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Goldman Sachs Shifts Investment Strategy

Goldman Sachs published their Investment Strategy today and there is a shift away from Financials and Consumer stocks to Energy, Materials, and Information Technology.

Their view now coincides fairly closely with our view with the exception of the Information Technology sector. We have started to review the fundamentals of Info Tech and there are a number of the large multinationals whose earnings are derived outside the US. That fits into our strategy of investing in domestic companies with > 65% of their earnings coming from foreign sales.

Here is what they have to say:

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Four macroeconomic themes will drive the overall market and relative sector returns during the next several months: (1) inflation, 2) consumer weakness, (3) global growth, and (4) fiscal stimulus.

Energy, Materials, and Information Technology sectors will likely outperform in such an environment while Financials and Consumer Discretionary will lag. Growth projections and valuation metrics support this view as well (see Exhibit 1).

We are reversing some of the sector weighting changes we made in early May when we argued for a tactical upward trend in the market and moved to an overweight position in the Consumer and a neutral weight in the Financials. Obviously, that forecast hasn’t turned out too well in hindsight, particularly in the case of Financials which has posted another awful month of performance. The sector is down 23% YTD.

Our new weightings bring us back to an underweight position in Financials and Consumer Discretionary. We recommend overweight positions in Energy, Materials and Information Technology. We are Neutral for other sectors (defined by us as within 100 basis points of the benchmark S&P 500 sector weights).

Inflation. Commodities prices continue to set new record highs almost on a daily basis. An intense debate has erupted among market participants as to whether we are experiencing a commodities boom or bubble. Goldman Sachs commodities research argues the jump in raw materials prices is fundamentally-driven given the inability of producers to bring on new supply to meet the increased demand. Goldman Sachs commodities research forecasts average 2008 prices for a variety of energy, industrial metals, and agricultural raw materials will be 50% above the 2007 average. Last week, we analyzed sector performance during periods of accelerating PPI “crude materials” inflation. Prior periods of rising PPI “crude materials” inflation coincided with falling operating margins, P/E multiple contraction, and low equity returns. We found that Energy and Materials posted high returns while Telecom Services and Financials performed the worst (see US Equity Views: Inflation dampens margins, multiples & returns, June 16, 2008).

Consumer weakness. Firms now routinely acknowledge weakening end-market demand and “trading down” by consumers. In addition to surging energy and food prices, credit availability remains tight. Mortgage and credit card delinquencies are rising. Unemployment recently jumped to 5.5%. These trends will negatively affect consumer-driven sectors.

Fiscal stimulus. Although the fiscal stimulus has prompted spending in the near term, the longer-term prospects for the consumer remain poor. Consumer Staples should perform better than Consumer Discretionary as consumers cut down on compulsory items in favor of necessities. What sustains consumer spending after the tax rebate checks have been spent?

Global growth. Global economic activity is slowing, but firms with high non-US sales are more better positioned relative to domestically-oriented companies. A weak dollar should also drive sales outside the US. Sectors with above-average foreign sales include Information Technology (55%), Energy (45%), and Materials (41%). Non-US sales are 29% of S&P 500 total.

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Earnings are not falling across the entire market. We believe consensus EPS estimates are far too optimistic in aggregate, but we do not see negative revision potential for most Energy and Materials companies. Year-to-date, analysts have actually revised Energy estimates upward by 13%. Materials estimates have risen slightly (0.6%) compared with estimates for the entire market S&P 500 which are down 12% this year.

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In early May, we changed our recommended sector weights to reflect our view that the S&P 500 would trade higher during the summer. We believed a combination of fiscal stimulus, the availability of new funds to recapitalize the balance sheets of major financial institutions, and a general lack of negative earnings news would provide optimism and push the market gradually higher (see US Equity Views: Tactically long: Adjusting sector weights for near-term SPX rise, May 5, 2008).

Accordingly, we shifted our sector allocation in a more cyclical direction, boosting Consumer Discretionary to an overweight and Financials to a market weight from longstanding underweights. However, we believed any recovery would be a short-lived “false dawn.” Our longer-term view was that falling home prices, together with margin pressures from higher commodity prices, would mean weak second-half 2008 earnings and an uncertain 2009 outlook. We expected the market would trade higher over the summer but eventually the S&P 500 would track towards a year-end fair value in the range of 1390-1480.

Clearly, the events described above did not take place as we anticipated. Instead of witnessing a summer rise we have experienced a 6% correction. We did not anticipate the dramatic jump in the US unemployment rate to 5.5% and the worldwide preoccupation with accelerating inflation. The 2Q earnings season begins in four weeks but we no longer expect a short-term bounce in the market.

Going forward, we believe that the market will stay within the same range that it has been trading in since the beginning of the year although the increased volatility in the market provides for the possibility of large swings within the range. We maintain our 2008 year-end target of 1380.

Our sector recommendations have generated a negative excess return of 67 bp since the start of 2008. Our performance since early May was aided by our continued overweight in Energy.