Equity Research Equity Market Outlook: The Receding Tide. December 7, Equity Strategy

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1 December 7, 2015 Equity Research 2016 Equity Market Outlook: The Receding Tide Monetary Policy Shift Separates The Strong From The Weak In 2016 Significant monetary policy went hand in hand with significant gains for U.S. stocks in the first five years of the economic recovery. However, the rising tide ended with balance sheet expansion a year ago, resulting in a slowdown in bull market gains and dispersion among sector and industry returns in In our view, Fed liftoff will mark the beginning of a receding tide for U.S. stocks, resulting not in the end of the bull market, but an increasingly disperse market driven by sector, industry, and stock specific stories as opposed to easy money in the year ahead. Equity Strategy As U.S. rates rise we expect several major themes to play out in stocks: First, we think equity investors will begin to focus on quality, and pay closer attention to balance sheets as the cost of debt rises in Meanwhile, higher short rates seem likely to transfer the center of volatility in the index from commodity and currency-sensitive shares to rate-sensitive shares. Domestic growth should remain steady or strengthen, supported by the U.S. consumer, while nondomestic growth continues to succumb to the pressure of a secular slowdown in emerging market growth. Finally, we think there is plenty of room for policy recommendations to rock the boat for stocks the 2016 election year. We expect S&P 500 EPS to grow about 8% to $129 in 2016, following 2% growth in 2015E and 6.8% growth in Our view on earnings is contingent upon the following assumptions: (1) oil prices are in the process of bottoming, (2), the dollar rises a more manageable 5-7% in 2016, and (3) the Fed achieves liftoff but long rates remain somewhat anchored. Our fundamental model of the market PE, which includes rates, inflation, demographics and the federal deficit, suggests that the market multiple should contract a touch to 17.4x, after rising from 10x to 18x over the last 6 years. Combining our modeled PE and EPS estimates yields a 12- month forward fair value estimate of 2,245 for the S&P 500. However, we see downside risk to 1940, in the event the economy is unable sustain tightening, and upside potential to 2325, should economic growth surprise significantly, resulting in faster rate hikes from the Fed. While our fundamental outlook leans constructive, our read of market technicals is more mixed. The longer-term bull trendline has not been broken, despite waning breadth and weak momentum, supporting our view that the market is consolidating within the scope of a longer-term uptrend, not topping. If defensive sectors start to dominate performance, we would be forced to change our view. We continue to suggest large caps are likely to outperform small, growth outperform value, and stocks outperform bonds again in Our preferred factors are momentum and quality, with growth a not-so-distant third. We recommend investors overweight the technology and consumer discretionary sectors, where momentum is strongest, growth most stable, political risks low, and macro trends supportive in In our view, investors should marketweight industrials, financials (upgrade from underweight), health care, staples and energy in 2016, where our view is more mixed. Finally, we suggest underweighting materials, telecom and utilities (downgrade from market weight). Materials faces an unfortunate challenge of high earnings growth expectations amid a persistent deterioration in metals prices and ongoing emerging market weaknesses. Meanwhile, among S&P 500 sectors, telecom and utilities are most vulnerable to higher interest rates. Please see page 26 for rating definitions, important disclosures and required analyst certifications All estimates/forecasts are as of 12/07/15 unless otherwise stated. Gina Martin Adams, CFA, CMT, Equity Strategist (212) gina.martinadams@wellsfargo.com Peter Chung, Strategy Analyst (212) peter.k.chung@wellsfargo.com Wells Fargo Securities, LLC does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of the report and investors should consider this report as only a single factor in making their investment decision.

2 2 Table of Contents I. Receding Policy Tide Should Separate the Strong from the Weak in 2016 (p. 3) II. Themes A. Monetary Policy Shift Still Center Stage (p. 4) B. Quality is the New Black (p. 5) C. Rate Sensitives Likely the Key Center of Volatility (p. 6) D. Commodities and Currencies Still Make Waves (p. 7) E. Domestic Outlook: U.S. Consumer Gathers Momentum (p. 8) F. Non-consumer Economy: Tale of Two Worlds (p. 9) G. Election Year: New Uncertainty or Welcome Change (p. 10) III. (p. 11) IV. Valuation and Fair Value Estimate (p. 13) V. Style Recommendations (p. 14) VI. Sector & Industry Recommendations (p. 15) A. Overweight: Technology and Discretionary (p. 17) B. Marketweight: Industrials, Financials, Staples, Health Care, Energy (p. 19) C. Underweight: Materials, Utilities, Telecom (p. 24) Equity Strategy EQUITY RESEARCH DEPARTMENT

3 3 I. The Receding Policy Tide Likely Separates the Strong from the Weak in 2016 Significant monetary policy went hand in hand with significant gains for U.S. stocks in the first five years of the economic recovery. However, the rising tide ended with balance sheet expansion a year ago, resulting in a slowdown in bull market gains and dispersion among sector and industry returns in In our view, Fed liftoff will mark the beginning of a receding tide for U.S. stocks, resulting not in the end of the bull market, but an increasingly disperse market driven by sector, industry, and stock specific stories as opposed to easy money. On the technical side, upside potential should be driven by any improvement in retail flows, while downside risk is likely highly contingent on monetary policy impacts on pricing in commodities, currencies, and rates. Meanwhile, the fundamental outlook will likely reflect a trade-off between earnings improvement and valuation compression in the year ahead. Our S&P month fair value estimate is 2,245, for while gains will not be easily attained without support from the Fed, the economy is still likely to grow, producing earnings growth and increasing levels of investor optimism in the year ahead. Themes: As U.S. rates rise we expect several major themes to play out in stocks: First, we think equity investors will begin to focus on quality, and pay closer attention to balance sheets in Leverage drove 57% of the last five years increase in ROE as rates were remarkably accommodative. However, a higher cost of debt should result in some degree of balance sheet scrutiny on the part of equity investors. Second, higher short rates are likely to induce volatility for rate-sensitive shares in the S&P 500. This should be beneficial for U.S. banks but may pressure high yielding and capital-intensive sectors with limited growth prospects. Third, dollar strength and commodity price weakness likely continues, though the pressures may ease somewhat in the year ahead, as these asset classes had a head start in adjusting to tighter Fed policy. We expect divergences among commodity price may open next year, given ongoing cuts to supply and production. Fourth, domestic growth seems likely to remain steady or strengthen, supported by the U.S. consumer, while nondomestic growth continues to succumb to the pressure of a secular slowdown in emerging market growth. Finally, we think there is plenty of room policy recommendations to rock the boat for stocks this election year, with U.S. competitiveness falling, the U.S. corporate tax rate the highest amongst OECD (Organization for Economic Co-operation and Development) countries (at 35%), more than 2 of consumption allocated to the health care sector alone, and plenty of wood to chop on the federal deficit. : We expect S&P 500 EPS to grow about 8% to $129 in 2016, following 2% growth in 2015E and 6.8% growth in The bottom-up consensus is expecting $127 in After extensive downward revision to forward estimates, we believe bottom-up consensus estimates now appear relatively achievable for However, our view on earnings is contingent upon the following assumptions: (1) oil prices are in the process of bottoming, (2), the dollar rises a more manageable 5-7% in 2016, and (3) the Fed achieves liftoff but long rates remain somewhat anchored. Valuation Estimates: The first leg of monetary shift resulted in a stall in the valuation uptrend in place for the last several years, and we suspect the second leg to result in similar difficulty for PE expansion. Our fundamental model of the market PE, which includes rates, inflation, demographics and the federal deficit, suggests that the market multiple should flatten contract a touch, to 17.4x, after rising from 10x to 18x over the last 6 years. Combining our modeled PE and EPS estimates yields a 12-month forward fair value estimate of 2,245 for the S&P 500. However, we see downside risk to 1,940 in the event the economy is unable sustain tightening, and upside potential to 2,325, should economic growth surprise positively, resulting in faster rate hikes from the Fed. Style and Sector Recommendations: We continue to suggest large caps are likely to outperform small, growth outperform value, and stocks outperform bonds again this year. Our preferred factors are momentum and quality, with growth a not-so-distant third. We recommend investors overweight technology and consumer discretionary, where momentum is strongest, growth most stable, political risks low, and macro trends supportive in In our view, investors should market-weight industrials, financials (upgrade from underweight), health care, staples and energy in 2016, where our view is more mixed. Finally, we suggest underweighting materials, telecom and utilities (downgrade from marketweight). Materials face an unfortunate challenge of high earnings growth expectations amid a persistent deterioration in metals prices and ongoing emerging market weaknesses. Meanwhile, among S&P 500 sectors, telecom and utilities are most vulnerable to higher interest rates Equity Market Outlook: The Receding Tide EQUITY RESEARCH DEPARTMENT

4 4 II. Monetary Policy Shift Still Center Stage Monetary policy shifts are likely to remain center stage in 2016, as liftoff from the Fed contrasts starkly with continued easing in other developed markets. In our view, the end of U.S. balance sheet expansion and great easing in Europe and China in 2015 marked the first leg of a great policy divergence underway, and Fed "liftoff" will mark the second leg of the theme. While the first stages of adjustment most profoundly impacted commodity and currency markets, we suspect the next stage of the adjustment will more strongly center on rates. We think the economic impact of tighter policy will be minimal, particularly if the Fed tightens at a slow pace, as expected. Like the consensus, we believe domestic growth should be stable in the year ahead, supported by consumption and construction. However, unlike the consensus we believe emerging market growth could continue to struggle to record much acceleration in the year ahead, contending with dollar strength, capital outflows and weak commodity prices. The financial market impact of tighter policy could be more worrisome, however. Historically, Fed tightening has resulted in a slowdown in bull market gains, but not necessarily a top, as earnings growth accelerates with tighter policy. However, the commodity and currency adjustments were challenging last year, and corporate spreads are already widening, suggesting the payback for easy money could be more extensive this time around. In our view, there is yet little evidence that the longer term bull market for stocks is over. Instead, we see a market continuing to normalize with policy. As was the case this year, we see higher dispersion among sector and industry returns likely, as the receding tide of monetary policy results in greater separation between market winners and losers in Short Term Interest Rates By Country -0.4 US 3 Month - Yield (Left) Euro 3 Month - Yield (Left) China 3 Month - Yield (Right) -0.5 Jan-13 Oct-13 Jul-14 Apr Impact of Fed Tightening By Asset Class Average Returns Around Initial Rate Hikes Since M 6M 6M 12M Before Before After After S&P % % 0.6% Oil, WTI 18.5% % 17.2% DXY Dollar Index -2.4% 0.1% % High Grade Spreads (bps chg) High Yield Spreads (bps chg) % 8% 7% 6% 5% 4% 3% 2% 1% Domestic v. Emerging Market GDP Growth Actual and Estimated Annual Growth U.S. (Wells Fargo) Emerging Markets (Wells Fargo) U.S. (Consensus) Emerging Markets (Consensus) E 2016E estimates 2,300 2,100 1,900 1,700 1,500 1,300 1, S&P 500, With & Without QE S&P 500 Price and Moving Averages Non-QE Periods S&P D MAvg 200D MAvg Equity Strategy EQUITY RESEARCH DEPARTMENT

5 5 II. Quality is the New Black The end of Fed balance sheet expansion appears to have marked the end of the "rising tide" that lifted all stocks in the U.S. market. Indeed, one impact of the changing tides of monetary policy was a breakout in sector dispersion and reduced stock level correlation in As the broad market may continue to struggle to record strong gains with less monetary support, we expect the natural result to be continued divergence between winners and losers. However, while 2015 returns have been concentrated among momentum and growth names, we think quality will be the "new black" in Rising rates seem likely to highlight company management of balance sheets for the first time in the post-crisis era. Debt/EBITDA is back to its pre-crisis peak and total debt on S&P 500 balance sheets more than double the pre-crisis level. Already, investors appear to be fading stocks that buyback stocks (many of whom tapped debt markets to do so), and are beginning to favor higher quality companies. Since its peak on February 24th, 2015, the S&P 500 buyback index had underperformed the S&P 500 by 1,154 basis points, the largest and longest period of underperformance since Jan-05 S&P 500 Sector Return Dispersion Jun-05 S&P 500 Sector Return Dispersion Monthly YoY Price Change, 12MMA, Highest less Lowest Return Nov-05 Apr-06 Sep-06 Feb-07 Jul-07 Dec-07 May-08 Oct Debt-to-Equity Buybacks Mar-09 Aug-09 Jan-10 Jun-10 Nov-10 Apr-11 Sep-11 Feb-12 Jul-12 Buybacks Fading, Quality Gaining? Factor Returns Dec-12 May-13 Oct-13 Mar-14 Aug-14 Jan-15 Jun-15 Nov YTD Factor Returns S&P 500 Constituents Total Returns 2015 YTD Factor Top Decile % Return Benchmark 3. Bottom Decile % Return Spread 200D % Price Chg % 12.2% Revenue 1Y Growth 7.3% -1.6% 8.9% Price % Diff to 200D MAvg 6.4% -1.4% 7.8% Cash Flow 1Y Growth 7.8% 0.6% 7.2% Sales Surprise % Latest Qtr 4.9% -1.4% 6.3% Market Cap 4.2% -0.3% 4.4% Net Income 1Y Growth 2.7% -1.1% 3.8% Margin 1Y Growth 2.3% -0.6% 2.9% Analyst Rating 3.8% 1.3% 2.5% Debt-Equity Ratio* 0.6% -1.7% 2.3% NTM Est 3M% Chg 1.5% -0.7% 2.3% ROE EPS Surprise % Latest Qtr -0.7% -1.3% 0.7% ROA 0.3% -0.3% 0.6% Asset Turnover 1.4% 2.7% -1.3% 50D % Price Chg % -2.5% Price to Forward EPS* -4.8% -0.7% -4.1% Price to Trailing EPS* -4.7% 0.1% -4.8% Dividend Yield % -5.9% Price to Sales* -5.8% 0.8% -6.6% Price to Book* -7.2% -0.3% -6.9% Beta 1Y -8.4% % Price Volatility 90D -10.5% -0.1% -10.4% Price to Cash Flow* -14.9% 0.3% -15.3% *Lower values fall into top decile ranking. Source: Bloomberg, Wells Fargo Securities, LLC 2016 Equity Market Outlook: The Receding Tide EQUITY RESEARCH DEPARTMENT

6 6 II. Rate-Sensitives Likely the Key Center of Volatility While we think the Fed moving rates from 0 to 1.25% is not likely to broadly slowdown domestic growth, it is likely to have significant impacts on performance in financial markets. Within the S&P 500, the impact should be particularly significant on rate sensitive issues, which have enjoyed a long period of relatively stable rates. On average, stocks have tended to go nowhere in past periods of policy tightening, as valuation compression is largely offset by earnings growth in the early stages of a rate hike. However, there is no consistent pattern of performance around rate hikes. 62.5% of the time since 1970, stocks have been higher six months after the first policy tightening, and 75% of the time, stocks have been higher 12 months later, suggesting the first hikes are unlikely to end the bull trend. Most frequently, rate-sensitive and defensive sectors tend to underperform, as economic growth boosts cyclical performance and higher rates weigh relatively on performance of rate sensitive shares. At the sector level, we see higher rates dampening prospects for the higher dividend yield paying, capital-intensive industries and defensive sectors lacking growth. Thus, utilities and telecom appear areas of considerable risk going into However, higher rates should offer some short-term reprieve for U.S. financials, which have been struggling with the generally stagnant rate environment for years. That said, to get really excited about financials relative prospects, one needs to witness some increase in the slope of the yield curve, a forecast we are not prepared to make unless growth accelerates rapidly. S&P 500 Batting Averages Around Rate Hikes Percent os Time Positive Sector Returns Around Initial Rate Hikes 12M 6M 6M 12M Before Before After After S&P % % 75. Energy % 37.5% 62.5% Materials 87.5% 62.5% % Industrials 87.5% 87.5% 62.5% 62.5% Discretionary Staples 62.5% 87.5% 37.5% 50. Health Care 62.5% 62.5% Financials 37.5% Technology % 50. Telecom % 62.5% 50. Utilities 62.5% 62.5% % Yield Curve and Financials Relative Price Yield Curve & Financials Relative Performance Rate Hike Period 10s2s Spread (left) S&P 500 Financials Relative Price (right) -1.0 Jan-02 Jan-03 Jan-04 Jan-05 Jan S&P 500 Price Performance Around Rate Hikes Average Sector Returns Around Initial Rate Hikes 12M 6M 6M 12M Before Before After After S&P % 6.9% 1.3% 0.6% Energy 25.6% 12.7% % Materials 13.6% 8.5% % Industrials 11.4% % 0.2% Discretionary % -0.3% -3.7% Staples 6.9% 7.3% -1.1% 0. Health Care 7.5% 7.3% 1.2% 7.3% Financials 1.3% 2.7% -6.2% -5.3% Technology 17.9% 8.6% 6.4% 3.5% Telecom 8.7% % 0.7% Utilities 2.7% 1.2% -2.9% 0.9% 10Y U.S. Treasury Yield and S&P 500 Utilities Relative Price US Treasury 10 Year Yield (Left) S&P 500 Utilities Relative Price (Right) Equity Strategy EQUITY RESEARCH DEPARTMENT

7 7 II. Commodities and Currencies Still Make Waves In 2015, commodity and currency movements explained an unusual amount of divergence in stock price returns. Indeed, to the end of October, the average stock price return for the 100 S&P 500 companies with the strongest correlation to oil prices was -17.1%, while the average return for the 100 companies with the strongest negative correlation to the dollar was -15.6%. While the trade was the same for all commodities in 2015 (i.e. down), we expect some divergence in commodities may emerge in the year ahead due to supply adjustments that got underway in recent months. In our view, metals and agriculture prices still have considerable downside risk due to emerging market production concentration and currency exposure. Oil appears most likely to stabilize first due to the U.S. supply response as well as the renewed bout of geopolitical pressures, in our view. The dollar surge from the middle of 2014 to early 2015 was historic in magnitude, and indeed was one of only 3 such moves in the last thirty-five years. We think it unlikely another 2 gain over such a short period of time will be replicated. However, after consolidating gains since March, it appears the dollar is set to resume its uptrend in 2016, provided the Fed does indeed tighten rates. We think the risk remains to the upside for the dollar, and would generally avoid stocks with high negative correlations to the U.S. currency Jan-11 Mar-11 May-11 Jul-11 Energy and Agriculture Commodity Indices Industrial and Precious Metals Indices BBG Agriculture BBG Energy Sep-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Source: Bloomberg, Wells Fargo Securities, LLC 4% -1% -6% -11% -16% -21% Sep-12 Nov-12 Stock Performance in S&P 500 Jan-13 Mar-13 May-13 Jul-13 Price Return Jan Nov 30, % Average Return Top Quintile International Sales Sep % Nov-13 Average Return Bottom Quintile Correlation to USD Jan-14 Mar-14 May-14 Jul % Sep-14 Nov-14 Average Return Top Quintile Correlation to Oil, WTI Jan-11 Mar-11 Industrial and Precious Metals Commodity Indices May-11 Jul-11 Industrial and Precious Metals Indices BBG Industrial Metals BBG Precious Metals Sep-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Source: Bloomberg, Wells Fargo Securities, LLC Sep-12 Nov-12 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 DXY Dollar Index Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov Equity Market Outlook: The Receding Tide EQUITY RESEARCH DEPARTMENT

8 8 II. The Domestic Outlook: U.S. Consumer Gathers Momentum While global monetary policy moves are likely to make waves again in 2015, they are not the entire story for stocks. In our view, an improving outlook for the U.S. economy is likely to stand out amid a persistently weak global growth landscape. Since 88% of growth in the U.S. is services oriented, and 7 of economic growth is exclusive to consumption, these categories within the S&P 500 deserve a nod for We expect recovering consumer spending will power a broadening of growth in the U.S. economy. However, unlike 2015, spending power should come from growth in income, as opposed to falling gas prices. The bulk of the case for broadening spending growth over the last year came from the discretionary income windfall from lower gas prices. Now that the anniversary is upon us, the consumer will have to get their spending power from other sources. We think that other source is an even more powerful one job and income recovery. Historically, wage growth and rising rates go hand in hand, so if the Fed is correct in reading the tea leaves of the economy, tighter policy could signal a significant improvement in wage growth is likely for As the primary determinant of how much money consumers spend is income, rising wages could power a relative strong earnings outlook for consumer-focused companies. Our earnings models suggest discretionary EPS growth of 15% and staples EPS growth of 7% in 2016, both stronger than index earnings growth Personal Income & Spending (% 1YR) Personal Income (% 1YR) Personal Consumption Expenditures NAHB/Wells Fargo Housing Market Index, Traffic of Prospective Buyers % % % % Average Hourly Growth Vs. Fed Funds (% 1YR) Average Hourly (Left) US Federal Funds Target Rate - Yield (Right) Retail Spending Categories Nonstore Retailers (Internet & Catalog) Motor Vehicle And Parts Dealers Food and Drinking Places Health And Personal Care Stores Building Material And Garden Equipment Clothing And Clothing Accessories Stores Food And Beverage Stores General Merchandise Stores Furniture, Electronics And Appliance Stores 5% 1 Total 12% 1 8% 6% 4% 2% Equity Strategy EQUITY RESEARCH DEPARTMENT

9 9 II. Non-Consumer Economy: Tale of Two Worlds The industrial economy has generally been painted with the broad brush of oil struggles, dollar gains and export stagnation over the last year, but there are a few components of the non-consumer economy that are doing reasonably well. Indeed, while oil prices dropped 6, export growth has slowed from 4.3% to 1.2%, industrial production growth has been flat, as ex-energy production has slowed significantly less than production of energy product. Several categories of industrial production are rising at a reasonable clip, many of which are related to consumer spending, such as auto production (up 11.7% YoY) or consumer parts production (up 7.2% YoY). Tech production is likewise growing rapidly, up 9.7% YoY. Likewise, construction industries are generally performing well, benefiting from a slowly improving residential and nonresidential landscape. Residential construction is has continued to edge higher all year. Multifamily housing unit growth largely continues to drive gains (up 18.8 YoY so far in 2015), but single-family construction is likewise still improving, up 14.0 YoY so far in 2015). 6% 5% 4% 3% 2% 1% -1% Industrial Production (% 1YR) Industrial Production (% 1YR) Industrial Production Non-Energy -2% Jan-12 Oct-12 Jul-13 Apr-14 Jan-15 Oct-15 U.S. Construction ($B) Growth in manufacturing construction has $400 slowed considerably with the decline in oil prices and increase in the dollar, but other $300 categories of construction continue to grow at a faster pace. Nonresidential $200 construction is thus still rising $800 $700 $600 $500 Construction, Nonresidential Construction, Residential Strong Categories of Industrial Production (% 1YR) Industrial Production, Automotive Products (% 1YR) Industrial Production, Computers, Video And Audio-visual equipment (% 1YR) Industrial Production, Consumer Parts U.S. Construction Segments (% 1YR) Construction, Health Care (% 1YR)Construction, Lodging (% 1YR)Construction, Manufacturing (% 1YR)Construction, Amusement And Recreation 2016 Equity Market Outlook: The Receding Tide EQUITY RESEARCH DEPARTMENT

10 10 II. The Election Year: New Uncertainty or Welcome Change? With U.S. competitiveness falling, the U.S. corporate tax rate the highest amongst OECD countries (at 35%), more than 2 of consumption allocated to the health care sector alone, and plenty of wood to chop on the federal deficit, it seems there is plenty of room for policy recommendations to rock the boat for stocks this election year. Of all sectors, we believe health care will come under the greatest degree of pressure from policy rhetoric in Though little is likely to change in the election year, much will be discussed, particularly when it comes to tweaking or outright abolishing ACA (Affordable Care Act) legislation. From a broader perspective, potential change to the tax code, and perhaps most importantly, a change to the corporate tax code, could be the most consequential discussion for stocks. With nearly a year to go, discussions are still wide-ranging, from eliminating inversions to closing loopholes to outright reduction of rates. The federal deficit has improved markedly in recent years, but there is clearly more room to repair the U.S. fiscal situation and restore confidence in policymakers. As rates rise, the focus on paying down the Federal debt is likely to become more profound. While each election year is unique in our view, market performance is usually a touch better than average during election years on both a median and average basis. 75% of election years since 1900 have been positive years for stocks and 57% of years have recorded gains above the long-term average price gain of 7% Health Care Share of Spending/Consumption S&P 500 Health Care Relative Price (Right) Health Care Share of PCE (Left) % 1 8% 6% 4% 2% S&P 500 Presidential Election Year Performance, Present S&P 500 Presedential Election Year Performance, Present Average Median 7. All Years 9.7% 7.8% 10.4% Election Years United States France Belgium Mexico Australia Japan Israel Greece Austria Korea United Kingdom Germany Canada Switzerland Corporate Tax Rates Globally Spain Italy Corporate Income Tax Rate Source: OECD, Wells Fargo Securities, LLC U.S. Treasury Deficit/Surplus ($B) ,000-1,200-1,400-1, Equity Strategy EQUITY RESEARCH DEPARTMENT

11 11 III. We expect S&P 500 EPS to grow about 8% to $129 in 2016, following 2% growth in 2015E and 6.8% growth in The bottom-up consensus is expecting $127 in After extensive downward revision to forward estimates, we believe bottom-up consensus estimates now appear relatively achievable for However, our view on earnings is contingent upon the following assumptions: (1) oil prices are in the process of bottoming, (2), the dollar rises a more manageable 5-7% in 2016, and (3) the Fed achieves liftoff but long rates remain somewhat anchored. We arrive at expectations for solid earnings growth via both a top-down and sector aggregate approach. The top down model is driven by the rate of improvement in the Conference Board s Leading Economic Indicators index. With very high predictive power, the LEI leads S&P 500 index EPS by an average of 5 months. Our sector aggregate relies upon 10 different econometrically derived sector models for EPS. Major factors impacting the model for 2015 include, but are not limited to, oil prices (we assume $50 average WTI), the yield curve (we assume 100 bps), the dollar (we assume up 5%)) and leading economic indicators such as the ISM, initial claims, durable goods orders and the like. The biggest risks to our EPS model likely surround reactions to shifts in Fed policy. As shown in the scenario tables at right, another leg lower on oil prices, should it occur, would again result in earnings weakness in the year ahead, and vice versa, should oil prices escalate. Yield curve shifts outside of our expectations likewise have the potential to create earnings disruption. 25% 2 15% 1 5% -5% -1-15% -2 Leading Economic Indicators and S&P 500 EPS Growth Leading Indicators & S&P Operating EPS Leading Indicators YoY (left axis) S&P 500 LTM Operating EPS YoY (right axis) Consensus EPS Growth Estimate (right axis) Wells Fargo EPS Growth Estimate (right axis) -25% Jan-99 May-02 Sep-05 Jan-09 May-12 Sep-15 Source: IBES, First Call, FactSet, Wells Fargo Securities, LLC Estimates Estimate Oil Price EPS Sensitivity Scenario Analysis S&P 500 EPS Growth Scenario Analysis: Oil 2016 Oil (WTI) Price % Change 2016E Forecasted S&P 500 EPS Growth E Forecasted S&P 500 EPS Bull % $150 Base 8.3% $136 Bear % $129 S&P 500 EPS Forecasts Wells Fargo Ests CY CY CY Sector 2015E 2016E 2017E Energy -55% 5% 3% Materials -5% 4% 2% Industrials -1% 5% 4% Discretionary 12% 15% 8% Staples 4% 7% 5% Health Care 12% 8% 4% Financials 8% 9% 5% Technology 5% 9% 7% Telecom 4% 4% 3% Utilities 2% 2% 1% S&P 500 2% 8% 5% Estimates US Yield Curve Sensitivity Scenario Analysis S&P 500 EPS Growth Scenario Analysis: Yield Curve s2s Spread (in bps) 2016E Forecasted S&P 500 EPS Growth 2016E Forecasted S&P 500 EPS Bull % $141 Base % $136 Bear % $ Equity Market Outlook: The Receding Tide EQUITY RESEARCH DEPARTMENT

12 12 III. Components S&P 500 EPS growth should be supported by all cylinders in the year ahead, as revenue growth, margin expansion to a new all-time high, and share count reduction all add to EPS in Revenue growth is expected to rise just over 4.5%% in 2016, acceleration from the 3.8% revenue decline expected this year and 3.1% posted in Six of the ten sectors are expected to post acceleration in revenue growth, with energy, health care, industrials, and utilities the only sectors expected to record slowing growth rates. Analysts expect operating margin to expand to above 10.8% in the year ahead, a new all-time high. Seven of ten sectors are expected to post YoY margin improvement. Margins have come under considerable scrutiny in recent years, as companies have managed to persistently produce stronger efficiency and productivity gains, while likewise utilizing low bond rates to engineer ever higher margins. While rapid increases in rates may slow the margin trend, we expect concerns are largely overblown. In fact, if revenues do indeed rise in the year ahead, and rates move slowly higher, margins will likely continue to expand. With $896B in cash (ex-financials, flat YoY), sitting on S&P 500 balance sheets and leverage still accelerating (up 10.3% YoY ex-financials), use of cash is likely to continue to be an ongoing theme. However, with rising debt costs, we expect investors to become slightly more wary of segments of the market overly reliant upon share count reductions for EPS growth. 25% 2 15% 1 5% -5% -1-15% -2-25% S&P 500 Revenue Growth S&P 500 Revenue Growth Consensus Estimates S&P 500 S&P 500 ex-financials 12 S&P 500 Operating Margin Operating Margin % 8% 7% 6% 5% 4% 3% 2% 1% Sector Level Revenue Growth Consensus Forecast S&P 500 Sector 2016E Revenue Growth Consensus Estimates EPS vs Income Growth Growth Rates EPS Income Diff S&P % % Energy 0.1% -0.2% 0.3% Materials 11.7% 8.3% 3.4% Industrials 4.6% 0.9% 3.7% Discretionary 14.9% 11.7% 3.2% Staples 6.1% 4.9% 1.2% Health Care 9.8% 9.3% 0.5% Financials 8.2% 5.1% 3.1% Technology 7.4% 5.1% 2.4% Telecom 2.6% 7.6% -5.1% Utilities 3.1% 5.3% -2.2% Equity Strategy EQUITY RESEARCH DEPARTMENT

13 13 IV. Valuation & Fair Value Estimate The first leg of monetary shift resulted in a stall in the valuation uptrend in place for the last several years, and we suspect the second leg to result in similar difficulty for PE expansion. In the past, Fed funds rate hikes have been relatively difficult for the equity market multiple to absorb. Indeed, since the early 1970s, the market PE has been lower 75% of the time in the first twelve months after the Fed starts hiking rates. On average, stocks have dropped 7.5% in the 12 months following tightening. Our fundamental model of the market PE, which includes rates, inflation, demographics and the federal deficit, suggests that the market multiple should flatten contract a touch, to 17.4X, after rising from 10x to 18x over the last 6 years. Assuming our modeled PE of 17.4 and EPS of $129 in 2016, our 12-month forward fair value estimate shifts only marginally to 2,245 from 2,222 currently. However, we see downside risk to 1940, in the event the economy is unable sustain tightening, and upside potential to 2,325, should economic growth surprise positively, resulting in faster rate hikes from the Fed. We think this cycle is anything but average, and expect the market to weather higher rates rather well, for a few reasons. First, nothing about this cycle is average. Investors have been anticipating the first rate hike for at least a year, suggesting the anticipation may have already been reflected in valuation. Also, while PE is difficult to model, our model says it likely that valuations merely trade sideways in the year ahead, for rates should remain unusually low. Market technicals continue to suggest the market is either in a long topping process or consolidating gains in the context of the longer term bull market, supporting our fundamentally based view of a market that rises about 7% in the year ahead. From the technical side, we expect upside potential should be driven by any improvement in retail flows, while downside risk is likely highly contingent on global monetary policy moves and subsequent impacts on pricing in commodities, currencies, and rates. 35x 30x 25x 20x 15x 10x 5x PE Model S&P 500 PE Actual vs. Model Predicted Actual Predicted 0x Estimates PE Struggles Around Rate Hikes 12M Prior 6M Prior At Hike 6M After 12M After Jun x 20.0x 18.4x 18.1x 16.7x Jun x 27.8x 29.3x 28.4x 26.2x Feb x 19.1x 17.7x 15.3x 14.6x Apr x 14.2x 17.9x 19.4x 13.7x Mar x 12.4x 10.4x 10.0x 10.7x Aug x 7.6x 8.2x 9.2x 8.7x Aug x 10.2x 9.3x 8.1x 8.8x Jan x 17.7x 18.2x 17.8x 17.8x Median % Change -2.6% -7.6% Average % Change -2.2% -7.5% Percent of times Positive 25% 25% Forward PE market and market exenergy S&P 500 Price-to- Ratios S&P 500 ex-energy 10 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Fair Value Scenarios Impact of Fed Policy on Fair Value Estimates Fed Funds Rate Unchanged Fed Funds Rate up to 75 bps Fed Funds Rate up to 125 bps Fed Funds Rate up to 175 bps Fed Funds Rate up to 225 bps Wells Fargo Model PE Wells Fargo Model EPS S&P Month Fair Value Estimate 17.0x $114 1, x $122 2, x $129 2, x $136 2, x $142 2,325 estimates 2016 Equity Market Outlook: The Receding Tide EQUITY RESEARCH DEPARTMENT

14 14 V. Style Recommendations We continue to suggest that large caps are likely to outperform small caps in Despite the dollar gains of 23.4% from mid-2014 to date, large caps have outperformed small caps by 520 basis points. Large caps have broadly outperformed small caps in the second half of each of the last two economic cycles, as small caps are generally more sensitive to rising interest rates. As for growth/value, we sense it an increasingly unpopular view among investors, but we continue to give growth the edge, as we believe earnings growth will be critically important to driving performance, as valuations may come under pressure as the Fed reverses course. The yield curve tends to be the dominating macro factor in selecting style, and its current state flattening should favor growth styles in the near term. Momentum and quality are the primary factors that have driven performance following the beginning of monetary policy tightening since We likewise will continue to lean on momentum and quality as performance drivers in the year ahead. The path to progress for the equity market may not be easy in 2016, but we nonetheless suggest that stocks should outperform bonds. That said we do not believe a slightly higher cost of capital will derail the equity market at large, just merely adjust relative performance within it. In the last two cycles, stocks continued moving higher for 32 months and 29 months, respectively, following troughs in high-grade spreads Large vs. Small Cap S&P Price / Russell Price % 2 15% 1 5% Quality and Momentum Are Favored Factors Average 12M Returns Following Initial Rate Hikes, 1990-Present Growth vs. Value S&P 500 Growth / Value (Left) US Treasury 10 Year Yield less 2 Year Yield (Right) Stocks vs Bonds 0 Momentum Quality Growth Value Benchmark BAML U.S. Corporates Hgh Grade OAS (Left) S&P Price (Right) ,200 2,000 1,800 1,600 1,400 1,200 1, Equity Strategy EQUITY RESEARCH DEPARTMENT

15 15 VI. Sector and Industry Strategy We recommend investors overweight technology and consumer discretionary, where momentum is strongest, growth most stable, political risks low, and macro trends supportive in Both sectors offer considerable opportunity to leverage the improving picture for U.S. consumption, as well as the long-term transition to mobility. In our view, investors should marketweight industrials, financials (upgrade from underweight), health care, staples and energy in 2016, where our view is more mixed. Industrials may offer the most compelling opportunities among beaten down cyclicals, as there is a considerable amount of domestic exposure in the sector. Our financials estimates are in line with the consensus for the first time since Health care has arguably the strongest secular tailwind among sectors, but faces short run political pressure and difficult earnings comparisons. Staples are extremely expensive, and vulnerable to yields rising, but offer a compelling earnings story if the middle and lower income consumer gathers momentum. Finally, the worst of the declines for energy stocks should pass with a bottoming in oil price, but upside also could be limited due to long-term excess supply. We suggest underweighting materials, telecom and utilities (downgrade from marketweight). Materials sector faces an unfortunate challenge of high earnings growth expectations amid a persistent deterioration in metals prices and ongoing emerging market weaknesses. Meanwhile, among S&P 500 sectors, telecom and utilities are most vulnerable to higher interest rates. Sector Rating (Relative to Index) UNDERWEIGHT MARKET WEIGHT Sector & Industry Recommendations Industry Rating (Relative to Sector) SECTOR Overweight Market Weight Underweight Technology Discretionary Industrials Financials Health Care Staples Energy Materials Telecom Utilities Internet Software & Services Software Consumer Services Aerospace & Defense Commercial Services & Supplies Building Products Banks Insurance Equipment & Supplies Health Care Technology Tobacco Construction Materials IT Services Semiconductors & Equipment Computers & Peripherals Retailing Media Household Durables Industrial Conglomerates Transportation Electrical Equipment Real Estate Capital Markets Thrifts & Mortgages Providers & Services Life Science Tools & Services Food & Staples Retailing Beverages Food Products Oil, Gas & Fuels Energy Equipment & Services Chemicals Containers & Packaging Paper & Forest Products Telecom Utilities Communications Equipment Electronic Equipment Leisure Equipment & Products Autos & Components Textile, Apparel & Luxury Goods Construction & Engineering Machinery Consumer Finance Biotechnology Pharmaceuticals Household Products Personal Products Metals & Mining 2016 Equity Market Outlook: The Receding Tide EQUITY RESEARCH DEPARTMENT

16 16 VI. Sector & Industry Selection Process Our sector selection strategy largely reflects the current combination of relative price trend, relative earnings revision momentum, earnings trends, and valuation. Analyst revision momentum has been negative across the board, but weakest for materials and financials and best for utilities and health care in recent months. On the earnings front, we are close to in line with consensus estimates for all but the energy and materials segments. However, for the first time in several years, our estimate for financials EPS is above consensus and our estimate for health care is below consensus. We forecast discretionary will offer the strongest EPS growth among sectors in Price momentum is clearly strongest for technology and discretionary, which make up 58% of the top fifty stocks in the S&P 500 on price momentum scores. On the other end of the spectrum, telecom and materials stocks have been among the weakest in the index for a considerable time. Valuation is not likely to be a strong factor for performance for a second consecutive year, in our view, as momentum, quality and growth should overwhelm at this stage of the cycle. Nonetheless, for longer term investors, the largest discounts in the index appear to be found in the energy, utilities and financials sectors. Sector Revision Momentum Relative SECTORS Most Recent Month (Nov) Avg S&P % -12.6% Utilities -3.2% 0.9% Health Care -6.3% -2.4% Telecom -2.9% -4.4% Technology -5.5% -4.7% Discretionary -17.6% -8.2% Staples -14.7% -11.1% Industrials -32.4% -20.9% Energy -0.4% -22. Financials -23.8% -22. Materials -34.8% -26.6% Revision M omentum Index tracks the number of Up Revisions less Down Revisions divided by Total Estimates So urc e: FactSet, Wells Fargo Securities, LLC Sector Relative Price (INDEX) Technology Relative Price (INDEX)Telecom Relative Price % 14% 12% 1 8% 6% 4% 2% Wells Fargo vs Consensus 2016 EPS Estimates Wells Fargo vs. Bottom-Up Consensus 2016E EPS Growth Estimates Sector Valuations Bottom-Up Consensus Wells Fargo S&P 500 Sector Valuations % Diff to 10Y Avg Sector PB Rel PB Rel PB S&P x Energy 1.64x 0.585x -33.9% Materials 3.12x 1.111x -4. Industrials 3.71x 1.320x 10. Discretionary 4.71x 1.675x 48.2% Staples 4.36x 1.551x -3.3% Health Care 3.72x 1.325x 0.9% Financials 1.39x 0.495x -14. Technology 4.23x 1.507x -2.6% Telecom 2.73x 0.973x 10.5% Utilities 1.56x 0.553x -18.4% Equity Strategy EQUITY RESEARCH DEPARTMENT

17 17 Technology Relative Price Performance S&P 500 Info. Tech. Relative Price S&P 500 Info Tech Relative Price 50D MAvg 200D MAvg 0.28 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Technology Industries Overweight Industry Recommendations Consensus NTM EPS Growth Revision Momentum Price-to- Forward Div Yield Internet Software & Services 17.9% -3.8% 24.8x 0. Software 8.8% -2.9% 18.1x 1.7% Marketweight IT Services 8.5% 0.1% 16.8x 1.5% Semiconductors & Equipment % 15.1x 2. Computers & Peripherals 6.6% -5.3% 11.1x 1.8% Underweight Communications Equipment 4.8% 6.9% 12.5x 2.9% Electronic Equipment 7.7% -24.8% 14.5x 1.8% Relative Momentum Number of Up Revisions less Down Revisions divided by Total Estimates Revision Momentum 3MMA Index -2 Jan-05 May-06 Sep-07 Jan-09 May-10 Sep-11 Jan-13 May-14 Sep-15 Source: IBES, FactSet, Wells Fargo Securities, LLC S&P 500 Industries Drivers Latest Month Avg S&P % Technology -5.9% -4.7% Communications Equipment -2.5% 6.9% IT Services % Software % Internet Software & Services % Computers & Peripherals -10.2% -5.3% Semiconductors & Equipment -9.1% -12.1% Electronic Equipment & Instruments -39.2% -24.8% Technology Consumption Growth (% 1YR) PCE,Video, Audio, Photographic, And Info. Proc Equip. And Media (% 1YR) E-commerce Sales Technology is our top rated sector for 2016, reflecting the strongest combination of technical and fundamental factors among sectors in the S&P 500. While investment trends at large remain grim, technology spending is less so, and consumer spending on technology is vastly outpacing spending on other categories. Software and services industries, particularly the internet software and services group, are particularly well positioned in our view, with likely very strong forward growth relative to the equipment and/or hardware groups within technology Equity Market Outlook: The Receding Tide EQUITY RESEARCH DEPARTMENT

18 18 Discretionary Relative Price Performance S&P 500 Discretionary Relative Price Consumer Discretionary Industries Overweight Relative Momentum -2 S&P 500 Discretionary Relative 3MMA 50D MAvg 200D MAvg -3 Jan-05 May-06 Sep-07 Jan-09 May-10 Sep-11 Jan-13 May-14 Sep Industry Recommendations Consensus NTM EPS Growth Revision Momentum Price-to- Forward Div Yield Consumer Services 14.9% 7.5% 21.3x 2.1% Marketweight Retailing 16.6% 1.2% 23.4x 1. Media 12.3% -20.7% 16.1x 1.5% Household Durables 15.3% 4.7% 13.9x 1.5% Underweight Leisure Equipment & Products 12.5% 7.4% 17.1x 4.2% Autos & Components 17.6% -3.7% 8.6x 3. Apparel, Accessories & Luxury 7.8% -0.8% 17.8x 1.3% Number of Up Revisions less Down Revisions divided by Total Estimates S&P 500 Industries Latest Month Avg S&P % Discretionary -5.1% -1.4% Leisure Equipment & Products -23.3% 12. Hotels, Restaurants & Leisure -1.5% 7. Internet & Catalog Retail -1.3% 6.7% Household Durables -9.7% 4.7% Textiles, Apparel & Luxury Goods 12.1% 4. Specialty Retail -1.7% 3.2% Autos & Components -13.4% -3.7% Multiline Retail -6.5% -7.8% Media -18.2% -20.7% Diversified Consumer Services % Retail Distributors -84.6% -84.6% Source: IBES, FactSet, Wells Fargo Securities, LLC Drivers Consumer Confidence & Dining Out Consumer Confidence Index (Left) PCE Food Services (Right) While lower gas prices have failed to excite consumers to spend at traditional brick and mortar retail, the consumer is gathering momentum headed into 2016, evidenced by 2.9% YoY growth in PCE (through October) and ISM services near a 10-year high. Spending on services remains strong, with restaurant sales up 5.5% YoY (through October) and ecommerce sales continue to soar. Given the strong backdrop for earnings growth (our model suggests 15% EPS growth for the sector in 2016 and the consensus projects double digit earnings growth for six of the seven discretionary industries), we think high valuations are justified Equity Strategy EQUITY RESEARCH DEPARTMENT

19 19 Industrials Relative Price Performance S&P 500 Industrials Relative Price S&P 500 Industrials Relative 50D MAvg 200D MAvg 0.21 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Industrials Industries Overweight Industry Recommendations Consensus NTM EPS Growth Revision Momentum Price-to- Forward Div Yield Aerospace & Defense 7.4% -15.2% 16.3x 2.1% Commercial Services & Supplies % 18.6x 1.8% Building Products 22.7% 8.2% 20.3x 1. Marketweight Industrial Conglomerates % 20.1x 2.5% Electrical Equipment 0.5% -64.2% 15.7x 3. Transportation 0.9% -12.1% 12.3x 1.7% Underweight Construction & Engineering % 12.7x 0.7% Machinery % 15.6x 2.7% Relative Momentum Industrials Relative Revision Momentum Number of Up Revisions less Down Revisions divided by Total Estimates 3MMA -3 Jan-05 May-06 Sep-07 Jan-09 May-10 Sep-11 Jan-13 May-14 Sep-15 Source: IBES, FactSet, Wells Fargo Securities, LLC S&P 500 Industries Drivers Latest Month Avg S&P % Air Freight & Logistics -3.7% 15.4% Building Products -3.4% 8. Commercial Services & Supplies 4.6% 6.7% Aerospace & Defense % Industrial Conglomerates -17.5% -9.7% Construction & Engineering -10.7% -19.7% Machinery -39.2% -26.1% Road & Rail -49.3% -31.9% Trading Cos & Distributors -50.9% -42.2% Electrical Equipment -46.2% -56.3% Capital Goods New Orders (MOV 3M, % 1YR) New Orders, Defense Capital Goods (MOV 3M, % 1YR) New Orders, Defense Aircraft And Parts (MOV 3M, % 1YR) New Orders,Machinery As the drag from falling oil prices fades, so should industrials underperformance, in our view. However, industrials is still largely a tale of two worlds - remarkably successful domestic and defense groups stand apart from the beleaguered oil and emerging market sensitive machinery and construction & engineering. While we expect this divergence to fade as 2016 progresses, we want to wait for longer stability to emerge in emerging markets and the commodity complex before we abandon our barbell approach to the sector. For now, we remain optimistic that aerospace & defense, building products and commercial services industries can carry the sector performance in the near term Equity Market Outlook: The Receding Tide EQUITY RESEARCH DEPARTMENT