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To be sure, there are good reasons to be cautious, as we discussed in Section I, The Risks to Our Outlook. Even worse, investors are exposed to these dangers at a time when most asset valuations are expensive by historical standards, providing them with a narrow margin of safety to absorb such adverse developments. This is particularly true in the US, where valuations have been cheaper at least 90% of the time historically.*°> Even in Europe, where valuations are more attractive, that fact is counterbalanced by greater geopolitical risks and deeper structural fault lines. Still, as we highlighted in Section I of this Outlook, there are three reasons why remaining invested in risk assets is still warranted despite what are likely to be uninspiring returns. First, we see only a 15% probability of a US recession, which has historically been the key driver of losses in risk assets. Indeed, the S&P 500 has generated positive annual total returns 86% of the time during economic expansions in the post- WWII period. Second, the comparable returns of investment alternatives—such as cash and bonds—are unappealing, particularly in the rising interest rate environment that we expect. Third, risk assets can surprise us to the upside, as last year demonstrated. The potential for returns to exceed our expectations is especially true in the US, given the possibility of tax reforms, fiscal expansion and deregulation. The same could be said for our tactical positions across various asset classes, which we discussed in Section I, Our Tactical Tilts. While we have suggested that the dilemma should be resolved in favor of remaining invested, we are not Pollyannaish. Investors have ridden this bull market for eight years, and while we don’t expect the ride to end in 2017, we must stay vigilant to avoid the horns. Exhibit 47: US Equity Price Returns from Each Valuation Decile In the past, subsequent returns from high valuation levels have been muted. % Annualized m5-Year Annualized Price Return % 14 - @% Observations With Positive Returns (Right) - 100 + 90 12 bs od e ry | 80 10 - 70 8.3 8 ¢ 60 - 50 6 40 4 30 20 2 10 0 0 Data as of December 31, 2016. Note: Based on 5 valuation metrics for the S&P 500, beginning in September 1945: Price/Trend Earnings, Price/Peak Earnings, Price/Trailing 12m Earnings, Shiller Cyclically Adjusted Price/ Earnings Ratio (CAPE) and Price/10-Year Average Earnings. These metrics are ranked from least expensive to most expensive and divided into 10 valuation buckets (“deciles”). The subsequent realized, annualized 5-year price return is then calculated for each observation and averaged within each decile. Past performance is not indicative of future results. Source: Investment Strategy Group, Bloomberg, Datastream, Robert Shiller. Valuation Decile US Equities: Life in the Fast Lane US stocks have been driving in the fast lane since 2009. Over this nearly eight-year period, the S&P 500 has generated a stunning 16.5% annualized price return, a pace exceeded only 3% of the time since 1945. As a result, the 500 companies in the index are collectively worth $20 trillion today, about 3.5 times as high as they were at the trough of the financial crisis. Needless to say, investors have had a good ride. Yet such a fast drive also raises the question of whether US equities are now running on empty. Exhibit 46: ISG Global Equity Forecasts—Year-End 2017 End 2017 Central Case Implied Upside from Current Dividend 2016 YE Target Range Current Levels Yield Implied Total Return S&P 500 (US) 2,239 2,225-2,300 -1-3% 2.1% 1-5% Euro Stoxx 50 (Eurozone} 3,291 3,250-3,400 -1-3% 3.6% 27% FTSE 100 (UK} 7143 7,050-7,310 2% 4.0% 3-6 % TOPIX (Japan} 1,519 1,530-1,590 —5% 1.9% 3-7% MSCI EM (Emerging Markets} 862 880-925 2-1% 2.6% 5-10% Data as of December 31, 2016. Note: Forecast for informational purposes only. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this Outlook. Source: Investment Strategy Group, Datastream, Bloomberg. 50 | Goldman Sachs | JANUARY 2017 HOUSE_OVERSIGHT_014583