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The latest bout of earnings releases has only strengthened Goldman Sachs’ resolve with regards to their bullish outlook for equities.ย  In their latest market commentary they describe why the earnings cycle will justify higher equity prices in the coming year.ย  Ultimately, they see 13.5% upside this year driven by stronger ROE and what they believe is an undvervalued market:

“2Q 2010 earnings results have been better than expected with 54% of the 175 reporting S&P 500 firms exceeding consensus estimates by more than one standard deviation and just 5% missing compared with an average of 41% and 14%, respectively. Some firms trimmed full-year EPS guidance (JNJ, GENZ and TRV) while others provided cautious commentary.
We forecast ROE for the S&P 500 will reach 15.5% in 2010 and 17% in 2011, above its 35-year average of 15.2%. The magnitude of ROE expansion we currently assume would leave about 200 bps of incremental upside relative to the โ€œaverageโ€ cycle. S&P 500 ROE troughed at 9.9% in September 2009, its lowest level since 1975. However, the downturn was far less severe excluding Financials in which case ROE bottomed at 15%. Risks to our view include higher borrowing costs and corporate taxes, slower US economic growth, and reduced financial leverage. Valuation implications: ROE shows a positive relationship with the Price/Book ratio. The level of ROE and P/B has a correlation of nearly 0.70.”

“Investors assign a higher value to equity when it generates a higher return. Although ROE does not provide a trading signal and does not appear to be a significant determinant of market returns over shorter periods of time, medium-term S&P 500 returns track ROE cycles reasonably well. Looking at rolling five-year intervals, a clear pattern emerges between ROE growth and S&P 500 annualized returns. Our expectation that ROE will expand over the next two years has positive implications for equity performance over that time. In fact, the historical relationship between ROE and price/book points to 20% upside.”

“ROE cycle decomposition: the margin story. The US equity market is currently in the early stages of its 6th ROE cycle since 1975. Previous cycles have seen ROE rise by about 500 bps from trough to peak. Operating margins have contributed more than 2/3 of ROE contraction/expansion. We expect ROE will continue its recovery in 2010 and 2011 driven nearly entirely by margin expansion despite the Goldman Sachs Economics forecast of below-trend real US GDP growth.

We maintain our 3-month price target of 1160 (+6%) and expect the S&P 500 will rise to 1250 (+14%) at year-end 2010.”

Source: GS

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