JP Morgan - US Equity Strategy FLASH

Hang on . . . . fundamentals still improving. 3Q top-line beat not just FX. Payrolls is next catalyst

Since mid-October, equities have weakened substantially, falling 7 of the last 11 trading sessions and down 6% from an intraday high of 1100 (which has acted as an invisible ceiling for now). It seems the quality and durability of this Economic recovery (many still doubt if this is sustained) are questioned, given the role stimulus/programs and a weak dollar played in 3Q GDP and EPS growth. The drama, however, is largely taking place in the equity markets, as credit markets, while weaker, have retained most of their gains, and the JPM Global HY Index still trades at 96.4, closing in on par.

• Skeptics have dismissed 3Q top-line beats as primarily due to a weaker dollar.
This is a false argument. 200 of the companies in the S&P 500 have essentially
ZERO international sales. Of these companies, 66% beat Street top-line estimates
(Figure 3), an improvement over the 51% in 2Q09 and 38% in 1Q09 and above
the 63% figure overall. The point here is that dollar-related issues were not at
work - the beats are driven by volumes. Unless one wants to argue that these
companies have “pricing power” and managed to raise prices.

• With 3Q largely behind us, it is natural to wonder what positive catalysts emerge
by year-end. Pertinent even for those investors maintaining an intermediate
investment timeframe, given the increased volatility (VIX surged last week),
particularly as many Cyclicals have fallen 15% or more from their recent highs.

• A progressive, material but uneven recovery in the US labor markets over the next
few months, in our view, is likely to be the most significant positive catalyst. A
recovery in labor markets sustains a recovery in US consumer income, hence,
balance sheets and spending - hence, a convincing signpost for the U.S. recovery.

• THE S&P 500 HAS TYPICALLY RISEN 12% IN THE 4 MONTHS PRIOR
TO PAYROLLS TURNING POSITIVE. As we noted last week, the surge in
GDP per worker to an all-time high of $120k, and up 2.8% yoy, is a strong signal
that payrolls are likely to turn positive by early 2010, and as early as January (see
“US Equity Strategy FLASH: Surge in GDP per worker suggest positive payrolls
by early 2010” dated 10/29/09). The period leading to a positive turn in payrolls is
extraordinarily strong for the S&P 500. Since 1949, the S&P 500 has gained 12%
in the 4 months leading to positive payrolls (see Figure 6), with a gain of 17%-
25% seen in the 1975/1980 years, when unemployment surged similar to today.
The best-performing Sectors are Technology, Consumer Discretionary, and
Basic Materials, all with additional gains of 1250bp (above S&P 500).

• SOME REASONS FOR GROWING OPTIMISM ON LABOR MARKETS.
This Friday, we will see the October jobs report, and Bruce Kasman, J.P. Morgan
Chief Economist, sees a 140k loss, better than consensus of 175k and improving
over the 263k last month. Beyond the GDP/worker analysis cited above, we have
other reasons for expecting “upside” in jobs data in the next few months: (i) ISM
Manufacturing Employment Index reached 53, with positive jobs in the past
occurring within a month (Figure 11); (ii) Workers unemployed 5-14 weeks
peaked in May and typically sees positive payrolls within 4-7 months (Figure 13);
(iii) Consumer Confidence “Jobs Plentiful” is likely nearing a trough as it was
recently 3.4%, and positive payrolls follow within a month of a trough (Figure 15).

Bottom line: We remain constructive on equities and see at least 1100 by YE. We
favor Cyclicals over Defensives; Small-cap over Large; Higher-Debt balance
sheets; and also like Energy.