U.S.

Equity Market Comment

September 1, 2011 Portfolio Advice & Investment Research

Report Prepared by: Ryan Lewenza, CFA, CMT V.P. & U.S. Equity Strategist Highlights:

Are We Witnessing the Sequel to 2008?

In recent weeks, weve been fielding increasing queries on whether the current global economic deceleration and stock market weakness is the sequel to 2008s horror film. In this report, we examine the current market environment, looking at the similarities and differences between 2008 and now, and provide our assessment of this important question. While we are witnessing some unnerving similarities, there are a number of differences which make us believe that the U.S. financial markets are in a better position to handle exogenous shocks, or another recession, should that transpire. Similarities From experience we know that it is difficult to contain problems once they metastasize. In the U.S., the problems of a heavily indebted U.S. consumer, coupled with the bursting of the U.S. housing bubble, led to calamitous results spreading from the U.S. housing market to the global financial markets. Some are drawing parallels between the European sovereign credit crisis and the popping of the U.S. housing market, wondering if the outcome will be the same. In our view, the two central issues with Europe are: 1) too much debt among many European nations, and 2) too little capital held by European banks. In this regard we note the similarities to the 2008 U.S. financial crisis, with many U.S. financial institutions being heavily leveraged with underperforming debt and loans, and low capital ratios during that period. Given this common thread, we remain focused on developments from the region, and are closely watching European sovereign bond yield spreads, which will capture an escalation of the sovereign credit crisis as it unfolds. At its core, our free market economic system is built on the premise of confidence. Given our concerns stated above, along with the recent U.S. debt debacle (i.e., debt ceiling missteps and credit rating downgrade), and the stalling of economic momentum, investor confidence has deteriorated quickly, which is also reminiscent of 2008. A lack of confidence is often the cause of financial crises, which we are monitoring closely through investor sentiment polls and the Volatility Index. Finally, we note the link between confidence and interbank lending, which is also beginning to show some signs of stress. During the U.S. financial crisis, banks stopped lending to each other due to the lack of confidence in their peers. Similarly, weve seen interbank lending rates creep higher in recent weeks, as concerns mount for European banks (Exhibit 1). If the rate that European banks charge each other continues to rise, it will signal rising stress within the financial system.

While we are witnessing some unnerving similarities, there are a number of differences which make us believe that the U.S. financial markets are in a better position to handle exogenous shocks, or another recession, should that transpire. The key differences in our view are: 1) corporate America is in much stronger financial shape than it was in 2008, 2) stocks are much more reasonably valued at present, making them less susceptible to valuation compression if the current macro headwinds persist, and 3) U.S. banks are in a much stronger position than they were heading into 2008. There are times to increase risk within portfolios, focusing more on cyclical names that will outperform their defensive counterparts. We believe now is the time to focus on capital preservation, by reducing risk in portfolios and concentrating on high quality, dividend paying stocks.

This publication is for distribution to Canadian clients only. Please refer to Appendix A in this report for important disclosure information

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U.S. Equity Market Comment

September 1, 2011 Portfolio Advice & Investment Research

Exhibit 1: Keeping an Eye on European Bank Lending

bps
250

Euribor OIS Spread

200

We're closely watching interbank lending in Europe, which would capture an escalation in the Europe debt crisis.

150

100

50

0 Jun-08

Source: Bloomberg Finance L.P. As of August 22, 2011

Dec-08

Jun-09

Dec-09

Jun-10

Dec-10

Jun-11

Differences While there are some similarities to 2008, there are many differences, making us more confident that the U.S. economy may fare better in the face of a European debt crisis and/or recession. First, and most important in our view, corporate America is in much stronger financial shape than it was in 2008. Presently, nonfinancial U.S. corporations have nearly 7.5% of total assets in cash and liquid assets or a total of nearly $2 trillion dollars (Exhibit 2). This is more than 2 percentage points above its 2008 low of around 5%. As a result of strong earnings, and a strict focus on costs, corporate America has amassed significant hoards of cash making it less vulnerable to potential shocks that may arise. Exhibit 2: Corporate America Is in Strongest Financial Shape in Years
in billions

Nonfinancial Corporations: Cash and Other Liquid Assets

$2,100 $1,900 $1,700 $1,500 $1,300 $1,100 $900 $700

Source: Bloomberg Finance L.P. As of August 22, 2011

U.S. companies continue to shore up their already strong balance sheets by holding more cash and liquid assets.

$500 2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

Another important difference between today and 2008 is the significantly lower stock market valuations. The S&P 500 Index (S&P 500) is currently trading at 11.5x trailing earnings (12x forward), compared to 16-17x heading into 2008 (Exhibit 3). Stocks are much more reasonably valued at present, making them less susceptible to valuation compression if the current macro headwinds persist. For illustrative purposes, if we do experience a global recession similar to that of 2008, our worst case projection for the S&P 500 would be around 900, or roughly 25% downside from current levels. In determining this level we assume that the current 12-month S&P 500 forward earnings forecast of $100 declines by 20% (average EPS decline during recessions) and we use a trough valuation of 11x. While not very comforting, we believe our worst case assumptions would result in a potential peak-trough loss of 35% (from the April 2011 high), but less than the 55% loss that was experienced in 2008.

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September 1, 2011 Portfolio Advice & Investment Research

Exhibit 3: Lower Market Valuations Help Limit PE Contraction

S&P 500 Trailing P/E
20 19 18 17 16 15 14 13 12 11
Source: Thomson. As of August 22, 2011

At 11.5x, the S&P 500 is roughly 4-5 multiple points cheaper relative to 2008.
Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11

10 Jan-07

Jul-07

Jan-08

Jul-08

Finally, while the recent poor stock performance from U.S. financials does not capture this, it is our view that U.S. banks are in a much stronger position than they were heading into 2008. Our view is based on the following: 1) U.S. financials have issued roughly $500 billion of capital since the beginning of the credit crisis, 2) as a result of the massive equity issuance and improving earnings since the crisis, the median tier 1 common equity ratio for large-cap banks has increased steadily from 4.7% in Q1/09, to its current 9.9% (Exhibit 4), and 3) U.S. financials have been slowly shedding or reducing higher risk divisions such as proprietary trading. Clearly, if the U.S. experiences some contagion effects from Europe, then U.S. financials will be negatively impacted, however given these improvements, we believe they are better positioned to handle any potential shocks that may occur. Exhibit 4: U.S. Banks Are Better Positioned to Handle Shocks
U.S. Large Cap Banks Tier 1 Common Ratio
12.0%

10.0%

8.0%

6.0%

4.0%

Large cap U.S. banks have been steadily strengthening their capital ratios since 2008.

2.0%
Source: SNL Interactive. Credit Suisse. As of August 22, 2011 Teir 1 ratio is the median of BAC, C, JPM, PNC, USB and WFC.

0.0%

Q1/09

Q2/09

Q3/09

Q4/09

Q1/10

Q2/10

Q3/10

Q4/10

Q1/11

Q2/11

Conclusion Recession odds are increasing, while the European credit crisis remains the largest risk to the financial markets. Given the rising risks we continue to recommend a defensive posture. Subject to ones risk tolerance and investment objectives, our key strategic recommendations are: 1. maintain higher than normal cash levels, 2. overweight defensive stocks relative to cyclicals, 3. focus on large-cap, high-quality, dividend playing stocks, and 4. continue to hold gold with a mix of direct gold exposure (through bars or ETFs) and gold miners as insurance. There are times to increase risk within portfolios, focusing more on cyclical names that will outperform their defensive counterparts. We believe now is the time to focus on capital preservation, by reducing risk in portfolios and concentrating on high quality, dividend paying stocks. We hope lawmakers will finally begin to develop lasting solutions to our current global problems, and that in the near future we will begin to shift our investment strategy to a more cyclical posture.
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September 1, 2011 Portfolio Advice & Investment Research

Appendix A Important Disclosures

Full disclosures for all companies covered by TD Securities Inc. can be viewed at https://www.tdsresearch.com/equities/coverage.disclosure.action Research Dissemination Policy TD Waterhouse makes its research products available in electronic format. TD Waterhouse posts its research products to its proprietary websites for all eligible clients to access by password and distributes the information to its sales personnel who may then distribute it to their retail clients under the appropriate circumstances either by email, fax or regular mail. No recipient may pass on to any other person, or reproduce by any means, the information contained in this report without the prior written consent of TD Waterhouse. Analyst Certification The TD Waterhouse Portfolio Advice & Investment Research analyst(s) responsible for this report hereby certify that (i) the recommendations and technical research opinions expressed in the research report accurately reflect the personal views of the analyst(s) about any and all of the securities or issuers discussed herein and (ii) no part of the research analyst's compensation was, is, or will be, directly or indirectly, related to the provision of specific recommendations or views contained in the research report. Conflicts of Interest: The TD Waterhouse Portfolio Advice & Investment Research analyst(s) responsible for this report may own securities of the issuer(s) discussed in this report. As with most other TD Waterhouse employees, the analyst(s) who prepared this report are compensated based upon (among other factors) the overall profitability of TD Waterhouse and its affiliates, which includes the overall profitability of investment banking services, however TD Waterhouse does not compensate analysts based on specific investment banking transactions. TD Waterhouse Disclaimer The statements and statistics contained herein are based on material believed to be reliable, but are not guaranteed to be accurate or complete. This report is for information purposes only and is not an offer or solicitation with respect to the purchase or sale of any investment fund, security or other product. Particular investments or trading strategies should be evaluated relative to each individuals objectives. Graphs and charts are used for illustrative purposes only and do not reflect future values or future performance. This document does not provide individual, financial, legal, investment or tax advice. Please consult your own legal, investment, and tax advisor. All opinions and other information included in this document are subject to change without notice. The Toronto-Dominion Bank and its affiliates and related entities are not liable for any errors or omissions in the information or for any loss or damage suffered. TD Waterhouse Canada Inc. and/or its affiliated persons or companies may hold a position in the securities mentioned, including options, futures and other derivative instruments thereon, and may, as principal or agent, buy or sell such securities. Affiliated persons or companies may also make a market in and participate in an underwriting of such securities. TD Waterhouse represents the products and services offered by TD Waterhouse Canada Inc. (Member Canadian Investor Protection Fund), TD Waterhouse Private Investment Counsel Inc., TD Waterhouse Private Banking (offered by The Toronto-Dominion Bank) and TD Waterhouse Private Trust (offered by The Canada Trust Company). TD Securities Disclaimer TD Securities is the trade name which TD Securities Inc. and TD Securities (USA) Inc. jointly use to market their institutional equity services. TD Securities is a trade-mark of The Toronto-Dominion Bank representing TD Securities Inc., TD Securities (USA) LLC, TD Securities Limited and certain corporate and investment banking activities of The Toronto-Dominion Bank. Trade-mark Disclosure Bloomberg and Bloomberg.com are trademarks and service marks of Bloomberg Finance L.P., a Delaware limited partnership, or its subsidiaries. All rights reserved. All trademarks are the property of their respective owners. / The TD logo and other trade-marks are the property of The Toronto-Dominion Bank or a wholly-owned subsidiary, in Canada and/or in other countries.
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