investment strategy outlook... · after the 25 basis point rate hike in december, the fed has been...

Please refer to Appendix – Important Disclosures.

2016 At The Half: Contrasts and Consistency

Highlights: • Fed Continues to Struggle with Messaging • Prospects for Economy May Be Better Than Assumed • Despite Rally, Equity Funds Continue to See Outflows • Breadth Offering More Support This Year Than Last

2016 has been a study in both contrasts and consistency. Contrast can be seen in the performance of the stock market over the course of the first half. Near the mid-way point of the first quarter, the S&P 500 had posted a year-to-date decline of more than 10%. By the end of the quarter, however, the S&P 500 was back in positive territory for the year. Since then the S&P 500 has oscillated within a narrow 75 point range, echoing the price action that was seen over the course of the first half of 2015.

The consistencies and contrasts extend beyond the movement of popular stock market averages. While the fundamental situation is little changed, technical conditions now are quite different from 2015. The Fed continues to offer mixed signals and struggle with communication while its actual policies have not become a headwind. The economy, while poised for growth continues to struggle to build momentum and valuations remain stretched, with corporate fundamentals not matching price

performance.

Investors continue to have elevated exposure to equities but optimism has been slow to build even as stocks have rallied off of their lows. From a seasonal perspective, clarity around the outcome of this fall's elections could be a tailwind for stocks, provided off course, that we do not get any more NOISE (News-driven One-time Important Strategic Events). While NOISE tends to be just noise, getting through it can add to volatility. The marked improvement in the broad market is a significant difference between 2015 and 2016 and could be a source of support if noise levels do become elevated.

Investment Strategy Outlook June 24, 2016

Baird Market & Investment Strategy

Outlook Summary

Weight of the Evidence Turns Mildly

Bullish

Valuation Excesses Have Not Been Relieved; Exposure to Equities Still High

Breadth Tailwind Supportive of Stocks

U.S. Leadership Intact, With Focus On

Mid-Caps

Rising Inflation A Risk for Bonds

Bruce Bittles Chief Investment Strategist [email protected] 941-906-2830

William Delwiche, CMT, CFA Investment Strategist [email protected] 414-298-7802

Indicator Review

Fundamental Factors• Federal Reserve Policy Neutral 0• Economic Fundamentals Bullish +1• Valuations Bearish -1

Technical Factors• Investor Sentiment Neutral 0 • Seasonal Patterns/Trends Neutral 0• Tape Bullish +1

Weight of the Evidence = Mildly Bullish +1

10R.17

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Investment Strategy Outlook

Robert W. Baird & Co. of 14

The weekly chart of the S&P 500 provides a nice visual representation of the contrast and consistency that we are discussing. For all the noise that can be seen on a day-to-day basis, the S&P 500 continues to move within a well-defined trading range (as seen in the top portion of the chart to the right) that is nearly two years old. From a momentum perspective (seen at the bottom of the chart), 2016 could hardly be more different that 2015. While it is too early to conclude that a new momentum up trend has emerged in 2016, it does look like the downtrend that was in place last year has been broken. In other words, the consistency suggested by the continuation of the trading range environment may gloss over improvements that are being seen beneath the surface.

Federal Reserve Policy remains neutral. Actual monetary policy has not become a headwind for stocks. After the 25 basis point rate hike in December, the Fed has been on hold and the median projection among FOMC members is that only 50 basis points of tightening will be seen in 2016 (down from an early year expectation of 100 basis points of tightening). The Fed has been able to take a wait-and-see approach to rate hikes because inflation remains relatively benign. But when one looks across several inflation indexes (the chart here shows different takes on the CPI), it appears that inflation has started to move off its lows. The yearly change in the median CPI, for example, is now above 2.5%, the highest level since 2008.

Source: Ned Davis Research

Source: StockCharts



Despite this up-tick in inflation, fixed income investors have pushed bond yields lower in 2016, with the most recent drop in yields coming as macro-related uncertainties have intensified in June. Low yields around the world have helped keep demand for U.S. Treasuries relatively robust. But the gyrations seen in the yield on the 10-year T-Note this year reflect our view on why Fed policy is currently neutral. While the Fed has not yet raised rates in 2016, it has, through various media, hinted that it would at upcoming meetings. These hints have helped produce spikes in bond yields, which have then reversed once it became clear that the Fed was not yet ready to act.

The issue for the Fed is that its intention to be transparent and open has the effect of providing more noise and uncertainty for stocks and bonds. At this point, less might be more when it comes to Fed communications. This might mean fewer Fed officials giving speeches and doing away with (or reducing the frequency off) the now quarterly Summary Economic Projections released in conjunction with FOMC meetings. While it might seem useful to know what members of the Fed are forecasting for growth, inflation and the path of interest rates, this should be tempered by the realization that forecasts are rarely correct. On the positive side, the recent lowering of the long-rung expected growth for the economy could provide a lower threshold for the economy to get over.


Source: StockCharts



Economic Fundamentals are still bullish. Growth has been weaker than expected to start 2016, but that has been a recurring theme over the course of the last few years. Domestic demand (the bottom clip in the chart to the right) has been a bit more robust that overall GDP growth, but after posting better than average growth in five of six quarter, growth in domestic demand has slipped over the past six months. The good news from a growth perspective is that real-time tracking of second quarter activity suggests growth has rebounded and the numbers for the first half overall will not be out of line with what has been seen in recent years.

A hotly debated economic topic in the first half of 2016 has been the decline in productivity growth. While it has come into focus this year, the trend has really been deteriorating since 2000. That was about the same time that actual growth started to fall short of economist expectations. Growth began exceeding expectations in the early 1980s, which according to this chart was the same time that the trend in productivity growth began to improve. Weakness in productivity growth may just be part of a secular trend for the economy – and if long-term conditions in the economy are improving, productivity growth (and economic growth overall) could soon surprise on the upside.





One of the reasons suggested for weak productivity growth is the relative lack of investment that has been taking place in the economy. While investment shrank to nearly zero after each of the past two recessions, more recently it has rebounded and is at a historically high level relative to GDP. Looking again at 1980 as an example, the cumulative effect of investment spending took time to manifest itself in productivity growth and economic growth. It is not clear that the same will not hold this time around. That this is not being widely forecast does not, in our mind, make it less likely to happen. In fact, with businesses now facing rising labor costs and having trouble hiring skilled workers, investment spending could accelerate in coming quarters.

There are numerous ways to discuss the health of the labor market. Unfortunately, the headline generating monthly payroll data might be one of the least useful. The last two data points in that survey have been disappointing and this has helped fuel speculation that the recovery in the labor market is running out of steam (this appears to have played a part in the Fed’s decision not to raise rates in June). Wage growth (as measured by the Federal Reserve Bank of Atlanta) seems to suggest the opposite. Wage growth is accelerating for all workers, especially for those who are switching jobs. This seems consistent with an economy that is finding its footing and continuing to show improvement. It may also help put upward pressure on inflation.

Source: Federal Reserve Bank of Atlanta




Valuations are bearish. The median P/E ratio for stocks in the S&P 500 is at its highest level in over a decade. Historically, valuations do tend to trend higher over the course of a secular bull market. But at this point it appears that prices have gotten ahead of fundamentals.

Valuations are poor timing indicators – a stock (or market) that is expensive can get more expensive, and one that is cheap can get cheaper still. Over the longer term, however, valuations are a good indicator of risk. When stocks are cheap (by historical standards) forward returns tend to be robust. When stocks are more expensive forward returns tend to be depressed. As seen in the chart to the left, based on average 10-year earnings, the S&P 500 is currently in the most expensive quintile and forward returns under such conditions have tended to be weak.





The good news from a valuation perspective is that some of the fundamental headwinds may be diminishing and earnings growth could soon rebound. Forecasts for earnings are as notoriously unreliable as forecasts for growth, but there is still some reason for optimism. Earnings revisions are starting to get tweaked higher, and the U.S. Dollar is now declining on a year-over-year basis, which has historically been a strong tailwind for earnings growth. The valuation excesses described on the previous page could as easily be resolved through improving fundamentals as through price weakness.

Investor sentiment is neutral. The weakness early in 2016 led to an explosion of pessimism that has not been fully unwound. Even as stocks have rallied, optimism has been slow to build and funds have continued flow away from equities (and toward bonds). The pace of outflows has been intense, rivaling on a 4-week basis the outflows seen in 2008 and 2000. This has historically been bullish for stocks.


Source: StockCharts



The skeptic might argue that mutual funds are in secular decline, and investors increasingly favor ETFs. This is true to a degree, but the pace inflows to ETFs has not matched the pace of outflows from mutual funds. There have been only three weeks over the course of the first half of 2016 in which the combined ETF + Mutual Fund flows were positive by more than just a marginal amount for U.S. equities. The tone was set early in the year as stocks swooned and investors have not yet found reason to shift funds back toward equities. If that happens in the second half, it could be a tailwind for stocks.

Despite the weekly data showing persistent outflows from equities, aggregate exposure to stocks across all ETFs and mutual funds remains elevated by historical standards. Exposure to equities is just below its recent peak and cash levels have scarcely risen off of their lows. For all the near-term fear and uncertainty that has been expressed in 2016, there is little evidence of a meaningful build in cash on the sidelines. On possible explanation may be that while the fund flow data (even when aggregated to include mutual funds and ETFs) is measured in hundreds of millions and billions, total assets are measured in trillions. While the flows get the headlines, they are simply not making much of a dent in overall exposure.





In the same way the elevated valuations have a depressing effect on future stock market returns, so too has elevated exposure to equities. The chart to the right shows a strong inverse correlation between the percent of household financial assets in equities and forward returns for the S&P 500 (shown on the right axis, and inverted to facilitate the comparison). While the latest update to this data shows that exposure to equities has been reduced slightly in recent quarters, it remains elevated by historical standards.

Seasonal patterns are neutral. The intense focus that seasonal patterns have received in recent years has reduced some off their effectiveness. But we believe there is still information in them and history remains the only guide we have. While the first quarter was a clear aberration in terms of the degree of the move, it was not totally out of character with historical election year patterns. Nor for that matter has the second quarter’s range-bound drift. Looking ahead, seasonal patterns suggest stocks could drift higher until the presidential election really heats up this fall and the pattern after that could depend on which candidate appears to have the upper hand.





Breadth has turned bullish with the average stock leading the popular averages. This is in marked contrast to 2015. Last year, the S&P 500 was up on the year because of the so-called FANG stocks (represented by the blue line in the chart to the right). In 2016, it is the opposite. The S&P 500 is positive on a year-to-date basis despite weakness in the FANGs. Those four stocks are down an average of 3% in 2016, while the remaining stocks in the S&P 500 are up an average of more than 5% this year. A market that is narrowly supported is vulnerable if the few leaders stumble, while a market that is broadly supported can usually find another sector or stock to pick up the leadership baton.

Another way to view this change in leadership is by comparing the performance of the S&P 500 (which is cap-weighted) to an equal-weight version of the index. That is represented in this chart. The ratio in the middle clip rises when the equal-weight index is leading and falls when the cap-weighted index is leading. The contrast between 2015 and 2016 is significant and suggests the S&P 500 enters the second half of 2016 with strong underlying support. This could be a tailwind despite some of the fundamental uncertainties that have yet to be resolved. Or especially if those fundamental uncertainties move toward resolution.

Source: StockCharts




Industry group trends quickly turned higher early this year and have continued to improve even as the S&P 500 has consolidated its gains. While back to the level seen in early 2015 (and not yet matching the broad strength seen in 2013 and the first half of 2014), the direction now versus a year ago is completely different. Then, rallies were joined by fewer and fewer groups still in up-trends, while now, more and more stay robust even if the overall S&P 500 is not going anywhere.

One final difference between 2015 and 2016 to point out here is the number of stocks making new 52-week highs and lows. Similar to the industry group trend indicator above, the number of stocks making new highs is not yet back to the levels seen in 2013, but it is expanding and has broken the dominant trend from 2015. Perhaps more importantly, the number of issues making new lows has remained muted. In the second half of 2015 and opening weeks of 2016, weakness in the S&P 500 was quickly joined by an expansion in the new low list. That is not happening now, and is bullish for stocks.




What to Do (or Where to Go):

- While the weight of the evidence has turned more bullish, risks (as represented by high valuations and fully exposed investors) remain elevated. As such maintaining higher-than-normal levels of cash may not be unwarranted.

- With inflation creeping higher, bond yields could follow suit. Optimism in bonds is elevated and investors have flocked to bond funds in the first half of 2016. Tactical investors may want to tilt away from bonds (perhaps use these funds to build cash positions).

- In terms of equity exposure, we have continued to see U.S. leadership relative to the rest of the world. While global macro uncertainties are adding to volatility, the trend favoring the U.S. remains intact.

- Domestically, small-caps have gained strength relative to large-caps, both at the index-level and within our industry group rankings. Given the convergence of longer-term trend-lines and other mixed signals between large-caps and small-caps, we would tilt domestic equity exposure toward mid-caps.

- From a sector perspective, global uncertainties and a thirst for yield has helped keep defensive areas like Consumer Staples and Utilities in the leadership group. More recently we have seen more cyclical areas of the market, like Energy, Materials and Industrials move into the leadership group, where we expect them to stay in the second half of 2016.

Source: Stock Charts



BAIRD STRATEGIC ASSET ALLOCATION MODEL PORTFOLIOS Baird offers six strategic asset allocation model portfolios for consideration (see table below), four of which have a mix of equity and fixed income. An individual’s personal situation, preferences and objectives may suggest an allocation more suitable than those shown below. Please consult a Baird Financial Advisor in determining an asset allocation that will meet your needs.

Model Portfolio Mix: Stocks / (Bonds + Cash) Risk Tolerance Strategic Asset Allocation Model Summary

All Growth 100 / 0 Well above average Emphasis on providing aggressive growth of capital with high fluctuations in the annual returns and overall market value of the portfolio.

Capital Growth 80 / 20 Above average Emphasis on providing growth of capital with moderately high fluctuations in the annual returns and overall market value of the portfolio.

Growth with Income 60 / 40 Average

Emphasis on providing moderate growth of capital and some current income with moderate fluctuations in annual returns and overall market value of the portfolio.

Income with Growth 40 / 60 Below average

Emphasis on providing high current income and some growth of capital with moderate fluctuations in the annual returns and overall market value of the portfolio.

Conservative Income 20 / 80 Well below average

Emphasis on providing high current income with relatively small fluctuations in the annual returns and overall market value of the portfolio.

Capital Preservation 0 / 100 Well below average

Emphasis on preserving capital while generating current income with relatively small fluctuations in the annual returns and overall market value of the portfolio.

Baird’s Investment Policy Committee offers a view of potential tactical allocations among equity, fixed income and cash, based upon a consideration of U.S. Federal Reserve policy, underlying U.S. economic fundamentals, investor sentiment, valuations, seasonal trends, and broad market trends. As conditions change, the Investment Policy Committee adjusts the weightings. The table below shows both the normal range and current recommended allocation to stocks, bonds and cash. Please consult a Baird Financial Advisor in determining if an adjustment to your strategic asset allocation is appropriate in your situation.

Asset Class / Model Portfolio All Growth Capital Growth Growth with

Income Income with

Growth Conservative

Income Capital

Preservation

Equities: Suggested allocation 95% 75% 55% 35% 15% 0% Normal range 90 – 100% 70 - 90% 50 - 70% 30 - 50% 10 - 30% 0% Fixed Income: Suggested allocation 0% 15% 35% 45% 50% 60% Normal range 0 - 0% 10 - 30% 30 - 50% 40 - 60% 45 - 65% 55 – 85% Cash: Suggested allocation 5% 10% 10% 20% 35% 40% Normal range 0 - 10% 0 - 20% 0 - 20% 10 - 30% 25 - 45% 15 - 45%



ROBERT W. BAIRD’S INVESTMENT POLICY COMMITTEE

Bruce A. Bittles B. Craig Elder Jay E. Schwister, CFA Managing Director Director Managing Director Chief Investment Strategist PWM – Fixed Income Analyst Baird Advisors, Sr. PM

Kathy Blake Carey, CFA Jon A. Langenfeld, CFA Timothy M. Steffen, CPA, CFP® Director Managing Director Director Associate Director of Asset Mgr Research Head of Global Equities Director of Financial Planning Patrick J. Cronin, CFA, CAIA Warren D. Pierson, CFA Laura K. Thurow, CFA Director Managing Director Managing Director Institutional Consulting Baird Advisors, Sr. PM Director of PWM Research, Prod & Svcs

William A. Delwiche, CMT, CFA Director Investment Strategist

Appendix – Important Disclosures and Analyst Certification This is not a complete analysis of every material fact regarding any company, industry or security. The opinions expressed here reflect our judgment at this date and are subject to change. The information has been obtained from sources we consider to be reliable, but we cannot guarantee the accuracy. ADDITIONAL INFORMATION ON COMPANIES MENTIONED HEREIN IS AVAILABLE UPON REQUEST The indices used in this report to measure and report performance of various sectors of the market are unmanaged and direct investment in indices is not available. Baird is exempt from the requirement to hold an Australian financial services license. Baird is regulated by the United States Securities and Exchange Commission, FINRA, and various other self-regulatory organizations and those laws and regulations may differ from Australian laws. This report has been prepared in accordance with the laws and regulations governing United States broker-dealers and not Australian laws. Copyright 2016 Robert W. Baird & Co. Incorporated Other Disclosures United Kingdom (“UK”) disclosure requirements for the purpose of distributing this research into the UK and other countries for which Robert W. Baird Limited (“RWBL”) holds a MiFID passport. This material is distributed in the UK and the European Economic Area (“EEA”) by RWBL, which has an office at Finsbury Circus House, 15 Finsbury Circus, London EC2M 7EB and is authorized and regulated by the Financial Conduct Authority (“FCA”). For the purposes of the FCA requirements, this investment research report is classified as investment research and is objective. This material is only directed at and is only made available to persons in the EEA who would satisfy the criteria of being "Professional" investors under MiFID and to persons in the UK falling within articles 19, 38, 47, and 49 of the Financial Services and Markets Act of 2000 (Financial Promotion) Order 2005 (all such persons being referred to as “relevant persons”). Accordingly, this document is intended only for persons regarded as investment professionals (or equivalent) and is not to be distributed to or passed onto any other person (such as persons who would be classified as Retail clients under MiFID). Robert W. Baird & Co. Incorporated and RWBL have in place organizational and administrative arrangements for the disclosure and avoidance of conflicts of interest with respect to research recommendations. This material is not intended for persons in jurisdictions where the distribution or publication of this research report is not permitted under the applicable laws or regulations of such jurisdiction. Investment involves risk. The price of securities may fluctuate and past performance is not indicative of future results. Any recommendation contained in the research report does not have regard to the specific investment objectives, financial situation and the particular needs of any individuals. You are advised to exercise caution in relation to the research report. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. RWBL is exempt from the requirement to hold an Australian financial services license. RWBL is regulated by the FCA under UK laws, which may differ from Australian laws. This document has been prepared in accordance with FCA requirements and not Australian laws.

investment strategy outlook... · after the 25 basis point rate hike in december, the fed has been...

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