THE MONTHLY RESEARCH CONFERENCE CALL THE MARKET AT MID-YEAR: SOLID FUNDAMENTALS, BUT CHALLENGES PERSIST ARGUS

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1 THE MONTHLY RESEARCH CONFERENCE CALL THE MARKET AT MID-YEAR: SOLID FUNDAMENTALS, BUT CHALLENGES PERSIST ARGUS MODERATOR Jim Kelleher, CFA Director of Research John M. Eade Argus President Peter Canelo Chief Investment Strategist Wednesday, July 5, :00 a.m. ET 61 Broadway NYC, N.Y Telephone: (212)

2 WHAT'S NEW AT ARGUS JULY 2017 General Availability of A6 reports Our A6 universe includes over 1,100 stocks Quant process based on our six-point system Simply enter ticker on web site Integral part of our high-quality research product High usage in the roughly one month since availability Argus flips its calendar of product releases The Monthly Argus Research Conference Call is moving from second Wednesday of month to first Wednesday of month Institutional Model Portfolio Action Alert is moving from first day of month to second week of month Designed to align Institutional Model Portfolio release with Equity Income, Growth & Income, and Growth Model Portfolios - 2 -

3 MACRO FORECASTS REAL GDP W/FORECASTS (%) TREASURY YIELD CURVE (%) 8 6 Source: Bureau of Economic Analysis, Argus Research Corp. 4 Year-Ago Current 6-Month Forecast '00 '01 '02 '03 '04 ' E 18 E 0 3-Mo bill 2-Yr Note 5-Yr Note 10-Yr Bond 30-Yr Bond S&P 500 QUARTERLY EARNINGS GROWTH MARKET SECTOR DISTRIBUTION - PERCENT OF S&P % 80% 60% 40% 20% 0% -20% -40% '00 '01 '02 '03 '04 '05 06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 17 E Sectors in Green are Recommended Overweight; Blue are Marketweight; Red are Underweight Telecom Basic Materials Utilities Consumer Discretionary Industrial Consumer Staples Energy Healthcare Real Estate Financial Services Technology 18 E 0% 5% 10% 15% 20% 25% - 3 -

4 NM MARKET PERFORMANCE DATA AS JUNE 30, 2017 MAJOR INDEX SECTOR Nasdaq Composite Real Estate Technology NM Growth Stocks (Wilshire Large Growth) S&P 500 Health Care Consumer Discretionary Industrials DJIA Russell 2000 Materials Utilities Consumer Staples Value Stocks (Wilshire Large Value) Financials Telecom Lehman US Aggregate Bond Index Energy 0% 5% 10% 15% 20% -20% -10% 0% 10% 20% GLOBAL EQUITY MARKETS China India DJ World Index Mexico US Euro Zone Japan UK Brazil Canada Russia -20% -10% 0% 10% 20% 30% - 4 -

5 Executive Summary. A more-difficult second half. It has been our view this year that stocks would move to fair value (and possibly moderately higher) before encountering a more-difficult environment later this year. Now at 2425, the S&P 500 has risen 8% year-to-date and stands just slightly above fair value. And with earnings likely to show double-digit gains each quarter this year, we could still see the market moving moderately higher. But with stronger economic growth ahead, the Fed will begin to draw down its enormous balance sheet, bond yields are likely move higher and investors might become more concerned about inflation. In this environment, the market P/E is not likely to move much higher. Market and sector performance is thus increasingly dependent on earnings growth. By year-end, we could see the market move higher, but only modestly so in our opinion. Ø Late in the market cycle. The market multiple has moved from 16-times in late 2015/early 2016 to more than 19-times normalized earnings. Further upside will depend on the pace of earnings growth. Ø Focus on earnings. The manufacturing slump in the US and abroad has ended. Key indicators of earnings from ISM, CRB and the Fed s US dollar index all point to higher earnings. We think the drop in crude oil price will reverse with little impact on S&P earnings. Ø Expect economic growth to move above trend in coming quarters. In our opinion, the outlook for jobs, autos and retail spending is stronger than some recent reports would suggest. Ø Policy issues. US T-bill rates remain negative in real, inflation-adjusted terms. We do not expect rates to reach 2% until late next year or early The median CPI has risen 2.5% this past year. Ø Our earnings outlook remains unchanged, with EPS up 12.6% in 2017 and 7.5% in Ø US stocks are fairly valued, but they offer significantly better value than bonds as we see it. Ø Cyclical sectors are still undervalued relative to the market; defensive groups are overpriced. Ø Market indicators: Technical indicators improve steadily; Strategic indicators remain neutral. Ø Leadership picks (top 10 subsectors). Cons. Services; Health Care Equip & Svcs, Pharma-Biotech; Transportation, Capital Goods; Software, Semis; Insurance, Div. Finl s; and Materials. 5

6 Late In The Market Cycle The market multiple, which we measure using normalized earnings (a centered five-year moving average of operating earnings) has ratcheted higher from 12-times normalized earnings at the 2011 correction low. After briefly touching fair value in early 2014, the market multiple fell to 16- time earnings in late 2015/early At the recent high of 2453, the normalized P/E reached 19.3-times before settling back to 19.1-times at Ø From fair value, the market multiple can move moderately higher, but for a number of reasons we doubt stocks could reach the upper P/E band at 23.8-times earnings (a rise of 25% from current levels). We see the downside risk at the lower P/E band at 16-times NEPS (a fall of 17%). Ø We expect growth and inflation expectations to pick up, putting upward pressure on bond yields. Ø Tighter monetary policy should constrain the market upside. The Fed will probably raise rates just once more, but it will begin to draw down its $4.5 trillion balance sheet, a significant tightening. 6

7 Key Drivers Of S&P Earnings Globalization of the S&P 500 has made the pace of domestic growth less important -- and global growth more -- as indicators of S&P earnings. Growth of manufacturing remains a strong barometer of US profitability. Ø ISM Manufacturing Index and New Orders show the best correlation with S&P profits. At 55 and 60, respectively, the Index and New Orders stand near cyclical recovery highs. Important Drivers of S&P 500 Profits Correlation Coefficients Since 1971 Industrial Commodities US Dollar* Other Commodities Manufacturing PMI CRB Raw CRB Metals Inverse of Gold Crude Oil Since ISM Index New Orders Indl. Spots** Index MTP USD Spot WTIC Apr na Jun Jun Jun * Foreign Exchange index based on inverse value of the FR Major Trading Partners US Dollar index. ** CRB Raw Industrial Spot prices do not include energy prices. Ø CRB Raw Industrial Spot and Metals Price indexes also move closely with industrial profits (see following page). Ø The US dollar does not have a strong direct correlation with S&P earnings, but it has many strong indirect impacts on export orders, industrial materials prices and crude oil. 7

8 Industrial Prices Drive Industrial Profits The idea that industrial prices drive industrial profits was a virtual truism when the US economy had a higher proportion of manufacturing. But even as the service economy has expanded, ordinary materials have remained an excellent guide to the trend in S&P 500 profits. Service businesses also need paper and other materials, they often run on cars and trucks and all consume energy. Ø CRB Raw Industrial Spots have risen 28% since Dec. 15. Raw Industrials have the highest correlation with S&P Operation EPS of any major commodity group. They were weakened by the surge of the US dollar from late 2011 through mid-2013 and again from mid-2014 through late The index does not include energy, which has a poor correlation with overall S&P profits (see previous page). Ø CRB Metals Index have surged 58% since Dec. 15. CRB Metals exclude precious metals, and have the second-best correlation to S&P earnings among major commodity groups. 8

9 Is Crude Oil Really In A Bear Market? The 22% drop in crude oil from its Q1 high of $54.50/bbl is widely seen as a bear market that may have a negative impact on the overall US economy. However, since crude oil is historically one of the mostvolatile commodities, we do not see the pullback as a bear market, but rather as a (successful) retest of recent lows. Crude is up more than 50% above its February 2016 low and, to us, looks to be at the low end of a broad $40 to $55/bbl. trading range that has persisted for over 15 months. Ø Crude oil is twice as volatile as the S&P 500, indicating that a normal correction or a bear market in oil are much greater than the those for stocks. Ø A normal correction in crude oil is 25% compared to 13% for the S&P 500, based on the standard deviation of changes about the trend in the past 25 years. Ø The S&P Energy index, and its XLE ETF, are considerably less volatile than crude, and have fallen 17% since their December high. What's A Bear Market? Returns & Volatility of Selected Stock Groups BBG Price-Only Returns Beta Corrections & Bears Index Ticker 5-Yr Avg Vs. Low * 5-Yr Std. Dev.** Bear Mkt. S&P 500 SPX Nasdaq 100 NDX Russell 2000 RTY US Dollar, FR MTP Gold GOLDS Crude Oil, WTIC USCRWTIC S&P Energy S5ENRS Oil Services OSX S&P Materials S5MATR CRB Raw Indls. CRB RIND CRB Metals CRB METL * Change vs. low price from late 2015 through early ** Standard deviation vs. trend--determioned by centered 5-year averages. Computed over the time period. Sources: Standard & Poor's, Federal Reserve Board, CRBTrader.com; Bloomberg 9

10 Weaker Dollar Will Support Crude The 7% decline in various measures of the US dollar this year will reduce the world price of industrial materials priced in US dollars, including crude oil. Trend changes in the US dollar have had a strong discernable impact on industrial materials, and on crude oil in particular. Ø The 25% surge in the US dollar from mid-2014 through late 2016 depressed exports, foreign profits and the entire US manufacturing sector. It also played a large part in the plunge in crude oil, but we do not see the drop in oil as the cause of the slump in manufacturing: it was the US dollar. Remember that the losses in Energy sector profits provided lower costs for all sectors that are intensive energy users. Ø The recent decline in crude oil should have limited impact on overall US economic growth. Unlike the drop in crude, the smaller decline in oil this year is not accompanied by a rising USD, weakness in ISM orders or declines in other industrial materials. 10

11 Atlanta Fed Sees 3% GDP Growth in Q2 Since early, May the Atlanta Fed s GDPNow model was looking for second-quarter GDP to grow between 3.5% and 4%. But after the May Employment and Auto Sales reports on June 2 nd, the Atlanta forecast tumbled, falling back near the Blue Chip consensus estimate of 3.1% We still expect a positive surprise for Q2 GDP, as alternative measures of jobs and consumer spending are stronger than non-farm payrolls survey, and auto-related spending remains strong. 11

12 Employment Is Stronger Than Payroll Survey The two main surveys of private employment (the BLS Non-Farm Payrolls and the ADP Private Employment Survey) often diverge on a month-to-month basis, particularly in the early months of the year. Much of that difference is dampened by looking at year/year changes, which largely wash out changes in seasonal adjustments. But in the past six months, even the annual changes show a stark difference, as the government numbers show significantly less job creation. We think other employment indicators suggest that ADP has it right. Most important, unemployment insurance claims have averaged 242 thousand in the past month, just off a 30-year low. Also, strong growth in Personal Income suggests the pace of job creation is rising, not falling. Ø ADP reported 211 thousand jobs/month in the past year, 32 thousand more than seen by BLS. Ø The discrepancy is getting bigger: In the past six months, ADP reported 233 thousand/month vs. just 159 thousand for BLS. In March-May, ADP counted 227 thousand vs. just 126 thousand for BLS. 12

13 Autos Sales Down, But Not Spending The auto industry SAAR selling rate has plummeted over 6% in the past six months. Apart from the holiday burst in car sales around year end, the year/year change has been falling from around 2% to almost 4% over the past year. However, the SAAR measures units, not dollar sales volume -- and the Census Bureau data shows that consumers continue to spend more money on cars and parts. Ø In the past year, the SAAR selling rate has fallen 3.7%, down sharply from the 2% drop a year ago. We think the drop in unit sales owes largely to cheaper gas and other lower operating costs which have prompted purchases of more SUVs, larger cars generally, and more-expensive appointments. Ø Spending on vehicles and parts has risen 4.4% in the past 12 months, which is actually up from the 3.7% rise in spending a year ago. 13

14 Weak PCE At Odds With Key Retail Trends Personal Consumption Expenditures (PCE) -- the broad consumer spending measure in GDP reports -- has been slowing in both real and nominal terms since mid But core measures of retail sales (which normally move with PCE) have risen since 3Q16. Ø PCE peaked at 6.4% in 2Q16, and fell to 3% in this year s Q1. Ø Core retail sales have climbed from 1.5% in 2Q16 to 3% in 4Q16 and to 3.9% in 1Q17. Core and control sales -- which exclude auto, gas and home spending -- are the basis for calculating PCE in the GDP. Annual changes in other retail sales components confirm that retail spending is Improving. Ø Ø Total Retail Sales (DOC) rose to 4.5% in May, up from 3.25% a year ago. SpendTrend Same-Store Sales rose to 4% in May, up from 2.6% a year ago. 14

15 Europe Leads Global Growth Higher The J.P. Morgan Global Manufacturing and Services PMI rose 0.1% to 53.7 in May, just under the 30-month high of 53.9 set in January. J.P. Morgan noted the higher level of the PMI was underpinned by stronger inflows of new orders, faster job creation, rising backlogs of work and improved business sentiment. Ø A strong recovery in Europe. The Eurozone: Manufacturing rose to 57 and Services stayed just under 57. Employment rose at a 20-year record pace. The UK: Manufacturing, at 56.7, stayed just under April s three-year high. Ø Japan at best levels in years. Manufacturing back at 2015 high. Services at mid-2015 levels. Ø Emerging markets steady. China, India manufac. slips. Brazil, Russia push higher. PMIs in US and Other Developed Countries Latest Report 12- Mo. Low Change Country Report Index Month Change Index Month Vs. Low USA Manuf 54.9 May Aug [ISM] New Orders 59.5 May Dec Services 56.9 May Aug Bus. Activity 60.7 May Aug New Orders 57.7 May Aug USA Manuf 52.7 May May [Markit] Services 53.6 May Aug U.K. Manuf 56.7 May Jul Services 53.8 May Jul Eurozone Manuf 57.0 May May Services 56.3 May Sep Japan Manuf 53.1 May May Services 53.0 May Sep Emerg Mkt Manuf 50.5 May Feb Services 52.9 May Feb [HSBC] Composite 52.2 May Sep Global Comp Manuf 52.6 May May [JPMC] Services 53.8 May Jun Composite 53.7 May May Sources: Markit Economics; ISM; JPM Chase; Bloomberg 15

16 Real US Yields Are Too Low We expect the Fed to raise rates once more in 2017, probably in September. However, if the central bank moves late this year to reduce its huge holdings of Treasury and mortgage debt -- which constitutes a real tightening -- we doubt the Fed would also hike rates in the fourth quarter. We think the FOMC will raise interest rates three time in q The 3-month Treasury bill, now yielding 1.0%, offers a negative -0.80% real return versus the 1.8% year/year inflation in the PCE Deflator. The real rate is even less vs. the CPI. q At 2.25%, the 10-year Treasury note offers a real yield of just 1.05%, compared with the 1.2% five-year inflation in the PCE Deflator. Such low real yields precede big selloffs in bonds. 16

17 Key Inflation Rates Remains High Led by higher wages, core measures of inflation, including the median CPI, all have trended higher since the late 2014/early 2015 lull in inflation that was created by the strong rise in the US dollar during that period. Headline CPI has fallen back from its first quarter peak of 2.8% as energy prices have fallen back, but the Median CPI remains high. Ø Employment costs are rising. Average hourly earning for all non-farm workers have risen 2.5% in the past year, down from a first-quarter peak. But total employment costs remain at 2.5%. Ø The Median CPI is up 2.5% in the last 12 months, just under its 2.6% cyclical high. Ø The year/year change in PPI Core Crude Materials turned positive in August, and has risen 13.6% in the past year. 17

18 S&P 500 EPS Projections First-quarter S&P 500 earnings jumped 14%, the first double-digit gain since early We see further 10%-plus growth in coming quarters before growth slows in First-quarter earnings came in at $30.84, up 14%, well above the 9.6% projection made at the start of earnings season. Results also were stronger than our optimistic forecast of $30.40, up 13%. Our EPS growth estimates for 2017 and 2018 are unchanged, despite some small cuts in coming quarters. Results should beat BBG estimates by 2% to 4%. We see steady gains in S&P earning power. We estimate normalized earnings (a centered five-year average of operating EPS) to be $ at mid-year and $ and $ in the September and December quarters S&P Estimates Bloomberg Survey Argus Research Corp. Analysts Analysts Prev. Estimate Revised, 6/23/17 Bottom- y/y Bottom- y/y Qtly y/y Qtly y/y Qtly y/y Up %-Chg Up %-Chg EPS %-Chg EPS %-Chg DPS %-Chg Q Q Q3p Q4e Q1e Q2e Q3e Q4e S&P 500 Earnings and Dividend Projections Q1e Q2e Q3e Q4e Sources: Standard & Poor's;, Bloomberg [2017 based on FY Est.]; Argus Research Corp. 18

19 The S&P 500 Stands At Fair Value At 2425, the S&P 500 has reached our estimate of fair value, which is based on normalized earnings, long-term inflation and the real corporate bond yield. Reaching fair value does not necessarily imply a market peak, but generally marks a transition to a late-cycle stock market that is increasingly sensitive to higher inflation and higher interest rates. Ø Our Fisher valuation model is based on normalized earnings of $ (a five-year average of operating earnings from ), discounted by the five-year PCE inflation of 1.21% and the real Moody s AAA bond yield of 2.49% (the nominal yield of 3.71% less the 1.21% long-term inflation rate). Ø Market peaks generally have occurred when the market valuation is well above fair value. Since 1960, market peaks followed by 15% or greater declines have occurred on average after the S&P reaches a 17% valuation. Excluding the 1972 and 2000 peaks, the average overvaluation has been just under 12%. Since 1972, only one 15% drop (in 2013) has occurred when the market was undervalued. 19

20 Strongly Favor Stocks Over Bonds Stocks seem fairly valued, but long-term bond yields are far too low relative to long-term inflation. Our bond/stock mix indicators continue to favor stocks over bonds. Bond yield/stock earnings yield spread strongly favors stocks. The Moody s AAA yield is 3.71% vs. the S&P earnings yield of 5.22%; this spread is now -1.51%. It has been at these levels or lower since In the previous 24 years, it traded mostly between 2% and 4%. The bond/stock mix barometer favors stocks over bonds by 0.86 sigma (standard deviations), also a very favorable comparison for stocks on a historical basis. Since 1965, no major stock market peaks have occurred unless the B/S mix was over zero and the S&P 500 was over-valued by 8% to 20%, sometimes even more. 20

21 Cyclicals Look Cheaper Cyclical groups remain near the top of the S&P 500 sector PEGY ranking, indicating under-valuation. Defensive, higher-yields groups remain near the bottom of the list, indicating over-valuation. Overall the market valuation improved slightly since February. Our valuation rankings are based on PEGY ratios, which compare P/Es on normalized operating earnings to the sum of projected earnings Growth plus dividend Yield. Ø Cyclicals look cheaper and improve in ranking. Economically-sensitive sectors occupy four of the best five value ranks. Consumer Discretionary remains the cheapest. Financials improved by three ranks. Technology and Industrials improved by one rank. Ø Defensive sectors look more expensive. Telecoms fell five spots in rank. Staples and Utilities remain in 9 th and 10 th place. Real Estate remains the most-expensive sector even though the PEGY valuation improved as analysts saw higher five-year growth. S&P Sector Growth & Valuation Comparisons Price Annual EPS Growth P/E On 5-Year EPS Growth Recent PEGY PEGY Ranking Sector 5/25/ Est 2018 Est Norm EPS Div Yield Ratio* Rank Change Ranked By Cheapest Sectors With Lowest PEGY Ratios Consumer Discr'ry Financials Info. Technology Health Care Industrials Energy Telecom Services Materials Consumer Staples Utilities Real Estate S&P Sources: Standard & Poors; Bloomberg; Argus Research Corp. 21

22 Industry Leadership: Cyclicals & Trump Groups The 10 best-performing S&P 500 subsectors in the second quarter were predominantly cyclical groups with strong projected forward earnings. Many are regarded as Trump groups (marked in yellow below) that led the market in the two months after the US election. Ø Ø Ø Cyclical leaders: Eight of the top 10 best performers in Q2 were economically sensitive. Each of the cyclical sectors are represented. The only defensive groups among the leaders were the Health Care subsectors. Strong forward EPS: Seven leaders saw big upward revisions in Q2 EPS, led by Semis, Cons. Services, Software and Transports. Strong earnings momentum: All of the leaders except Transports and Pharma ranked high on EPS Momentum & Revisions. S&P 500 Sub- Sector Performance Review of 2Q EPS Forward EPS EPS Brexit Election Y- T- D Q- T- D M- T- D Change in Estimates BBG Consensus Momntm S&P 500 Index 25 Sub- Sectors Pct. Change Thru 06/29/17 Since BBG Est. Change Vs Growth Estimates & Revn Code Sub- Sector Name 6/27/16 11/4/16 12/30/16 3/31/17 5/31/17 6/23/17 3/ Rank CD Consumer Services HC Health Care Equip & Svcs IN Transportation IT Software & Services HC Pharma, Biotech & Life Sci F Insurance IT Semiconds & Semi Equip IN Capital Goods F Diversified Financials M Materials U Utilities CS Food, Beverage & Tobacco RE Real Estate CD Consmr Durables & Appar CD Retailing F Banks CS Household & Personal Pro CS Food & Staples Retailing IT Tech Hardware & Equip IN Comml & Professional Svcs CD Media CD Automobiles & Components E Oil, Gas & Consmbl Fuels TC Telecomm Services E Energy Equip & Svcs S&P 500 INDEX

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