U.S. Equities Quarterly Update: Uncertainty Abounds

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1 U.S. Equities Quarterly Update: Uncertainty Abounds Executive summary Uncertainty and volatility have returned to the marketplace, which is a noticeable change from the relatively calm price trends of recent years. In our view, global economic turmoil, a delayed Federal Reserve (Fed) rate liftoff date, political wrangling, Middle East tensions and overly optimistic revenue and earnings expectations for 2016 are among items causing investor angst and concern while serving as the basis for a cautious bias. On balance, we are maintaining our longer-term constructive outlook for equities, based on macro and fundamental backdrops that seem supportive of equity prices and given that the classic signs of a frothy market are not evident. Whether the current market weakness is merely a soft patch in an ongoing bull market or the start of a bear trend will depend on the future pace of global growth and company earnings. We continue to believe that lackluster year-to-date performance affords investors with tax-loss selling, portfolio upgrade and dollar-cost average opportunities, particularly for investors with time horizons of six to 18 months or longer. Due largely to restrained inflation, we remain biased toward cyclical sectors, including Information Technology, Healthcare, Consumer Discretionary, Financials and, to a degree, Industrials. Our S&P 500 price target is 2,100, with a downside bias contingent on third quarter results and company guidance, based on a multiple of 18 times our earnings estimate of $117. Our 2016 price target remains a work in progress. Equities appear to be at the crossroads of near-term uncertainty and longer-term appeal. Earnings are likely to be the swing factor. Betterthan-expected third quarter results may pave the way for higher stock prices into year-end, and consensus estimates for 2016 seem overly optimistic, subject to being reset lower. Investment products and services are: NOT A DEPOSIT NOT FDIC INSURED MAY LOSE VALUE NOT BANK GUARANTEED NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY [ 1 ] Important disclosures provided on page 8.

2 Review of performance Index Market and sector performance Price 9/30/ September YTD * S&P 500 1, % -2.6% -6.7% Dow Jones Industrials 16, % -1.5% -8.6% Russell , % -5.1% -8.6% MSCI EAFE 1, % -5.3% -7.4% MSCI Emerging Markets % -3.3% -17.2% Sectors of the S&P 500 Weight Information Technology 20.2% 18.2% -1.1% -4.1% Financials 16.3% 13.1% -3.2% -8.4% Healthcare 15.4% 23.3% -5.8% -3.3% Consumer Discretionary 13.1% 8.0% -0.8% 2.9% Energy 7.0% -10.0% -6.8% -23.1% Consumer Staples 9.7% 12.9% 0.1% -2.9% Industrials 10.1% 7.5% -2.0% -11.2% Materials 2.9% 4.7% -7.6% -17.8% Utilities 3.0% 24.3% 2.6% -8.5% Telecommunication Services 2.3% -1.9% -3.7% -7.4% Source: FactSet Research Systems. *Data: 9/30/15; excludes dividends. Market and sector performance. Year-to-date performance as of the end of the third quarter remains lackluster and varied across both indices and sectors. Most popular broad-based indices and nine of 10 S&P 500 sectors are posting negative returns. Large- and small-cap stocks are performing generally in line, evidenced by the Dow Jones Industrial Average and Russell 2000, which have both declined 8.6 percent year to date. The emerging markets segment is leading overall performance downside by nearly a two-to-one margin as reflected by the 17.2 percent pullback of the MSCI EM index. Among S&P 500 sectors, Consumer Discretionary is the only sector posting year-to-date positive gains, up a modest 2.9 percent. Energy, Materials and Industrials are the worst- performing sectors, all posting double-digit declines from beginning-of-year levels. Ten percent correction. Adding to investor angst and concern, equities experienced a 10 percent correction in the third quarter for the first time since October Index level 2,400 2,200 2,000 1,800 1,600 1,400 1,200 1, Is the bull market in equities over? 210+% overall increase during this period Index reached all-time high on May 21st 10% overall decrease during this period Sep Source: FactSet Research Systems. Data period: 12/31/08-9/30/15. As illustrated in the chart, the S&P 500 retreated 12.3 percent intra-quarter from the all-time high of 2, reached on May 21, before ending the third quarter down almost 10 percent from the May high and 6.7 percent since the start of the year. Additionally, the current bull market streak is at risk, having reached its six-year anniversary on March 9,. Dating back to the 1920s, the average bull market has lasted approximately four years, according to S&P Capital IQ, which may imply that the probability of a negative return year has increased. Importantly, bear markets without a recession are rare. Bear markets typically occur in and around recessions when inflation is heating up, the Fed is in tightening mode, investor sentiment is approaching euphoria or extreme optimism, which, in aggregate, does not seem to describe the current environment. This arguably suggests that the recent volatility is within the normal ebb and flow of price swings and not the beginning of a prolonged downturn. [ 2 ] Important disclosures provided on page 8.

3 U.S. real GDP growth Bear markets without a recession are rare 3,000 2,000 1, s Black Monday was last occurrence Aug S&P 500 price Gross domestic product, real % change P/P - United States Source: FactSet Research Systems. Data period: 12/31/69-9/04/15. Gray bars represent recessionary periods. Macro and fundamental backdrop We continue to believe that the macro and fundamental environments are supportive of higher equity prices. Inflation remains restrained. Core inflation is trending near, and not above, the Fed s 2 percent target. Barring a policy error or an exogenous event, inflation is the mechanism through which business expansions end. With the decline in energy prices, symptomatic of a slow-growth global environment, the prospects for muted inflation and continued expansion of the current business cycle remain for the foreseeable future. Earnings are increasing, albeit at a moderate pace. Over time, as reflected in the following chart, equities, on average, tend to advance at a rate commensurate with the pace of earnings growth. The following chart suggests that equities in 2014 advanced at a rate exceeding the pace of earnings growth, implying that equities may remain largely in pause mode until earnings catch up to support current prices. S&P 500 price level S&P 500 earnings estimates Improving earnings have been a key support for equities 2,200 2,100 1,900 1,700 1,500 1, , Sep 29 S&P 500 earnings estimates S&P 500 price index Source: Cornerstone Macro. Data: 9/29/15. As of the end of the third quarter, consensus expectations are for earnings growth in over 2014 levels of 4.6 percent on modestly lower revenue. Relatedly, in our view, third quarter earnings season has the makings for a good news/bad news environment. In general, expectations for third quarter results are generally low, with consensus expectations reflecting declining year-over-year revenue and earnings growth, perhaps setting the stage for beat and raise opportunities. Conversely, and perhaps more importantly, 2016 year-over-year 5.5 percent revenue and 10.1 percent operating earnings growth seem overly optimistic and subject to being reset lower. As such, equity prices are likely to follow earnings, with volatility remaining elevated until visibility into 2016 improves and any adjustment to earnings estimates are made. Valuations are reasonable. The S&P 500 ended the third quarter trading at price-earnings multiples of 17 and 16.3 times consensus trailing 12-month and estimates, respectively. As illustrated in the following charts, price-earnings multiples in the 17 times range is consistent with the past when inflation has trended between 0 percent and 4 percent, according to Strategas Research Partners, implying that current valuation levels seem warranted. S&P 500 price index [ 3 ] Important disclosures provided on page 8.

4 30x 25x 20x 15x 10x S&P 500 P/E with long-term average Average 5x Source: Strategas Research Partners. Data: trailing 12-month basis through 9/30/15. 20x 18x 16x 14x 12x 16.8x Price earnings multiples vs. inflation 17.9x 17.2x 14.7x 10.9x 10x 9.5x 8.5x 8.3x 8x -2-0% 0-2% 2-4% 4-6% 6-8% 8-10% 10-12% 12-14% Source: Strategas Research Partners. Data period: /28/15. Interest rates remain low. The third quarter ended with the fed funds rate near 0 percent and the 10-year Treasury yielding 2.1 percent. It is hard to envision interest rates moving meaningfully higher in an environment where global growth is slow and inflation is generally restrained. Accordingly, interest rates a proxy for inflation seem poised to remain low for the foreseeable future, a potential positive for equity prices. Sentiment is generally positive. Consumer sentiment continues to be aided by low energy prices, firming wages, an improving housing market and low interest rates. List of compelling alternatives is limited. As of September 30, 52 percent of S&P 500 companies offer dividends yielding above the 10-year Treasury yield of 2.1 percent. This presents a compelling case for equities as they potentially offer investors with competitive income, appreciation potential and a degree of support to current price levels. Classic signs of a frothy market do not seem evident. Historically, bull markets have tended to end when inflation is ramping, the Fed is in tightening mode, recessions hit and valuations become extended. At present, the classic signs of a frothy market do not seem evident, perhaps suggesting that the current weakness is not the beginning of a prolonged downturn but rather part of the normal ebb and flow within a longer-term, upward-trending market. Heavy fund inflows from bonds to stocks are not occurring. Initial Public Offering (IPO) activity is not at excessive levels. Inflation fears are minimal. Large cap stocks are not outperforming small caps. Conversely, widening credit spreads, erosion in number of stocks making new highs and weakening earnings revisions are among reasons pointing toward caution. Federal Reserve and prospects for an interest rate hike The Fed s decision not to raise interest rates following the Federal Open Market Committee (FOMC) meeting on September 17 effectively prolonged lift-off uncertainty while introducing new concerns and reasons for investors to maintain a cautious near-term bias. Delaying the rate hike introduces the thought of more widespread economic deterioration both home and abroad than was previously thought, which is likely to take time to decipher. This suggests that market uncertainty and volatility among equities are likely to remain elevated as investors search for directional signs. [ 4 ] Important disclosures provided on page 8.

5 Lift-off uncertainty. The initial rate hike was marquee appeal, given that the Fed has not raised rates in nearly 10 years, dating back to June As such, not raising rates preserves an element of uncertainty, a possible negative for future sentiment and volatility. Economic scorecard. To a large degree, the Fed s dual mandate of full employment and modest inflation is approaching its target. In aggregate, the U.S. economy continues to reflect varying degrees of improvement. While manufacturing and retail sales levels are mixed, gross domestic product (GDP) growth is improving, inflation remains restrained, employment is firming, wage gains are increasing, housing is stable and consumer confidence is constructive. In our view, the U.S. economy has improved to a level that warrants something other than crisis-level rates. Year-over-year % change Closely watched indicator of consumer spending and inflation 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Average hourly earnings 2002 Source: Capital Economics. Data: 9/29/ Sep 29 Pace matters most. Beyond the initial rate hike is the pace of subsequent Fed hikes, which we believe will be in small increments and implemented over a prolonged period given the slow pace of global economic growth. Conceptually, this implies a contained inflation environment and, based on history, seems supportive of equity prices. As illustrated in the following chart, while past performance is no assurance of future results, according to Strategas Research Partners, equities, on average, have historically posted favorable returns three, six and 12 months following the date of the first rate hike. S&P 500 performance before and after first Fed tightening Date of first raise -6 mos -3 mos +3 mos +6 mos +12 mos Mar % 8.8% 9.9% 8.6% 4.1% Jan % 7.9% 19.1% 21.2% 2.6% Mar % 4.1% 6.0% 5.4% 13.3% Feb % 2.7% -3.9% -2.4% 1.9% Jun % 6.7% -6.6% 7.0% 6.0% Jun % 1.3% -2.3% 6.2% 4.4% Average 4.4% 5.2% 3.7% 7.7% 5.4% Source: Strategas Research Partners. Data as of February. Past performance is no guarantee of future results. Catalysts Several upcoming catalysts are likely to impact investor sentiment and equity prices throughout the fourth quarter, with the risk/reward appearing to be balanced. Third quarter results and guidance. Third quarter results and company guidance will provide an updated read on the pace of economic growth as reflected in quarterly results and forward guidance. At present, expectations for third quarter results are relatively low and expectations for 2016 seem too high and may need to be reset lower in light of evidence of further slowing in the rate of global growth. As such, volatility is likely to remain relatively high until visibility into 2016 improves. Importantly, in an earnings-driven market, as earnings go so too goes the broad market. Federal Reserve. Upcoming FOMC meetings will undoubtedly impact equity prices as investor angst and concern along with market volatility are likely to remain elevated leading up to each FOMC meeting until lift-off occurs. While another round of economic releases will provide an updated read on the pace of economic growth, in our view, the disappointing September employment report prolongs uncertainty as to the potential rate lift-off date. [ 5 ] Important disclosures provided on page 8.

6 Political wrangling and brinksmanship. The House Speaker transition, looming federal debt ceiling discussion and controversial presidential candidate campaign platforms (such as drug pricing) are likely to weigh on investor sentiment and equity prices throughout the fourth quarter, adding to uncertainty and overall market volatility. Holiday sales. Holiday sales have the potential to meet or exceed expectations. Improving wages, low energy prices, stable housing and generally favorable consumer confidence seem supportive of holiday spend levels. Additionally, according to the Bureau of Economic Analysis and the Federal Reserve Bank, consumers have deleveraged at a time when consumer assets are at new highs. The consumer household debt service ratio is near 35-year lows while household net worth is near all-time highs. While retail sales have yet to ramp, we think the potential exists for solid holiday sales. Seasonal tendencies. Seasonal tendencies favor fourth quarter performance. While the summer months are among the worst-performing months of the year, with September being the worst, October, November and December rallies are historically a consistent phenomenon, particularly when volatility is elevated and inflation is low. Our expectation is that seasonal tendencies will be among factors helping equities grind modestly higher into year-end, with significant upside likely held back by weak earnings growth. S&P 500 % of positive monthly returns 80% 75% 70% 65% 60% 55% 50% 45% 40% Next few months tend to be favorable ones 62% 55% 69% 57% 52% 54% 55% 45% 60% 66% Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Source: Strategas Research Partners. Data period: % Concerns The list of concerns impacting investors and equity prices is expansive, including global economic turmoil, potential deterioration of fundamentals, lack of technical price support, U.S. political wrangling, Fed-driven uncertainty, anxiousness surrounding third quarter results and company guidance, among others. Corporate spreads have widened. The widening of credit spreads (the difference between investmentgrade corporate bond yield minus 10-year Treasury yield) is typically associated with uncertainty, a risk-off bias, followed by a decline in equity prices. It is difficult to project equities to forge upward when credit spreads are widening. At a minimum, widening credit spreads implies continued uncertainty and future volatility. Basis points Rising credit risk = potentially weaker stocks Corporate bond spread* Source: BCA Research. Data: 8/31/15. *Investment-grade corporate bond yield minus 10-year Treasury yield. Pace of global growth remains slow. China matters. Much of the recent economic turmoil among emerging markets stems from the slowing in the rate of economic growth in China as the country transitions from capitalintensive to consumption-led growth. This too impacts U.S. equities it implies revenue and earnings growth for U.S. multinational companies is likely to be muted. This is part of the earnings reset for 2016 previously mentioned that is likely to occur in the fourth quarter. Without sales growth, profits can only grow if margins [ 6 ] Important disclosures provided on page 8.

7 expand through cost cutting, which is likely to be difficult to accomplish with a steadily improving labor market. Non-U.S. 32.5% S&P companies insulated to China S&P 500 revenues U.S. vs. non-u.s. U.S. 67.5% Europe 3.9% China 1.5% Asia Pacific ex. China 6.2% Source: FactSet Research Systems. Data: 8/31/15. Change from year earlier China s quarterly GDP 12% 8% 4% 0% A slowing giant 30% 20% 10% 0% Retail sales S&P 500 revenues by region Other 20.9% $ in trillions Source: The Wall Street Journal. Date: 8/24/15. $20 $15 $10 -$5 $0 U.S. 67.5% China vs. U.S China GDP 2014 U.S. GDP Conclusion We are maintaining our constructive outlook for equities leading into year-end and 2016 while maintaining a cautious near-term bias. As we look to year-end and into 2016, both uncertainty and market volatility are apt to remain elevated until greater clarity surrounding the pace of global growth, a likely Fed lift-off date and 2016 earnings estimates are gleaned. Among the questions faced today is whether multiples have fallen far enough to where expected economic and earnings growth can support current price levels. In our view, consensus earnings growth for 2016 over levels of roughly 10 percent is too optimistic and will likely need to be reset, perhaps to the 7 percent range, before price stabilization is likely to occur. We continue to believe that the lackluster year-to-date performance affords investors with tax-loss selling, portfolio upgrade and dollar-cost average opportunities, particularly for investors with time horizons of six to 18 months or longer. Due largely to restrained inflation, we remain biased toward cyclical sectors, including Information Technology, Healthcare, Consumer Discretionary, Financials and, to a degree, Industrials. In general, we believe: Information Technology is a pro-growth sector comprised of companies that, on balance, have strong free cash flow, mounting cash levels and attractive dividend prospects. Healthcare is a sector for all seasons, with defensive and growth-oriented companies. Ongoing debate in Washington about drug pricing is likely to result in increased near-term volatility and weigh on returns, particularly among biotechnology companies. Consumer Discretionary remains a bright spot. Improving employment conditions, favorable housing and the residual effects of low energy prices are likely to bolster spending. Financials generally benefit from an improving economic backdrop. Improving consumer credit quality and balance sheet metrics are positives. The sector may benefit once the Fed begins the rate normalization process. Industrials have an appealing longer-term valueadd profile. Near-term, however, many industrial companies are experiencing slow-growth headwinds, negatively impacted by the slowing in the rate of global growth and continued demand pressures in and around the oil patch. To a large degree, an improving global economic outlook is likely to be a prerequisite for improved performance. [ 7 ] Important disclosures provided on page 8.

8 Our S&P 500 price target is 2,100, with a downside bias contingent on third quarter results and company guidance, based on a multiple of 18 times our earnings estimate of $117. Our 2016 price target remains a work in progress. Contributed by: Terry D. Sandven Chief Equity Strategist U.S. Bank Wealth Management This commentary was prepared October 1,, and the views are subject to change at any time based on market or other conditions. This information represents the opinion of U.S. Bank and is not intended to be a forecast of future events or guarantee of future results. It is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. Any organizations mentioned in this commentary are not affiliated or associated with U.S. Bank in any way. Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Indexes shown are unmanaged and are not available for investment. The S&P 500 Index is an unmanaged, capitalization-weighted index of 500 widely traded stocks that are considered to represent the performance of the stock market in general. The Dow Jones Industrial Average (DJIA) is the price-weighted average of 30 actively traded blue chip stocks. The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, and is representative of the U.S. small capitalization securities market. The MSCI EAFE Index includes approximately 1,000 companies representing the stock markets of 21 counties in Europe, Australasia and the Far East. The MSCI Emerging Markets Index is designed to measure equity market performance in global emerging markets. Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. The value of large-cap stocks will rise and fall in response to the activities of the company that issued them, general market conditions, and/or economic conditions. Stocks of small-capitalization companies involve substantial risk. These stocks historically have experienced greater price volatility than stocks of larger companies and may be expected to do so in the future. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible difference in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. U.S. Bank N.A. (10/15) [ 8 ] reserve.usbank.com