U.S. Equities Quarterly Update: A Split Personality Market

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1 SITUATION ANALYSIS U.S. Equities Quarterly Update: A Split Personality Market Executive summary Equities ended the first quarter with the S&P 500 closing approximately 2 percent below all-time highs and a mere nine points above beginning of the year levels, all on the heels of mixed signals of economic strength. On average, first quarter performance was lackluster for U.S. large cap stocks, negatively impacted by the slow pace of economic growth in both the United States and abroad, declining oil prices and a strengthening dollar putting downward pressure on earnings, as well as fears of a looming Federal Reserve (Fed) rate hike. While we continue to maintain a constructive outlook for equities, valuation gives us reason for near-term pause. The S&P 500 continues to trend near all-time highs as earnings are being reset lower an unsustainable trend, in our view. We expect volatility to remain elevated until visibility of earnings improves following the release of first quarter results and the Fed initiates its first interest rate hike. Our published 2015 S&P 500 price target remains 2,150, based on a price-earnings multiple of 18 times our 2015 earnings estimate of $119. Our bias is to the upside, pending first quarter results and company guidance. Review of performance To a large degree, first quarter performance reflects a split personality market, with investor sentiment frequently shifting between angst and optimism, often influenced by the economic release du jour. Market and sector performance. First quarter performance was varied and generally below expectations, with international outpacing domestic stocks, small caps outperforming large and sector performance varying greatly, with no discernible leadership trends emerging between defensive and cyclical sectors. The developed international MSCI EAFE index is providing overall performance leadership so far in This strong outperformance is somewhat surprising given the slow pace of global growth. Performance appears to be favorably impacted by central bank liquidity, particularly in Japan and the eurozone, and, to a degree, falling currency values relative to the U.S. dollar. While first quarter volatility was elevated and performance lackluster, it seems premature to abandon the Goldilocks-like economic outlook of moderate growth when inflation remains contained, interest rates are low, valuations are short of extremes, and the list of compelling alternatives to equities appears limited. The performance of the small cap-oriented Russell 2000 has improved after lagging in Favorable small cap performance is typically indicative of an improving economy, which can bode well for equities. However, this year, small caps are likely most favorably impacted by the strong dollar. Compared to their large cap multinational brethren, many small cap companies are focused on the United States and thus are less impacted by the negative currency translation effects of a rising dollar. Sector performance appears highly fragmented, with over a 12 percentage point swing between the best-performing Healthcare and worst-performing Utilities sectors. The 3.6 percent decline in Energy is understandable, following the approximate 50 percent plunge in crude oil prices. The Utility sector underperformance presumably reflects investor angst over the bondlike qualities of the sector in anticipation of an eventual rising interest rate environment. Important disclosures provided on page 8.

2 Index Market and sector performance Price 3/31/ March YTD * S&P 500 2, % -1.7% 0.4% Dow Jones Industrials 17, % -2.0% -0.3% Russell , % 1.6% 4.0% MSCI EAFE 1, % -2.0% 4.2% MSCI Emerging Markets % -1.6% 1.9% Sectors of the S&P 500 Weight Information Technology 19.7% 18.2% -3.4% 0.2% Financials 16.2% 13.1% -0.8% -2.5% Healthcare 14.9% 23.3% 0.8% 6.2% Consumer Discretionary 12.6% 8.0% -0.6% 4.4% Energy 8.0% -10.0% -2.0% -3.6% Consumer Staples 9.7% 12.9% -2.4% 0.4% Industrials 10.4% 7.5% -2.7% -1.4% Materials 3.2% 4.7% -5.0% 0.4% Utilities 3.0% 24.3% -1.3% -6.0% Telecommunication Services 2.3% -1.9% -3.8% 0.3% Source: FactSet Research Systems. *Data: 3/31/15; excludes dividends. Six-year anniversary. The current bull market is advancing in years, having reached its six-year anniversary on March 9, While performance is not a guarantee of future results, only three other bull markets (out of 12) since World War II (WWII) have lasted this long, and only two went on to celebrate their seventh birthday. According to S&P Capital IQ, since WWII the average bull market has lasted approximately four years, and the current bull market is only the fourth to make it to year six. As such, while the probabilities of a market downturn are on the rise based on history, in our view, the environment remains favorable for the bull market to extend to year seven. Importantly, bear markets typically occur in and around recessions when inflation is heating up, the Fed is in tightening mode, and investor sentiment is approaching euphoria or extreme optimism rather than in the middle of an economic recovery and when sentiment remains guarded. S&P 500 annual total returns Year Return Year Return Year Return Year Return Year Return Source: Standard & Poor s. Highlighted figures reflect years with declining returns. Important disclosures provided on page 8. Page 2

3 Technical influences. Equities have been generally range-bound since the start of the year, with the S&P 500 largely trending between 3 percent above and below the 50-day moving average. In our view, it seems plausible to expect the S&P 500 to remain largely range-bound throughout the second quarter and into the second half of the year. In general, we continue to expect equities to remain a buy the dips, grind higher market, with any weakness likely reflecting more of pause that refreshes and resets, and not the start of a prolonged bear market. Earnings Equities remain an earnings-driven market connected to economic health, in our view. Consensus 2015 earnings estimates for the S&P 500 have progressively been reset lower, dropping approximately 5 percent since the beginning of the year to $118.35, as of the end of the first quarter according to Bloomberg. Much of this reset is due to the negative effects of the plunge in oil prices and rising dollar. Negatively impacted by oil. Energy represents a significant portion of the S&P 500 with, according to Strategas Research Partners, approximately 12 percent of S&P 500 earnings represented by the Energy sector. Additionally, while it seems premature to conclude that oil has reached a bottom, there is evidence suggesting that the sector is stabilizing, reflecting lowered expectations due to things such as 1) rig counts are down, 2) capital expenditure (capex) spending is being pared back, 3) work forces are being reduced, 4) instances of companies facing capital constraints are becoming more commonplace, and 5) analyst downgrades are becoming more prevalent, reflecting lowered expectations. Barrels per day, 4 week average (in thousands) Importantly, while rig counts are drastically being reduced, production continues to increase. A moderating in the trajectory of production could serve as a catalyst for a higher level of interest in the sector and upside to energy-related shares. 9,500 8,500 7,500 6,500 5,500 4,500 Jul U.S. crude oil rig count and U.S. crude oil production U.S. crude oil production Mar Nov Oil rig count Source: Strategas Research Partners. Data through 2/28/15. Jul ,800 1,500 1, Feb The United States, Saudi Arabia and Russia are among the largest oil and gas producers in the world, as illustrated. That said, low oil prices do not impact all countries equally. Net exporters, such as Saudi Arabia and Russia, obviously are seeing their cash receipts reduced as oil prices trend lower. Conversely, net importing countries on average are benefitting from lower energy prices, and this potentially bodes well for China, Japan and India, among others, as lower energy costs effectively serve as a tax cut. Energy is a significantly larger share of the U.S. equity market than the economy 14% Oil production by country 14% Market measures 12% 12% 10% 10% 8% 6% 4% Economic measures % of oil production 8% 6% 4% 2% 2% 0% 0% U.S. Saudi Employment GDP S&P market cap S&P earnings Arabia Russia China Canada UAE Iran Iraq Mexico Kuwait Source: Strategas Research Partners. Data through Source: Strategas Research Partners (EIA). Data through Important disclosures provided on page 8. Page 3

4 Largest oil net importers and exporters 10% S&P 500 operating margin (trailing 12 months) Barrels per day (in millions) Net importers Net exporters 9% 8% 7% 6% 5% Average United States China Japan India South Korea Germany France Singapore Spain Italy Taiwan Netherlands Thailand Indonesia Turkey Mexico Iran Algeria Kazakhstan Norway Canada Angola Qatar Venezuela Nigeria Iraq Kuwait UAE Russia Saudi Arabia Source: Strategas Research Partners (EIA). Data through In aggregate, first quarter results should provide greater insight and clarity into the degree to which lower oil prices are weighing on earnings and whether consensus estimates for 2015 have been reset too low. Pressured by dollar strength. The strong dollar reflects the health of the U.S. economy and it is also having an adverse impact on the profitability of the large multinational companies. While the rally in the dollar may not have much further to run, it, too, seems unlikely that the earnings of multinational companies will accelerate in the near term unless the U.S. currency weakens. Peak profit margins. S&P 500 performance has benefited from an improving operating margin environment stemming from the financial crisis in 2008, bolstered by low interest rates and tight wage gains. While operating margins are expected to remain above historical levels for the foreseeable future, it seems margins are on the cusp of change. Margin pressures are likely to mount when interest rates and wage gains eventually trend upward. While this is in the early stage of development and likely to unfold over several quarters, it does suggest that operating margins are unlikely to improve above current levels during this economic cycle. 4% 3% Source: Strategas Research Partners. Data through 2/28/15. Interest rates Fears of rising interest rates have been a source of recent volatility for the equity market. While the Fed has removed patient from its statement, it remains data dependent. To a degree, this implies increased volatility, with the economic statistic du jour likely influencing daily price swings and fueling speculation of when the Fed will begin raising rates. Remaining accommodative. While the path toward interest rate normalization remains a work in progress, we continue to believe that more important than the initial rate hike is the pace, which we expect to be slow and employed over a prolonged period. Performance following rate hikes. The Fed has not raised interest rates since 2006, prior to the financial crisis, leaving investors wondering what the impact will be to equity returns when the Fed reverses course and begins to hike rates. The Fed would like to move away from a crisis level, zero interest rate environment, signaling that the U.S. economy has improved to levels not warranting extreme stimulative measures to grow. Consensus expectations are for the Fed to move toward rate normalization in a slow and judicious manner, with interest rates, on average, remaining relatively low for longer. For equity investors, recent history shows that the equity market, in general, advanced after the first rate hike. According to Strategas Research Partners, following the first rate hikes in 1983, 1987, 1988, 1994, 1999 and 2004, as illustrated, the S&P 500 was up on average 3.7, 7.7 and 5.4 percent three, six and 12 months after the first rate hike, respectively. This Important disclosures provided on page 8. Page 4

5 suggests that the seemingly high degree of investor concern and angst over an eventual Fed initial rate hike may be misguided. Again, we continue to believe the pace of subsequent rate hikes is more important to future equity returns than the initial rate hike. S&P 500 performance before and after first Fed tightening 30x 25x 20x 15x S&P 500 P/E with long-term average Average 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 (3/13/15). Valuation Valuation is of mounting concern. The S&P 500 has trended flat, with an upward bias near all-time highs since the beginning of the year while earnings continue to be reset lower, which is an unsustainable trend, in our view. Price-earnings multiples. The S&P ended the first quarter trading at a price-earnings (P/E) multiple of 18.3 and 17.5 times trailing 12-month and 2015 consensus earnings estimates of $ and $118.35, respectively. Compared to historical levels, current levels are stretched but not necessarily at extremes. In aggregate, stocks appear priced-to-perfection, with a margin of error that continues to narrow. While price-earnings multiples appear within historical levels, of concern is the slowing in the rate of earnings growth. At present, consensus earnings growth for the S&P 500 in 2015 over 2014 levels is a relatively modest 5 percent. 10x 5x Source: Strategas Research Partners. Data through 3/31/15, trailing 12-month basis. Aided by dollar strength. Dollar strength has led to a rise in U.S. price-earnings multiples, reflecting high demand for U.S. financial assets. Current priceearnings multiples seem supportive as long as the dollar remains near or above present levels. Real Dollar Index S&P 500 P/E vs. Real Dollar Index (next 12 months) Dollar S&P 500 P/E Source: Strategas Research Partners. Data through 2/28/15. Valuation impact of interest rate hikes. Reflected in the illustrated price-earnings trend line chart is the implied implications for broad-market valuation in a rising interest rate environment. In general, market multiples tend to drop over time when interest rates rise and vice versa. While past performance is no assurance of future outcomes, since 1987, following the first rate hike, the S&P 500 has experienced only a modest reduction in next 12-month price-earnings multiples three, Important disclosures provided on page 8. Page 5

6 six and 12 months before and after Fed rate hikes, providing historical precedence that current multiples are warranted or at least can be supported for the foreseeable future, even after the Fed raises rates. S&P P/E points change before and after Fed rate hike (next 12 months) Date of first raise -6 mos -3 mos +3 mos +6 mos +12 mos Jan Mar Feb Jun Jun Average Source: Strategas Research Partners (3/13/15). Focused on inflation. Historically, wage inflation has led to tighter credit, which increases the chance of a recession. Today, average hourly earnings growth stands at a modest 1.6 percent. The recent strength in the dollar acts as de facto tightening, and the drop in oil prices could buy the economy another year or two of low headline inflation. As such, valuation is often a poor timing tool. Additionally, with inflation low and the list of compelling alternatives to equities remaining limited, it seems plausible that equity valuations can remain stretched until evidence of mounting inflation becomes more prevalent. Catalysts First quarter results and company guidance, Fed commentary, another round of economic indicators, price of oil, and geopolitics are among catalysts likely to impact equity prices throughout the second quarter and into the second half. Quarterly results. First quarter results and forward guidance will ultimately set the tone for performance throughout the second quarter, consistent with an earnings-driven (versus price-earnings expansion or Fed-liquidity) equity market. Expectations for earnings have been lowered following the drop in price of crude oil and rise of the U.S. dollar. Additionally, with expectations low, it seems plausible for companies, on average, to be cautious in their forward statements, setting the stage for upside surprises in the current and subsequent quarters. FOMC meetings. The next four Federal Open Market Committee (FOMC) meetings are scheduled on April 28-29, June 16-17, July and September Summaries of economic projections and press conferences are slated to follow the June and September meetings, prompting consensus thinking that should the Fed begin the rate normalization process, they would do so following either the June or September meetings. With consensus thinking that the Fed is increasingly leaning toward September, this may imply that the volatility and somewhat muted returns experienced throughout the first quarter could well continue into the second and third quarters. Economic indicators. With the Fed reporting to be increasingly data dependent, upcoming employment, housing, manufacturing, sentiment, etc. reports will provide updated readings on the pace of economic improvement. With consumer spending representing approximately two-thirds of economic growth, spending patterns of consumers throughout the second quarter are expected to impact equity performance. So far in 2015, consumers appear to be spending more on experiences (food and drink) versus goods. Consumer spending is widely expected to ramp and broaden out in the second quarter, prompted by low energy prices, placing focus on monthly retail sales releases. While gasoline prices at the pump are up roughly 20 percent from January lows, as of the end March, the average price of regular gasoline in the United States was $2.45, which was $1.13 below year-ago levels, according to the U.S. Energy Information Administration. Additionally, with modest optimism surrounding wage gains, the underlying fundamentals seem to be in place for future retail sales gains. Seasonality tendencies favor near-term performance. As illustrated, seasonality tendencies suggest favorable April performance followed by summer complacency. Looking toward year-end, it seems plausible that the fourth quarter could be the best-performing quarter this year. Important disclosures provided on page 8. Page 6

7 S&P 500 average monthly performance since % 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% Seasonal favorable through April Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Source: Strategas Research Partners. Data period The next two quarters may be needed to ascertain earnings visibility and conviction. By that time, the FOMC June and September meetings will have come and gone, including market reaction to potential rate hikes, and clarity surrounding oil production, inventories and overall supply/demand imbalances should help establish a bottom in oil-related companies. Renewed optimism about growth prospects in 2016 should add to investor sentiment. Sector preferences We continue to maintain a cyclical bias, with preference for sectors and companies that appear well-positioned to benefit from an improving, slow-growth, low inflationary, U.S.-centric economic environment (Information Technology, Healthcare, Consumer Discretionary, Energy and, to a degree, Financials). In the near term, a slower pace of advance for the U.S. dollar should alleviate some of the pressure on high foreign sales companies and commodity cyclicals. Longer term, consumer discretionary companies seem well positioned to outperform as low inflation, accommodative short rates and improving labor markets support the consumer. Conclusion As the equity bull market advances into its seventh consecutive year, the wide equity price swings experienced throughout the first quarter seemingly reflects a split personality market, with sentiment frequently shifting from angst to optimism. In aggregate, we consider equities to be priced-to-perfection. We also expect equities to remain a buy the dips, grind higher market, with weakness reflecting more of a pause that refreshes and resets, and not the start of a prolonged bear market. Bear markets have typically occurred in and around recessions rather than in the middle of an economic recovery, when inflation is heating up, the Fed is in tightening mode, and investor sentiment is approaching extreme optimism. Inflation and earnings are key. At present, inflation appears under control. The absence of widespread and ramping inflation also serves as the basis for interest rates to stay low for longer. Earnings remain a wildcard, with lower oil prices and a rising dollar negatively impacting estimates. Valuation gives us reason for pause. Equity prices have stayed near all-time highs throughout the first quarter while earnings are being reset lower, an unsustainable trend in our view. It seems plausible that the S&P 500 remains generally range bound between 2,000 and 2,150 throughout the summer until visibility of earnings, Fed rate decisions and overall global growth improves. Our published 2015 price target for the S&P 500 is 2,150, based on a price-earnings multiple of 18 times our 2015 earnings estimates of $119. We see modest upside to our target based on a slightly higher multiple on modestly lower earnings. We will officially reassess our earnings and multiple assumptions pending first quarter results. Important disclosures provided on page 8. Page 7

8 Contributed by: Terry D. Sandven Chief Equity Strategist U.S. Bank Wealth Management reserve.usbank.com Investment products and services are: NOT A DEPOSIT NOT FDIC INSURED MAY LOSE VALUE NOT BANK GUARANTEED NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY This commentary was prepared April 1, 2015, 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. The U.S. Dollar Index Indicates the general international value of the U.S. Dollar by averaging the exchange rates between the U.S. dollar and six major world currencies. 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. (4/15) Page 8