INVESTMENT STRATEGY and RESEARCH

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INVESTMENT STRATEGY

US Strategy Weekly
The Bears Are No Longer Hibernating

August 19, 2011

US Strategy Recommended S&P 500 Sector Weightings

Sector Consumer Discretionary Consumer Staples Energy Financials Health Care Industrials Information Technology Materials Telecom Services Utilities Opinion MW MW MW MW MW OW OW MW UW UW %Weight 10% 10.5% 13% 14% 11.5% 12% 20% 3.5% 2.5% 3%

Time to return to your cave bears, enough growling already

US fundamentals have not collapsed, faith in them has. As we point out again this week, corporate America has done its job in terms of sustainability, stability and credibility. That said, we firmly believe the indiscriminate re-pricing of equities the past few weeks is overdone and thus providing an attractive and disciplined opportunity to re-engage. As such, we believe it is time for the bears to nap and investors to wake up.

The market is already priced for a recession

The average forward multiple in each recession since 1960 is roughly 17x compared to about 11x based on current estimates. True, current estimates may be a bit optimistic (making current forward multiples higher than they really are), but we do not envision a scenario where earnings growth collapses. In fact, earnings typically fall by about 20% peak-to-trough during a recession.

Source: OAM Investment Strategy Group Key: Opinion: Investment Strategy Sector Opinion. UW: Underweight MW: Market Weight OW: Overweight

Equity risk premiums approaching peaks

There have been only two other periods since 1960 where the equity market risk premium (ERP) was at such an abnormally high levelthe mid-1970s and early 1980s (i.e. the Great Inflation). This is particularly compelling, in our view, since inflation-adjusted yields for most have become negative in recent months. In other words, investors are flocking to bonds for safety and as a recession hedge are paying instead of receiving to do so.

Major Market Index Performance Year to Date

SPX INDU COMP RUT SVX SGX 0 -5 -10 -15 -20 -10.7 -11.7 -5.1 -8.3

Dividend yields have eclipsed Treasury yields

For only the second time since the 1960s, S&P 500 yields have eclipsed the yield on the 10-year Treasury note. Thus, stocks have become increasingly attractive from a yield perspective relative to bonds, particularly those with a consistent history of increasing dividend payouts.

-15.5

-13.2

Earnings growth is unlikely to collapse

Earnings are up almost 130% since the market lows in March 2009 while the S&P 500 is up roughly 70%. Yet, an increasing number of investors are expecting an earnings collapse given all the global economic uncertainty. Although earnings growth is likely to wane given the challenging environment, the data we track simply does not suggest an apocalyptic earnings collapse is on the horizon.

Source: OAM Investment Strategy Group Prices as of 8/19/11

Brian G. Belski Chief Investment Strategist (212) 667-5961

brian.belski@opco.com

Multiples suggest the market should rebound

S&P 500 forward price multiples appear attractive from a historical perspective. In fact, the current multiple of roughly 11x represents the lowest level since 1988. According to our analysis, market performance has been relatively strong in past periods following similar forward P/E levels. Akin to last week, we are releasing this edition of the US Strategy Weekly early given market volatility. As such, the next report will be published on its regularly scheduled date, Monday August, 29, 2011.

Nicholas Roccanova, CFA Senior Investment Strategist (212) 667-5960

nicholas.roccanova@opco.com

Mira Borisova, CFA Investment Strategist

(212) 667-6364 mira.borisova@opco.com

Oppenheimer Asset Management Inc. 200 Park Avenue New York, NY 10166 Tel: 800-221-5588 Fax: 212-667-4959

INVESTMENT STRATEGY

The Bears are No Longer Hibernating

But is the pessimism warranted? We say, no
The markets sell-off over the past several weeks has reinvigorated the most bearish investors, who for all intents and purposes, were largely rebuffed for much of the past two years as the S&P 500 doubled from its March 2009 low. Now, with US and global economic growth prospects coming into serious question, the growls from this crowd seem to be louder than ever. Based on our client conversations, most polled present similar arguments: (1) the US economy will undoubtedly double dip within the next few quarters; (2) slow economic growth warrants an even lower price multiple than is currently attached to the market; and (3) current earnings estimates are unrealistic given the economic environment so forward multiples are actually much higher. Admittedly, recession risk has clearly risen given ongoing sovereign debt/fiscal issues and the fact that consumer and small business confidence remains somewhat low while unemployment remains stubbornly high. However, while the economy is likely to face some near-term challenges, we continue to believe that the US will avoid recession in the coming quarters. In fact, unlike the market downturn that occurred last year around this time (when investors first began talking about a potential double dip recession) there are some important trends that investors need to consider: Growth in money supply has accelerated sharply and is much higher than a year agothere has never been a recession following a period of this sort of money supply growth. Job growth, although still weak, remains positive while trends in private payrolls have begun to accelerate lately. In addition, jobless claims have begun to fall againalmost every recession is preceded by a period of job loss and an increasing amount of jobless claims. Supply chain disruptions that resulted from the earthquake in Japan earlier this year have eased and recent industrial production data appear to support this notion as August represented the highest level of monthly growth in 2011. Thus the incremental benefit from production being brought back on is being underappreciated. Bank lending has expanded recently, particularly for commercial and industrial loans while lending standards continue to ease. The market does not always get it rightno recession resulted from the bear markets of 1966, 1976-78, 1987 and 1998.

For these reasons, we believe that it is unlikely that a recession is imminent. On the other hand, 2H11 US growth is unlikely to be strong, but we do not believe it will be as weak as the markets are currently predicting, and as such, we would expect the market to rebound sharply sometime between now and year-end. In the remainder of this report, we discuss why we believe that investor concerns regarding valuations and earnings growth may be overstated.

The market is already priced for a recession

From our perspective, even if the economy is headed for a recession (we do not believe that) current market multiples do not appear overvalued based on our analysis. As Table 1 on the next page illustrates, the average forward multiple (based on realized earnings) in each recession since 1960 is roughly 17x compared to about 11x based on current estimates. True, current estimates may be a bit optimistic (making current forward multiples higher than they really are), but we do not envision a scenario where earnings growth collapses (more on this on page 5). In fact, earnings typically fall by about 20% peak-to-trough during a recession. So if you adjust the current earnings run rate by this amount, it would

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suggest trough S&P 500 earnings of roughly $80, or a 14.2x multiple based on current pricesa level that is still below the average multiple for a typical recession. Nonetheless, our bearish clients continue to remind us that multiples traded in the single-digit range during 1975-82 is where they expect multiples to be headed. Although we can appreciate the comparison, we simply do not agree that multiples will get that low since that period was characterized by a set of factors that do not exist in the current environment. For instance: Inflation and interest rates were extremely high Inventory and depreciation accounting methods overstated earnings due to higher inflation Capital gains taxes were significantly higher Productivity was extremely lower

It is the first bullet point that we believe is the most crucial since investors continue to underestimate the impact of inflation and interest rates on stock valuationsit just makes sense that when inflation and interest rates are low, stock valuations should be higher. Our own analysis confirms this. We ran a regression of the P/E for the S&P 500 against the 10-year Treasury yield and the year-over-year change in CPI since 1960. These two variables predict P/E levels reasonably well, judging by the R-squared of 0.58. More important, as Chart 1 illustrates, the actual P/E level is well below the predicted level, an indication that P/E is undervalued given the inflation and interest rate backdrop. Furthermore, our analysis implies that inflation and/or interest rates would have to surge from current levels in order to get S&P 500 P/E multiples anywhere close to singledigit territory, which is inconsistent with current economic forecaststhe consensus expects CPI and the 10-year Treasury yield to end 2012 at 2% and 3.5%, respectively. Table 1: P/E and Earnings Analysis During Recessions
Recession 1960-61 1969-70 1973-75 1980-82 1990-91 2001 2007-2009 Average Average Forward Multiple 18.4 15.8 10.1 8.7 17.0 28.5 23.4 17.4 Low Multiple 17.5 13.9 8.1 6.9 14.9 24.1 13.0 14.0 Peak to Trough % Chg. In EPS -6.7% -12.9% -16.0% -19.1% -17.8% -17.3% -56.6% -20.9%

Source: OAM Investment Strategy Group.

Chart 1: Multiples Appear Undervalued Given Low Interest Rates and Inflation
35 30 25 20 15 10 5 0 1960
PE = 24.1 - 0.6 * 10YR - 0.9 * CPI R2: 0.58

1965

1970

1975

1980

1985

1990 Fitted

1995

2000

2005

2010

Actual
Source: OAM Investment Strategy Group.

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The equity risk premium is at an all time high Another reason we remain comfortable with our relatively bullish market stance for US stocks is the fact that the reward for taking equity risk is approaching an all-time high. In fact, as Chart 2 illustrates, there have been only two other periods since 1960 where the equity market risk premium (ERP) was at such an abnormally high levelthe mid-1970s and early 1980s (i.e. the Great Inflation). This is particularly compelling, in our view, since inflation-adjusted yields for most have become negative in recent months. In other words, investors are flocking to bonds for safety and as a recession hedge are paying instead of receiving to do so. In addition, EPR spikes such as this are typically short lived and once they do peak stock market returns have proven to be quite strong in the period that followed. For instance, the average annual return of the S&P 500 was 30.4% during the ERP peak-to-trough period from 9/74-7/76 and 12.9% for the 6/803/85 ERP peak-to-trough period. Chart 2: The Equity Market Risk Premium is Quite High from a Historical Perspective
20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% -2%
1960 1965 1970 1975 1980

Light blue line represents +1 standard dev iation from the av erage

1985

1990

1995

2000

2005

2010

Source: OAM Investment Strategy Group, FactSet Estimates. Note: The equity risk premium is calculated by taking the forward earnings yield based on realized earnings (where available, estimates otherwise) less the yield on the constant maturity 10-year adjusted for the year-over-year change in the CPI index.

and dividend yields have eclipsed Treasury yields Low bond yields are likely to persist given the slowing global economic environment. In fact, we believe investors will eventually begin to seek out alternative avenues to find yield. For months we have advocated that investors focus on high quality dividend yield and growth strategies. That task has become a bit easier in recent weeks as the dividend of the S&P 500 Index has eclipsed the yield on the 10-year Treasury note for only the second time since 1960. Thus, we believe stocks have become increasingly attractive from a yield perspective relative to bonds, particularly those with a consistent history of increasing dividend payouts. Chart 3: S&P 500 Dividend Yields Exceed 10-Year Treasury Yields

S&P 500 Dividend Yield Less 10-Year Treasury Yield

2

0 -2 -4
-6

-8 -10
-12

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

Source: OAM Investment Strategy Group.

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A 2008-Style Earnings Collapse is Unlikely: 2008 represented the largest earnings loss in the history of the S&P 500 since WWII. Given the current challenging global economic outlook, many investors are fearful that corporate earnings could repeat 2008style losses. We believe that these worries are unfounded. Remember: Financials were largely responsible for the losses as many companies had to take massive mortgage-related write-downs. Although credit conditions remained strained, we believe future write-downs are likely to be limited. Earnings losses outside of Financials were not as severeexcluding Financials, 2008 earnings losses were about 7% compared to a 41% loss for the overall index. Financials are no longer as important to overall index earnings as they were pre-2008. For instance, 18% of 2007 earnings were related to Financials. For 2011, analysts expect Financials to make up roughly 12% of overall earnings.

while earnings growth is unlikely to collapse

Without question, corporate earnings have been a source of strength for much of the past two years and despite the weakness in the economy, companies have continued to deliver impressive results. In fact, earnings are up almost 130% since the market lows in March 2009 while the S&P 500 is up roughly 70%. In other words, stocks appear more attractive now than they were at their worst during the credit crisis. Yet, an increasing number of investors are expecting some sort of earnings collapse in the coming months given all the global economic uncertainty. Although earnings growth is likely to wane given the challenging economic environment, the data we track simply does not suggest that some imminent earnings collapse is on the horizon. For instance (see charts 3-5), we found that: Earnings growth volatility typically begins to rise sharply several quarters before growth becomes negative, yet it has fallen substantially over the past year and has recently stabilized well below its historical average. Like earnings growth volatility, earnings surprise typically turns negative before earnings growth. However, companies have posted upside earnings surprise based on the mean estimate at the start of the quarter in each of the past nine quarters (i.e. the beats are not due to analysts lowering their estimates throughout the quarter). Corporate guidance is not indicative of widespread corporate worry. Roughly 30% of all profit outlooks issued over the past 12 weeks have been negative. This compares to the historical average of 40% and about 60% at the height of the financial crisis in 2008.

Therefore, we think the potential Financials shock simply does not exist in todays environment and given that non-financials weathered the 2008 storm relatively well, we would expect them to fare even better this time given the strength of balance sheets.

Thus, we think it is perfectly reasonable for 2011 S&P 500 earnings to achieve our current below consensus target of $94. Interestingly, our target lines up almost perfectly with the normalized S&P 500 EPS growth trend since 1960 (Chart 7) and puts the current market multiple at an attractive 12x. Chart 5: Companies Continue to Beat Expectations

Chart 4: Earnings Growth Has Been Stable

25% 20%
15%

S&P 500 EPS Volatility standard deviation of Q/Q growth for past four quarters

10%
5%

0% 2/91 2/93 2/95 2/97 2/99 2/01 2/03 2/05 2/07 2/09 2/11
Source: OAM Investment Strategy Group.

60% 40% 20% 0% -20% -40% -60% -80%

S&P 500 Earnings Surprise compared to the mean estimate at the start of the quarter

8/06

2/07

8/07

2/08

8/08

2/09

8/09

2/10

8/10

2/11

Source: OAM Investment Strategy Group, FactSet Estimates.

Chart 6: Corporate Management Has Not Hit the Panic Button

Chart 7: Normalized Earnings Appear Achievable

80% 60% 40%

20%

Negative Profit Outlook Announcements % of total over the prior 12 weeks

$100 $80 $60 $40 $20 $0 4Q60

S&P 500 Trailing 4 Quarter EPS (actual vs. log normal trend)
Mean Consensus 2011 EPS Estimate: $98 Normalized 2011 EPS: $93

0% 3/00 3/01 3/02 3/03 3/04 3/05 3/06 3/07 3/08 3/09 3/10 3/11
Source: OAM Investment Strategy Group, Bloomberg.

4Q72

4Q84

4Q96

4Q08

Source: OAM Investment Strategy Group, FactSet Estimates.

INVESTMENT STRATEGY

so current multiples suggest the market should rebound

As Chart 8 illustrates, S&P 500 forward price multiples appear attractive from a historical perspective. In fact, the current multiple of roughly 11x represents the lowest level for the index since 1988. According to our analysis, market performance has been relatively strong in past periods following similar forward P/E levels. The S&P 500, for instance, averaged a roughly 12% 12-month return in all periods since 1960 when the forward P/E was between 10x and 15x. Interestingly, lower forward price multiples have actually produced inferior results (Table 2). In fact, we found that todays 10-15x forward price multiple range represents the sweet spot for future market potential. Table 2: P/Es Are in an Historical Sweet Spot: S&P Performance Comparison in Various Price Multiple Scenarios
NTM P/E Level Less than 10x Between 10x and 15x Between 15x and 20x Greater than 20x Average Rolling Holding Period Returns Since 1960 6 Months 1 Year 2 Years 5.5% 10.8% 9.9% 6.4% 12.3% 11.3% 4.0% 8.0% 6.1% -3.9% -5.3% -2.2%

Source: Oppenheimer Asset Management Investment Strategy.

Chart 8: S&P 500 Forward Price Multiples Are Historically Low

S&P 500 Forward P/E

40
35 30 25 20

15 10 5 0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Source: Oppenheimer Asset Management Investment Strategy, FactSet Estimates. Historical multiple is calculated using actual EPS is used where available; FactSet bottom up estimates used for 2011--2012 EPS. Light blue lines indicate upper and lower one standard deviation levels.

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Performance Statistics
Recent US Strategy Topics
Date 8/8/2011 8/1/2011 7/25/2011 7/18/2011 7/11/2011 6/27/2011 6/20/2011 6/13/2011 6/6/2011 5/23/2011 5/16/2011 5/9/2011 5/2/2011 4/25/2011 4/18/2011 4/11/2011 4/04/2011 3/28/2011 3/21/2011 3/14/2011 3/7/2011 2/28/2011 2/22/2011 2/14/2011 2/7/2011 1/31/2011 1/24/2011 1/18/2011 1/10/2011 12/20/2010 12/13/2010 11/29/2010 11/15/2010 11/8/2010 11/1/2010 10/25/2010 10/18/2010 10/11/2010 10/4/2010 9/27/2010 9/20/2010 9/7/2010 8/23/2010 8/16/2010 8/9/2010 8/2/2010 7/26/2010 7/19/2010 7/12/2010 6/28/2010 7/25/2011 12/6/2010 5/27/2010 5/24/2010 8/8/2011 US Strategy Weekly All Eyes Are Back On The Economy Industrials Are Down But Not Out Sector Snapshot Should Investors Wait and See? Time to Put Cash to Work Complacency is Prohibiting a Market Rebound Is the Economy Going Stag? Tick by Tick Macro Analysis is Too Narrow Get Ready for a Bumpy Summer Industrials Bestow Quality and Defense The Beta Trade Appears Long in the Tooth Transitional Market Taking Shape From Here On Out, It is All About Job Growth Active Strategies for Quants Theme Refresher Technology Struggles Continue Why Thematic Investing is Important Housing, Financials and the Market Our Thoughts on Japan Happy Birthday Bull Market Current Pricing Trends in the US Impact of Middle East Upheaval on Markets The Pursuit of Beta is on Are Interest Rates Really a Concern? Canary in the Coal Mine? Industry Focus: Life Insurance Downgrading Discretionary to Market Weight Industry Focus: Defense Seek, Not Chase 2010 Hot Topic Recap Optimism Galore Dividends Are Always a Worthwhile Strategy Finding Value Within Value Repositioning Industrials Upgrading Energy to Market Weight Midterm Elections and the Market Stockpickers Capitalize on Recent Strength Stocks Are Still a Viable Investment Discussing the Impact of Additional QE Not All Beta is Created Equal Notes from the Road: Earnings Revisions Tempering Our Tone, But We Remain Bullish This Remains a Value Oriented Market Whats Wrong With Technology? 2Q10 Earnings Update Still Overweight Discretionary Are We Range Bound? Sentiment Extremes and Market Performance Dont Miss the End of the Buyers Strike Reviewing our 2010 Investment Themes US Strategy Special Report Talking Points on the Debt Ceiling 2011 Market Outlook Reactions Create Opportunities Fear Factor, Russian Redux? US Strategy Monthly August Chartbook

Major US Indices
Index DJ Industrial Average DJ Transportation DJ Utilities NASDAQ 100 NASDAQ Composite Russell 1000 Russell 1000 Growth Russell 1000 Value Russell 2000 S&P 500 S&P 500/Citigroup Growth S&P 500/Citigroup Value S&P Mid Cap 400 S&P Small Cap 600 1W -2.5 -8.7 2.1 -6.6 -6.6 -3.5 -4.4 -2.5 -5.0 -4.7 -5.5 -3.9 -6.5 -6.4 1M -12.6 -21.0 -3.4 -14.6 -16.8 -14.5 -14.7 -14.3 -20.4 -15.3 -14.8 -15.9 -19.6 -20.5 3M -12.2 -22.5 -4.5 -13.3 -16.5 -15.0 -13.7 -16.3 -20.1 -15.7 -13.8 -17.8 -20.2 -19.6 6M -11.3 -20.3 2.1 -14.8 -17.4 -15.4 -14.2 -16.6 -20.6 -16.3 -13.4 -19.5 -19.8 -19.3 12M 7.0 0.1 9.4 11.8 7.5 6.5 10.1 3.0 8.4 4.5 8.4 0.4 6.8 8.9 YTD -5.1 -17.3 3.7 -8.1 -11.7 -9.6 -7.9 -11.1 -15.5 -10.7 -8.3 -13.2 -13.2 -14.3

Source: Oppenheimer Asset Management Investment Strategy Group, Prices as of 8/19/11

S&P 500 GICS Sectors

Sector Consumer Discretionary Consumer Staples Energy Financials Health Care Industrials Information Technology Materials Telecommunications Services Utilities 1W -5.6 -0.1 -5.3 -5.1 -2.0 -7.1 -8.0 -6.9 -0.2 1.9 1M -15.9 -6.2 -18.5 -19.3 -11.9 -20.7 -15.8 -19.1 -9.1 -4.1 3M -15.5 -8.3 -15.2 -22.9 -14.0 -22.2 -14.3 -16.2 -12.1 -5.4 6M -14.9 -0.7 -17.8 -29.5 -5.5 -23.7 -18.4 -19.8 -6.4 1.2 12M 10.3 10.6 18.8 -12.5 7.3 -1.0 4.8 5.0 5.5 6.3 YTD -9.1 0.4 -7.4 -24.1 -1.9 -16.6 -11.6 -16.3 -7.5 2.4

Source: Oppenheimer Asset Management Investment Strategy Group, Prices as of 8/19/11

S&P 500 - Top & Bottom 10 Performing Industries, Trailing Week

Top 10 Tobacco Electric Utilities Multi-Utilities Biotechnology Food & Staples Retailing Wireless Telecommunications Services Diversified Telecommunications Services Household Products Pharmaceuticals Beverages Bottom 10 Real Estate Management & Development Auto Components Internet Software & Services Building Products Internet & Catalog Retail Automobiles Electrical Equipment Machinery Computers & Peripherals Textiles & Apparel & Luxury Goods 1W 3.3 2.4 1.8 1.2 0.7 0.4 -0.3 -0.4 -0.8 -0.9 1W -17.4 -12.2 -11.7 -11.7 -11.6 -10.5 -10.1 -9.8 -9.6 -9.5 1M -0.5 -3.5 -3.3 -8.7 -9.7 -21.0 -7.6 -4.9 -8.7 -5.9 1M -41.0 -28.7 -17.0 -34.2 -17.4 -24.5 -25.6 -25.5 -15.0 -17.2 3M -4.2 -4.7 -5.3 -10.7 -12.3 -23.7 -10.6 -7.7 -9.9 -7.0 3M -48.7 -26.7 -11.6 -46.9 -11.1 -30.6 -24.1 -25.6 -7.4 -9.7 6M 10.7 1.7 1.1 3.8 -6.9 -16.2 -5.2 -2.7 -1.3 0.8 6M -46.1 -31.4 -23.6 -43.2 -2.8 -34.8 -31.9 -27.7 -14.2 -10.0 12M 27.1 5.8 5.6 11.3 10.9 -4.7 6.8 2.7 4.0 9.8 12M -16.4 2.4 2.8 -29.1 41.6 -11.0 -5.7 2.8 15.3 20.6 YTD 14.3 2.3 2.0 2.6 -4.7 -11.5 -7.1 -2.4 -1.0 -1.2 YTD -33.0 -22.9 -17.6 -40.3 3.8 -36.7 -24.2 -22.1 -5.2 -4.9

Source: Oppenheimer Asset Management Investment Strategy Group, Prices as of 8/19/11

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The research provided in this report is based on strategic analysis provided by Oppenheimer Asset Management Inc., a nonmember affiliate of Oppenheimer & Co. Inc. Strategic analysis is based on fundamental, macroeconomic and quantitative data to provide investment analysis with respect to U.S. securities markets. Strategic analysis may offer a view that is inconsistent with technical analysis generated by Oppenheimer Asset Management Inc. The author of this report also provides model portfolios to Oppenheimer Asset Management Inc. Securities mentioned in these reports may or may not be included in such model portfolios. The report is not intended to provide personal investment advice. Securities and other financial instruments discussed in this report or recommended or sold by Oppenheimer & Co. Inc. are not insured by the Federal Deposit Insurance Corporate and are not deposits or obligations of any insured depositary institution. Investments involve numerous risks including market risk, counterparty default risk and liquidity risk. Securities and other financial investments at times may be difficult to value or sell. The value of financial instruments may fluctuate, and investors may lose their entire principal investment.

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