incentives are also proposed for businesses. Among the business incentives
proposed in the compromise are:
The research and development (R&D) tax credit that expired onDecember 31, 2009 would be retroactively extended for an additional two years
(i.e., FY 2010 and FY 2011).
Businesses would be allowed to expense 100% of their capital expenditures (fortax purposes) in 2011. The write-off would be retroactive to September 2010
that is, it could be applied to capital expenditures made on or after
September 2010, when President Obama originally floated the proposals.
It is important to note that the proposed tax compromise does not include
spending cuts to offset the extension of lower tax rates and tax credits. Said
differently, none of the provisions will be paid for with offsets (or reductions) in
government spending. This means that the U.S. government will have to borrow
to pay for the plan.
The compromise would let companies keep more cash now; it is also meant to givecompanies that may be hesitant to invest an incentive to expand, which would in turn
act as a stimulus to the overall economy. Some think that businesses unnerved by the
faltering economic recovery but with investments already in the pipeline may decide
to accelerate some activities already planned for 2012 and after into 2011 to take
advantage of the proposed 100% depreciation tax break. If this behavior of
accelerating planned future activity into 2011 to take advantage of tax breaks does
play out, an implication is that it could essentially dampen longer-term economic
growth if the end result is simply to reallocate growth that would have otherwise
occurred in 2012 and beyond to 2011. If the end result is only to accelerate activity
that would have occurred with or without stimulus, then the primary benefit of such
legislation is a time-value-of-money benefit. This approach of accelerating future-
period demand into current periods to produce temporary effect has been seen before
with the homebuying tax credit, cash for clunkers, and tax rebates.
Cloudy with a chance of converged accounting standards
As the Financial Accounting Standards Board (FASB) and the International
Accounting Standards Board (IASB) round the corner that is 2011 and sprint towards
June 30, the likelihood that the boards will deliver a common set of high-quality
global accounting standards to investors remains uncertain. The boards have
narrowed their focus to four primary projects: financial instrument accounting,
revenue recognition, lease accounting, and insurance accounting.
In recent months, the FASB has slowed its work on the insurance accounting project.
As a result, it is our expectation that the IASB will move forward on its own to
finalize its proposed insurance accounting standard by June 30, 2011. Whether the
boards are able to deliver on their commitment to produce common accounting
standards on the remaining primary projects by the June 30, 2011 deadline is an open
question. Another open question is whether the final standards on those projects will
be received positively by market participants.
As the boards proceed in their redeliberations, we expect that market participants will
gain clarity in late 1Q 2011 about the final details of the new accounting standards.
The IASB is particularly motivated to land the four priority projects by the
June 30, 2011 deadline for two reasons. First, the IASB loses its founding chairman,
Sir David Tweedie, when he retires on June 30, 2011. Second, the U.S. Securities
and Exchange Commission (U.S. SEC) is scheduled to determine as early as mid-
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2011 whether and how International Financial Reporting Standards (IFRS) might be
incorporated into the U.S. financial reporting framework. Even if the U.S. SEC
chooses not to supplant U.S. Generally Accepted Accounting Principles
(U.S. GAAP) with IFRS, companies still face significant headwinds to implement
the new standards for the four primary projects. Below is summary information on
the four primary projects, including our take on whether a common FASB/IASBaccounting standard will be published for each project by June 30, 2011.
Financial instrument accounting. There are three parts to the financialinstrument accounting project: classification and measurement; impairment; and
hedge accounting. The FASB issued a comprehensive exposure draft in
May 2010 covering all three parts of the project; the IASB chose to deliberate
each part of the project separately. In particular, the IASB chose to fast track their
deliberations on classification and measurement, leapfrogging FASB in the
process and finalizing deliberations on classification and measurement in
October 2010.
We expect the FASB to move towards the conclusions reached by the IASB in
the area of classification and measurement (perhaps with some differencesremaining in the accounting for changes in own credit). Further, we expect that
the boards will attempt to reach a common answer on the impairment of financial
assets. We also expect that FASB will finalize its deliberations on parts one and
two of the financial instrument accounting project by June 30, 2011 and that the
conclusions reached will be substantially similar to the IASBs position on those
topics.
We are less certain as to whether the boards will be able to complete their
deliberations on the hedge accounting part of the project by June 30, 2011. While
the FASB released its proposals to improve hedge accounting in May 2010, the
IASB recently released its proposals on December 9, 2010. The IASB proposes to
reconsider fundamentally the accounting for hedges of both financial and non-
financial instruments in closed portfolios. FASB chose instead to proposeminimal improvements to the accounting for hedges of financial instruments
only. Given the overarching goal of publishing common standards to account for
financial instruments, the FASB has recently committed to exposing the IASBs
hedge accounting exposure draft in 1Q 2011. Feedback received on the hedge
accounting exposure draft will ultimately dictate whether the proposals are
carried forward for further consideration. However, given the fact that the IASBs
proposals represent a fundamental re-think of hedge accounting for both IFRS
and U.S. GAAP, it is unlikely that the boards will be able to complete
deliberations on hedge accounting in time to meet the June 30, 2011 deadline.
Instead, we expect that this part of the project will be completed closer to
year-end 2011.
It is worth noting that the boards are also deliberating jointly proposals todetermine when offsetting of financial assets and financial liabilities in the
balance sheet is appropriate. The balance sheet offsetting project is an outgrowth
of the boards work to reconsider the accounting for financial instruments.
Currently, U.S. GAAP allows for offset (i.e., netting) to a much greater extent
than what is permitted in accordance with IFRS. The issue is that, even if the
boards came to a common answer for recognition and measurement of financial
instruments, investors would not have comparable information because of
divergent presentation requirements in U.S. GAAP and IFRS. The boards are
expected to issue a joint exposure draft of their proposals for balance sheet
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offsetting in early 1Q 2011 and are expected to finalize their deliberations on
those proposals in time to meet the June 30, 2011 deadline.
Revenue recognition. In June 2010 the boards issued a joint exposure draftRevenue from Contracts with Customers. If finalized as written, the new revenue
recognition model would eliminate the industry-specific requirements currentlypresent in U.S. GAAP, replacing that body of accounting literature with a single
model to be used by all companies, irrespective of industry. The proposed
revenue recognition model is the most converged of the exposure drafts issued
on the four primary projects in 2010. Said differently, both the FASB and the
IASB reached common tentative decisions on all aspects of the proposed revenue
recognition model. The comment period on the joint exposure draft ended
October 22, 2010; redeliberations are expected to begin in December 2010. While
we expect it to be tight, we do think the boards will finalize their deliberations for
a new revenue recognition model in time to meet the June 30, 2011 deadline. We
expect that deliberations will focus on the scope of the proposed model, on the
measurement of revenue, and on the timing of its recognition in the income
statement.
Lease accounting. In August 2010 the boards issued another joint exposure draftLeases. In accordance with the proposed lease accounting model, the operating
lease concept would be eliminated from U.S. GAAP and IFRS, thereby bringing
substantially all leases onto the face of the balance sheet. While the FASB and
the IASB propose a right-of-use model for both lessee and lessor accounting, the
boards differ on a number of points in the model. We do not think the proposed
model is a converged solutionthat is, if each board were to finalize their
respective exposure drafts as written, the accounting result would differ
depending upon whether U.S. GAAP or IFRS is used as the basis for accounting.
The comment period on each boardsLeases exposure draft ends
December 15, 2010; we expect redeliberations to begin in earnest in
February 2011.
We think the boards have an outside chance at finalizing their proposals for a new
lease accounting model in time to meet the June 30, 2011 deadline if they decide
to delay their proposals on lessor accounting and, instead, focus their time in the
next six months on improving the proposed lessee accounting model. While we
do not expect the boards to reconsider their proposal to bring substantially all
operating leases onto the face of a lessees balance sheet, we do expect the boards
to spend most of their deliberations reconsidering the proposed measurement of a
lessees right-of-use asset and its associated lease liability. If the boards decide to
move forward with their discussion of the proposed lessor accounting model, we
expect deliberations to continue into 2012.
Insurance accounting. The boards have chosen to take different paths toreconsider the accounting for insurance contracts in IFRS and U.S. GAAP. In
July 2010 the IASB issued its own exposure draftInsurance Contracts; in
contrast, the FASB issued in September 2010 a discussion paperPreliminary
Views on Insurance Contracts. Many see the overhaul of insurance accounting
requirements to be a pressing need in IFRS; however, it remains to be seen
whether that same need exists in U.S. GAAP. It is worth noting that FASBs
Emerging Issues Task Force (EITF) published its consensus position to amend
the accounting for costs associated with acquiring or renewing insurance
contracts in U.S. GAAP (i.e., deferred acquisition costs) in October 2010. The
finalized amendments were approved by unanimous vote of the FASB in
September 2010. We consider the FASBs action on deferred acquisition costs
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(through the EITF) to be a signal that the board is in no hurry to overhaul
insurance accounting in U.S. GAAP.
Consequently, we think that the IASB will move forward on its own to finalize its
proposals to overhaul the accounting for insurance contracts in IFRS. While we
expect the FASB to participate (to some degree) in the IASBs redeliberations,we think that it is likely the FASB will take a wait-and-see approach regarding
further changes to the accounting for insurance contracts in U.S. GAAP. We
think that FASBs future deliberations on the accounting for insurance contracts
will ultimately be informed by the experience of non-U.S. companies that
implement the IASBs final insurance accounting standard.
Dane Mott is a member of the FASBs Investor Technical Advisory Committee and
several IASB advisory committees: the IFRS Advisory Council; the Analyst
Representative Group; and the Employee Benefit Working Group. Amy Schmidt is a
former Technical Manager at the IASB.
JPMorgan Chase & Co. and its affiliates do not provide tax advice or advice on tax
accounting matters. Accordingly, this material is not intended or written to be used,
and cannot be used or relied upon, by any recipient in connection with promotion,
marketing, or a recommendation for the purpose of avoiding U.S. tax-related
penalties. Each client should consult his/her personal tax and/or legal advisor to
learn about any potential tax or other implications that may result from acting on a
particular recommendation.
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Equity Derivatives
Global Volatility Outlook
Equity Volatility in 2010
In order to better understand market volatility in 2010, we point to some remarkably
similar volatility patterns of the past (see following two figures). Studying the
anatomy of market crises can also help anticipate future patterns of volatility. Spikes
in volatility similar to what we saw in 2008 and 2010 are likely to occur in 2011 as
well. The cause of many crises is a disconnect between asset prices and their
fundamental valuations. While the severity of each crisis is determined by the
magnitude of this disconnect, the behavior of equity investors and resulting volatility
patterns tend to be similar.
A primary cause of the 2008 crisis (figure below) was a housing and credit bubble in
the United States. The first serious showing of the severity of the crisis was the
collapse of Bear Stearns. Following the collapse, many market participants failed torecognize the magnitude of the problem or misconstrued a quick fix for a long-term
solution. The 2008 crisis fully escalated six months later, resulting in multiple
failures and a recession in the U.S. and Europe. During this most acute phase,
investors overreacted (i.e., projected a collapse of the global financial system and a
great depression), sending asset prices sharply lower. Large U.S. government
stimulus and Fed interventions helped set a floor for the collapse, while reduced asset
prices and the stimulus set the stage for the growth cycle in 2009. As the markets
rallied, propped up by the removal of systemic risk and a return to growth, volatility
plummeted. Several smaller aftershocks (e.g., Dubai, CIT bankruptcy) didnt notably
change the declining volatility pattern.
Figure 12: 2008 Market Crisis
10%
30%
50%
70%
90%
Jan 08 Apr 08 Jun 08 Sep 08 Nov 08 Feb 09 Apr 09 Jul 09 Sep 09 Dec 09
VIX
US Subprime
Bear Stearns
Collapse
Contained?US Financial
System?
Global Depression?
US ~$1T Stimulus
QE, Bailouts
Global GDP and
Earnings
Systemic Risk
Removed
CIT
Dubai
Source: J.P. Morgan Equity Derivatives Strategy.
Marko KolanovicAC
(1-212) 272-1438
Amyn Bharwani(1-212) 622-8030
Adam Rudd, CFA(1-212) 272-1215
J.P. Morgan Securities LLC
Bloomberg JPMA KOLANOVIC
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Figure 13: 2010 (Smaller) Market Crisis
10%
20%
30%
40%
50%
Dec 09 Jan 10 Mar 10 Apr 10 May 10 Jul 10 Aug 10 Oct 10
VIX
EU Finances
Greece
Greece Aid
Problem
Resolved?
Earnings, GDP
EU Govs
and Banks?
Global
Contagion?
EU/IMF $1T
Bailout Fund
Quantitative
Easing
US Earnings
(Q2, Q3)
Ireland
Source: J.P. Morgan Equity Derivatives Strategy.
Among the primary causes of the market crisis in 2010 (above figure) were the high
debt levels and budget deficits of several European sovereigns. In an almost identical
pattern to the 2008 crisis, Greeces issues were not fully acknowledged and only
superficially resolved in January. Following the initial spike, volatility declined,
propped up by strong growth in the U.S. and Asia. Following this brief phase of
problem denial, the sovereign credit problem resurfaced, causing multiple shocks in
volatility and the overreaction of market participants (i.e., projection of a collapse of
the euro and global contagion). The ensuing EU and ECB interventions ($1 trillion
bailout fund), further easing by the Fed (QE2), and strong U.S. corporate results setthe stage for a market recovery and decline in volatility. The most recent volatility
spike due to Irelands credit did not significantly impact S&P 500 volatility and
appears only as an aftershock of the 2010 crisis at this junction.
The 2008 global crisis was triggered by low-quality U.S. mortgages. In 2008, U.S.
GDP dropped faster and bottomed before Europes. Fortunately for the markets, the
quality of European sovereign debt was not in question at the peak of the 2008 crisis.
During the 2008 crisis, Emerging Asia never entered recession and maintained
positive growth through the crisis. The time lag between the U.S. subprime and
European sovereign crises, as well as positive growth in Emerging Asia, helped the
financial system avoid the perfect storm that could have made the crises all the more
severe. Currently, relatively strong growth in the U.S. and Asia is helping global
markets weather the European sovereign crisis. Less-than-perfect synchronization
between economic cycles, capital markets, and market regulations in different
regions in this way helps to protect the global economy from major disasters. For
instance, after recent crises in the U.S. and Europe, should risks start emerging in
Asia, the global economy may recover just enough to dampen its impact.
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2011 Volatility Outlook
In this section we discuss our base case volatility forecast for the S&P 500. We
base our forecast on J.P. Morgans 2011 projections for the overall economy,
equities,and credit and alsotake into account interest rate risk and ongoing
concerns in Europe. In addition to the S&P 500 volatility forecast, we will forecastthe volatility of major European and Asian indices. Finally, we outline the main risks
for our base case.
Volatility of the S&P 500 in 2011 will most likely be realized at the same or slightly
lower level compared to 2010. Our forecast is that the average realized volatility
of the S&P 500 in 2011 will be 18% with a most likely range of ~15-20% (please
see the end of this section for region-specific forecasts). While projected tightening
of credit spreads and the anticipated appreciation of equities point to a lower level of
volatility of ~15%, asset prices may have elevated volatility as a result of changes in
monetary stimulus and interest rate volatility. Over the course of the year, weexpect
periods of equity volatility below our target range and volatility spikes above our
target range. Volatility spikes are likely to occur due to the European sovereign crisis
and potential exit from QE and are less likely due to weak growth or inflation.
Economic DataBased Forecast
Evidence continues to build that the global economy is regaining momentum. Global
economies are expected to grow at a ~2.7% rate in Q3 and Q4. In 2011 the global
economy is expected to grow at a rate of 3.3%. This increase in growth rate should
benefit equity markets and put downward pressure on market volatility. The highest
growth is expected in the Asia ex-Japan region at ~7.6%. The U.S. is expected to
grow 3% in 2011 (growth is expected to be 2.6% in 2010), the Euro area 1.6%, and
Japan 1.45%. Based on the historical relationship between U.S. GDP and volatility,
market volatility has averaged ~15% in a 3% growth environment (the volatility
range was 10-20%). Given that we had 18% volatility with 2.6% growth in 2010, the
expected increase in GDP should be a positive and would point to an average
realized volatility at the end of 2011 of ~17%.
The current high unemployment rate is likely a structural problem. Unemployment
and a weak consumer segment will be a source of downside risk for equities, and
hence an upside risk for volatility. U.S. unemployment is expected to peak in
Q1 2011 and decline to 9.5% by the end of 2011. While the slight decline in
unemployment should benefit markets, these levels of unemployment were
historically associated with higher levels of volatility (~20%). A projected marginal
decline in unemployment would not have a meaningful effect. We think that the
unchanged unemployment outlook translates into unchanged end-of-2011 volatility
of ~18%.
Equity-Based ForecastThe J.P. Morgan outlook for global equities in 2011 is positive. Positive
developments in global economies are expected to lift equity indices from the current
levels by approximately ~15% in the U.S., ~15% in Europe, and ~25% in emerging
market economies. Our strategists see multiple reasons to remain constructive on
equities, ranging from U.S. post-election dynamics, quantitative easing, economic
momentum, and M&A activity. A significant part of any volatility forecast is related
to the directional view on equities. The historical regression of annual market returns
against the subsequent change in realized volatility suggests that a projected ~15%
increase in equities would lead to a ~2% drop in volatility. Given the current level of
realized volatility of 18%, this would point to an average realized volatility at the end
of 2011 of ~16%.
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Credit-Based Forecast
In our equity volatility forecast we also refer to J.P. Morgan Strategy outlooks for
HG and HY credit spreads. The CDX Investment Grade (IG) Index began 2010 at
~80bps and is now at ~95bps. The J.P. Morgan High Grade Credit Strategists
maintain an overweight recommendation for HG credit, with a 70bp 2011 year-end
target for the CDX IG Index. The strategists believe that spreads are likely tocontinue to tighten due to both the rise in sentiment and equity markets and the
reduction in available fixed income product supply. The midterm elections are also
positive for HG credit as the large banking, energy, and healthcare sectors, which
have been under significant regulatory scrutiny, could see some relief. In addition,
credit fundamentals such as record-high cash balances, profit margins, and free cash
flow support lower spreads. Based on the historical relationship between HG credit
and equity volatility, when the spread was 70bp, volatility averaged ~17%. However,
a drop of 27bps in HG spread suggests a significant drop in equity volatility (~5%).
Given the current level of 6M realized volatility of 18%, we assess that both level
and projected changes of high grade spreads point to S&P 500 realized volatility at
the end of 2011 of ~15%.
We repeated a similar analysis for HY credit spreads based on J.P. Morgan HY credit
2011 forecasts. The 2011 target for CDX HY index is 390bps, which is 140bps
below the current level. Based on the historical relationship of volatility to HY
spreads, the projected level of 390bps would point to a ~15% realized volatility level.
A 140bps tightening from current spread levels would suggest a drop in equity
volatility of ~5% from current levels. We think that such a decline of equity volatility
is not realistic and perhaps reflects a dislocation between the current levels of equity
volatility and HY spreads.
Interest RateBased Forecast
Interest rate volatility is highly correlated with equity volatility.1 Currently, the
volatility of the 10-year rate appears higher than equity volatility (based on the
regression of the past 30 years). The historical relationship between the two wouldimply S&P 500 volatility of ~20% (versus the current level of 18%). This
discrepancy wasnt of much concern for us over the past year as there was no
inflationary pressure and quantitative easing kept rates low. However, we think that
potential interest rate volatility could put some upward pressure on equity volatility
in 2011. There are essentially two scenarios in which interest rate changes can
negatively affect equities and thus cause higher volatility. The main risk is the Fed
removing monetary stimulus from the system, which would cause intermediate rates
to rise. During this Fed exit scenario, equity volatility would be elevated due to the
potential reduction of risky asset holdings (e.g., unwind of carry trades) and
increased borrow cost for companies and consumers. As the Fed exit is more likely
to happen in a growth scenario, we think that it would not cause a very large increase
of equity volatility. The other interest raterelated risk is inflation, which could cause
an increase of longer rates and introduce uncertainty for companies and increaseequity volatility.
1For instance, levels of volatility of the 10-year Treasury rate and S&P 500 volatility had a
70% correlation over the past 30 years. Returns of volatility had a 25% correlation to returnsof the 10-year rate.
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Non-U.S. Risks
Forecasting S&P 500 volatility based solely on U.S. economic, equity, and fixed
income projections is incomplete as it overlooks possible volatility shocks outside
the United States. In particular, we believe that an ongoing European sovereign debt
crisis will continue to add to S&P 500 volatility (e.g., Spain, Portugal). The transfer
of volatility from Europe to the United States is realized via the strong correlation ofglobal equity indices and via perceived risk of a spillover. While we believe that the
crisis will stay contained to the periphery of the region, and eventually be resolved
by EU policy makers, we estimate its impact to add ~100bps of volatility to the
S&P 500 in 2011. We also recognize potential risk from inflation and asset volatility
in China, though we perceive this as a smaller risk. Gradual monetary policy
tightening in 2011 would not significantly impact the growth in emerging Asia, in
our view.
Our S&P 500 volatility targeta weighted average of individual forecastsfor 2011
realized volatility is 18%, with a most likely volatility range of 15-20%. The table
below shows each of the factors influencing our forecast. While asset prices propped
up by quantitative easing point to the low end of our forecast range, risks related toglobal monetary and fiscal policy developments point to the upper end of our range.
Table 4: Forecast of S&P 500 Volatility
Asset 2010 2011 S&P Volatility
HG Credit 97 70 15%
HY Credit 530 390 15%
S&P 500 1180 1375 16%
GDP 2.6% 3.0% 17%
Unemployment 9.6% 9.5% 18%
Interest Rates -- +1% 19%
Non-US Risks +1% +1% +1%
S&P Volatility 18%
Source: J.P. Morgan Equity Derivatives Strategy.
Risks to Our Base Case
The risks to our base case forecast are skewed to the upside, in our view. These risks
are related to economic growth and associated changes in interest rates.
Should the economy start growing steadily, a removal of monetary stimulus and
related interest rate volatility could lead to medium-sized but short-lived volatility
spikes. The risk is that policy changes cause multiple interest rate and asset price
shocks and 2011 S&P 500 volatility ends in a 20-25% range.
Should growth start weakening and the central banks policies fail to reverse the
trend, we may see a period oflow growth and higher inflationstagflation.
Stagflation would negatively affect equities and would cause a significant increase ofequity volatility. Depending on the severity of the condition, S&P 500 volatility
would likely end up in a 20-30% range.
The most extreme and the least likely risk is a full-blown double-dip recession. The
ensuing unemployment, falling housing prices and consumption levels, and
disappointing corporate earnings would likely send S&P 500 realized volatility to a
30-40% range.
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Outside the United States, we see the European sovereign debt crisis as a main
source of upside volatility risk. Concerns about the solvency of peripheral European
sovereigns appeared to be most acute before the bailout of Greece. However, the
recent arrangement for Ireland has drawn attention back to the solvency and liquidity
of European sovereigns. The markets focus is now set to move to Portugal and
Spain. We accounted for some of this risk by increasing our largely U.S.-drivenvolatility forecast. However, our assumption was that this crisis will stay contained
within Europe and perhaps within its periphery. Should the crisis spill over, it could
potentially trigger a global crisis sending S&P 500 volatility above our target range.
Although hard to predict, escalations ofgeopolitical riskcan put further upward
pressure on volatility. A breakdown in global policy coordination, trade restrictions
(e.g., terms of trade between U.S. and China), and currency crises (currency
manipulations, dollar crisis) can all increase equity volatility. On a more extreme
end, there is a risk of conflicts between the two Koreas as well as a Middle East crisis
involving Iran and Gulf oil shipments.
Volatility Targets by RegionGlobal equity derivatives markets largely revolve around the ~$5 trillion listed index
option market.2 About 90% of index option markets consist of options on only the six
most active indices: S&P 500, Euro STOXX 50, DAX, FTSE 100, Nikkei 225, and
KOSPI 200. The S&P 500 listed option market represents ~40%, the European
Indices are ~50%, and Asian indices are about 10% of the global index volatility
market (see following table). Before we proceed to formulate our 2011 volatility
view for these indices, it is perhaps instructive to put the current volatility levels in a
historical context. Current levels of implied volatility of western indices (U.S. and
Europe) are elevated (in ~70th percentile relative to 10-year history). Over the past
quarter, short-term realized volatility dropped from high (~70th percentile) to below-
average levels (~40th percentile), which caused volatility carry to widen to 10-year
highs (~100th percentile). This high level of volatility premium will be the basis for
some of our short volatility recommendations for 2011. The volatility of equity
indices in Asia is lower. For instance, the KOSPI 200 realized volatility is at its
lowest point in ten years and slightly lower than the volatility of the S&P 500. While
this may be viewed as a historical dislocation, it can also be viewed as a convergence
of volatilities due to the increased globalization of risk. The figure on the following
page shows the level of implied volatility for these six indices over the past ten years.
We note how the difference between the most volatile and the least volatile index
dropped from 15 volatility points to only 5 volatility points over the past decade.
Table 5: Global Listed Index Option Market
SPX 1,946 SX5E 1,776 NKY 242RUY 114 DAX 397 KOSPI2 233
NDX 105 UKX 304 HSI 56
MNX 16 SMI 50 HSCEI 23
OEX 9 CAC 37 AS51 23
Notional OI of Listed Options in $Bn
US EMEA Asia
Source: J.P. Morgan Equity Derivatives Strategy.
2This does not include delta one derivatives, single-stock derivatives, or structured products.
For a more comprehensive overview of the listed equity derivatives market see our GlobalLiquidity Markets Volumes report.
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Figure 14: Implied Volatility of Global Indices over the Past Ten Years
5%
15%
25%
35%
45%
55%
65%
Nov 00 Dec 01 Jan 03 Feb 04 Mar 05 Apr 06 May 07 Jun 08 Jul 09 Aug 10
S&P 500 EuroStoxx
DAX FTSE
Nikkei KOSPI2Implied Volatility
Volatility SPX SX5E DAX UKX NKY KOSPI2
Implied 6M 22.7% 27.5% 24.1% 23.4% 22.6% 21.0%
%-tile Rank 67% 78% 62% 75% 47% 30%
Realized 3M 14% 18% 15% 14% 18% 13%%-tile Rank 42% 39% 24% 44% 26% 4%
Carry 6M-3M 8.7% 9.9% 9.4% 9.2% 4.5% 7.9%
%-tile Rank 99% 100% 100% 100% 87% 99%
Source: J.P. Morgan Equity Derivatives Strategy.
Volatility Targets by Region
Our base case volatility forecast was formulated in terms of realized S&P 500
volatility. Regional equity benchmarks can have higher or lower volatility compared
to the S&P 500. The volatility of a regional equity index typically depends on the
index composition, Emerging/Developed market designation, and region-specific
fundamentals.
Europe: We expect that the Euro STOXX 50 average realized volatility in 2011 will
be in an 18-24% range, with a most likely level of 21.5%. Our base case forecast putsrealized volatility for the Euro STOXX 50 3.5 points above our forecast for the
S&P 500, a spread slightly higher than the long-term average of 2 volatility points.
Our forecast for FTSE 100 average realized volatility is identical to our forecast for
the S&P 500, with a 15-20% range and most likely level of 18%.
Asia ex-Japan: We expect the volatility in the region to remain similar to or slightly
higher than the current leve