Eye on the Market I NOvember 1.2011 J.P.Morgan Topic: US economic/profits watch; the latest idea to save Europe (repo markets); Brazil; the Gospel according to Paul Equity markets have just been through something that has only occurred a handful of times over the last 80 years: a 15% selloff and recovery in the span of 3 months'. As we noted a few weeks ago, technical factors'- indicated that there was extreme pessimism regarding US and Chinese growth, and the European debt crisis. All it took were modest improvements in the US and China economic outlook and ambiguous plans out of Europe to drive markets higher. Where do we go from here? Sideways, most likely, with more volatility to come. The first chart below is a proxy for the environment we think we are in. In the wake of the 1970's recession, US and German equity markets collapsed, then rallied back sharply by the end of 1976. Afterwards, during a period of extreme monetary and fiscal policy uncertainty, markets went sideways for years until the smoke cleared, setting the stage for the next bull market. Lessons learned during the prior period: don't sell when valuations are very low and pessimism is extremely high; look for opportunities to add yield through high-dividend stocks, and credit; be prepared to shift to a more aggressive portfolio only when macroeconomics fade in importance relative to the profit cycle. On the latter point, we think we are not there yet; 2012 looks like another year in which macro will trump micro, as it has for the last 3 years. 19709 post-recovery equity market wilderness S&P level (Blue) Germany - DAX level (Brown) 180 r I 800 I Period of extreme monetary I I and fiscal uncertainty 160 140 120 100 80 60 40 20 1972 1974 Source: Bloomberg. US • • • • • 1976 1978 1980 1982 Consumers spend by drawing down savings (again) QoQ change, real, annualized, sa 12% - 10% - 700 8% - 6% - 600 4% - 2% Consumption Disposable income 1993 1996