U.S. Equities: Navigating a Slow Growth Environment

SITUATION ANALYSIS U.S. Equities: Navigating a Slow Growth Environment Executive summary Equities ended first quarter by posting lackluster results largely due to economic uncertainty and heightened geopolitical risk. Looking toward the remainder of the year, we continue to expect equities to trend higher, but at more moderate levels than what was experienced in 2013. Most notably, is proving to be a transition year with price appreciation driven more by earnings versus Federal Reserve-driven liquidity and price-earnings multiple expansion. In aggregate, we remain constructive on equities, believing that a low interest rate and low inflationary environment presents a favorable backdrop for stocks to trend still higher. We favor cyclical sectors and companies that benefit from a slowly improving economy such as industrials, technology, financials, healthcare, and select materials and consumer discretionary companies. Our current price target for the S&P 500 is 2,030 based on a price-earnings multiple of 17.5 times our current earnings estimate of $116, which is consistent with earnings growth of roughly 7 percent to 8 percent over 2013 levels. Review of quarterly performance Following remarkably strong equity performance in 2013, it is difficult to draw meaningful conclusions from the price trends of U.S. and international equities as a result of trading action in the first quarter of. In aggregate, performance among both domestic and international equity asset classes during the quarter was below the quarterly return levels experienced over the past 20 years. Additionally, there are no significant differences between the performance of U.S. or international indices, largecap and small-cap stocks, and cyclicals versus defensives. First quarter equity performance was lackluster, but we believe the drivers for higher equity prices remain in place for. The macroeconomic environment appears favorable. Valuation remains fair and not at extremes. Low interest rates and low inflation provide advantageous backdrop. ket and sector performance: The S&P 500, Dow Jones Industrial Average, NASDAQ Composite, Russell 2000, international-oriented MSCI EAFE and international emerging markets-oriented MSCI EM all posted first quarter returns ranging from negative 0.8 percent to positive 1.3 percent. For the S&P 500, six of 10 sectors posted favorable returns, led by the Utilities, Healthcare, Materials and Financial sectors. The Consumer Discretionary sector lagged. The strong outperformance of the Utilities sector is somewhat surprising given the defensive nature of the sector and its tendencies to underperform during periods when expectations of rising interest rates are increasing. Important disclosures provided on page 6.

Index ket and sector performance Price 3/31/14 2013 YTD * S&P 500 1,872.34 29.6% 1.3% Dow Jones Industrials 16,457.66 26.5% -0.7% Russell 2000 1,173.04 37.0% 0.8% MSCI EAFE 1,915.69 19.4% 0.0% MSCI Emerging kets 994.65-5.0% -0.8% Sectors of the S&P 500 Weight Information Technology 18.5% 26.2% 1.9% Financials 16.3% 33.2% 2.2% Health Care 13.0% 38.7% 5.4% Consumer Discretionary 12.6% 41.0% -3.2% Energy 10.2% 22.3% 0.2% Consumer Staples 9.7% 22.7% -0.2% Industrials 10.9% 37.6% -0.4% Materials 3.5% 22.7% 2.3% Utilities 2.9% 8.8% 9.0% Telecommunication Services 2.3% 6.5% -0.7% Source: FactSet Research Systems, Inc.; *through 3/31/14 S&P total returns: The five-year anniversary of the current bull market was reached on ch 9. While it is true that the number of consecutive years where equities have posted favorable returns has exceeded the historical average, there is precedent for the broad equity market to post favorable returns beyond five years. From 1926 through 2013, the S&P 500 posted negative returns roughly every four years (3.7 years). However, the popular index posted only two years of negative returns in a 20-year span of the 1980s and 1990s. Perhaps more telling than the probabilities of an equity market decline due to market rally duration is the expected level of interest rates and inflation. With our view that interest rates and inflation will remain largely contained throughout, we believe the path of least resistance for U.S. equities arguably remains up. S&P 500 total returns Year Return Year Return Year Return Year Return Year Return 1926 11.6 1946-8.1 1966-10.1 1986 18.5 2006 15.8 1927 37.5 1947 5.7 1967 24.0 1987 5.2 2007 5.5 1928 43.6 1948 5.5 1968 11.1 1988 16.8 2008-37.0 1929-8.4 1949 18.8 1969-8.5 1989 31.5 2009 26.5 1930-24.9 1950 31.7 1970 4.0 1990-3.2 2010 15.1 1931-43.3 1951 24.0 1971 14.3 1991 30.6 2011 2.1 1932-8.2 1952 18.4 1972 19.0 1992 7.7 16.0 1933 53.4 1953-1.0 1973-14.7 1993 10.0 2013 32.4 1934-1.4 1954 52.6 1974-26.5 1994 1.3 1935 47.7 1955 31.6 1975 37.2 1995 37.4 1936 33.9 1956 6.6 1976 23.8 1996 23.1 1937-35.0 1957-10.8 1977-7.2 1997 33.4 1938 31.1 1958 43.4 1978 6.6 1998 28.6 1939-0.4 1959 12.0 1979 18.4 1999 21.0 1940-9.8 1960 0.5 1980 32.4 2000-9.1 1941-11.6 1961 26.9 1981-4.9 2001-11.9 1942 20.3 1962-8.7 1982 21.4 2002-22.1 1943 25.9 1963 22.8 1983 22.5 2003 28.7 1944 19.8 1964 16.5 1984 6.3 2004 10.9 1945 36.4 1965 12.5 1985 32.2 2005 4.9 Macroeconomic environment influences The macroeconomic environment appears favorable for equities to trend still higher, despite lackluster year-to-date performance driven by low interest rates, favorable sentiment and benign inflation. In our view, higher earnings are key to favorable equity performance throughout. We continue to believe that an improving economy is needed to drive earnings, and increasing earnings are required to drive equity prices higher. Additionally, valuation remains fair, inflation appears contained and interest rates are at levels to support higher stock prices. Earnings: Currently, U.S. equities have advanced 178 percent from the post-financial crisis lows, a pace that is clearly unsustainable over the longer term as proclaimed by pundits who assert that a negative performance year is warranted. Importantly, while the broad equity market is near all-time highs, so, too, are earnings. Earnings have increased 100 percent from the financial crisis lows. At present, consensus estimates reflect earnings for the S&P 500 of approximately $117.25, roughly 8 percent over 2013 levels. Of near-term focus is the degree to which weather impacts company earnings. Clearly, winter weather conditions negatively impacted employment, manufacturing and commerce in the first quarter. In fact, consensus full-year earnings growth has declined from approximately 10 percent at the start of the year to the current 8 percent level. Our $116 estimate is admittedly more conservative than consensus thinking, reflecting our belief that, following first quarter results, the adverse winter weather since the beginning of the year will result in some additional downward pressure on estimates. S&P 500 Index price level 2,000 1,800 1,600 1,400 1,200 1,000 800 600 Source: FactSet Research Systems Inc. U.S. stocks: Fed-fueled flight! 178% overall increase during this period 2009 2010 2011 Index reached all-time highs in 1Q 2013 Source: FactSet Research Systems, Inc. Important disclosures provided on page 6. Page 2

S&P 500 Index and EPS growth have been the same since the prior market top 30x S&P 500 P/E with long-term average 120 25x 100 S&P 500 operating EPS 20x Average 80 15x 60 S&P 500 Index level 10x 40 2007 2008 2008 2009 2009 2010 2010 2011 2011 2013 2013 2013 Dec 5x 1950 1960 1970 1980 1990 2000 2010 Source: Strategas Research Partners (data through 3/25/14, trailing 12-month basis) Source: S&P Capital IQ Valuation, inflation and interest rates: To a large degree, inflationary pressures will influence the direction of equities. At present, inflation appears benign. As the economy improves, inflationary indicators will undoubtedly creep into expectations and serve as justification for future Fed rate hikes. While talk of higher interest rates recently rattled the equity markets following the Fed s ch Federal Open ket Committee meeting, the reality is that higher interest rates are not likely to occur until early or mid-2015 at the earliest and the pace of rate hikes understandably contingent on the pace of economic growth is currently projected to be gradual. That said, it is plausible to expect equities to sell-off modestly when the Fed eventually raises the fed funds rate. As illustrated, from the past three most recent years when the Fed reversed course and raised rates following a period of flat to downward trending rates (2004, 1999 and 1994), the S&P 500 was down between 0.3 percent to 6.6 percent three months following the initial hike but up 3.8 percent to 7.0 percent six months afterward. Additionally, with the S&P 500 currently trading just under 17.5 times trailing 12 month estimates, in line with the 60-year average, valuation appears fair and not at extremes. Equity market response to initial fed funds rate hike S&P 500 Raise 3 months after 6 months after 9 months after 3/31/1994-0.3% 3.8% 3.0% 6/30/1999-6.6% 7.0% 9.2% 6/30/2004-2.3% 6.2% 3.5% Source: FactSet Research Systems, Inc. Geopolitical headwinds: Geopolitical risks have risen following Russia s annexation of Crimea. While the Russia-Ukraine conflict remains a work-in-progress, the final outcome and economic impact to the region, including to the European Union, remains unknown. At present, the broad equity market seems to be shrugging off the conflict, perhaps signaling that Russia s aggressions will stop with Crimea and the final outcome will not be severely detrimental to global economic growth. At a minimum, geopolitical concerns are likely to result in increased market volatility over the ensuing weeks. International influences: We believe a primary factor driving above-consensus earning estimates is the pace of global growth. While Europe is widely believed to be slowly recovering from its recession, the uncertainty associated with the Russia-Ukraine conflict could impact global growth. Russia supplies around 30 percent of Europe s natural gas, as well as significant amounts of oil and coal, according to Capital Economics. Additionally, uncertainty is high regarding the pace of economic growth in China as the country transitions from an export- to consumptiondriven economy. China is also dealing with overall slow emerging markets growth, wage gains, higher shipping costs, tighter credit and rising interest rates, among other issues. Any slowing in China s manufacturing segment implies global inflationary pressures are likely to remain muted, an overall positive for U.S. financial markets. At a minimum, expectations for international operations to help drive earnings growth for U.S. multinational companies are being tempered. Favored sectors: We continue to favor cyclical sectors that tend to benefit from moderate economic growth. U.S. economic growth appears to be solidifying and broadening, driven in part by U.S. energy independence Important disclosures provided on page 6. Page 3

and a manufacturing renaissance of sorts. Our bias is for cyclical sectors and companies that have both U.S. and international footprints and tend to do well in a slow growth, relatively low interest rate, low inflationary economy, such as industrials, technology, financials, healthcare and select materials and consumer discretionary companies. We also like companies with increasing cash levels, high cash flow and strong balance sheets, thus presenting investors with both dividend income and price appreciation potential. Additional contributing factors Several market-related items or events are likely to impact the performance of equities throughout the remainder of. 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0% -0.5% -1.0% -1.5% Midterm elections: History suggests that midterm election years usually have a down first half followed by a rally into the election. As illustrated, from 1930 to 2010, the average monthly price return for the S&P 500 was noticeably higher in the fourth quarter of midterm election years. S&P 500 monthly price return during midterm election years (Average for 1930-2010) Jan Feb Apr May Jun Jul Aug Oct Nov Dec Source: Strategas Research Partners Fund flows: While fund flows into equities have on average improved since the beginning of 2013, flows into bond funds have dwarfed equity since the financial crisis. According to Strategas Research Partners, from 2008 through 2013, nearly $1 trillion has flowed into bonds with $377 billion coming out of equities. While this trend has reversed somewhat in 2013 and early, the rotation from bonds to equities and/or other asset classes arguably remains in the early innings and may serve as a catalyst supporting higher equity prices. Cumulative net flows (shown in billions) Cumulative net flows (shown in billions) 9,500 8,500 7,500 6,500 5,500 4,500 $1,400 $1,200 $1,000 $800 $600 $400 $200 $0 -$200 Flows into mutual funds -$400 2008 2009 2010 2011 $1,200 $1,000 $800 $600 $400 $200 $0 -$200 -$400 -$600 2008 2009 2010 2011 Source: Strategas Resource Partners; data: January Bond ETFs Equity Bond 2013 Equity 2013 Number of listed companies: The supply and demand characteristics of U.S. equities appear favorable. According to the World Federation of Exchanges, the total number of companies listed on U.S. exchanges has declined from 8,823 in 1997 to 5,008 today, a 43 percent decline. With lessening supply, this could help support an upward bias to equity prices. Number of companies listed on U.S. exchanges 8,823 1992 1994 1996 1998 2000 2002 2004 2006 2008 5,008 2010 Source: Strategas Research Partners; Data: sum of AMEX, NASDAQ, NYSE Important disclosures provided on page 6. Page 4

Mounting cash levels: Corporate balance sheets continue to reflect mounting cash levels, and expectations are for capital expenditures to increase in. According to Strategas Research Partners, for non-financial U.S. companies, corporate cash levels are near 50-year highs. Conversely, the dividend payout ratio for the S&P 500 is near historic lows. This presumably bodes well for future dividend increases as well as share buybacks and acquisitions. % of total assets 6% 5% 4% 3% 2% U.S. non-financial corporations cash 1990 1992 1994 1996 1998 2000 2002 2004 2006 Source: Strategas Research Partners 110 100 90 80 70 S&P 500 dividend payout ratio 2008 2010 Areas causing concern The list of items with potential to derail an advancing equity market is seemingly endless. It is often the unexpected that causes price trends to change course. Among the things we worry about are potential disruptions to global economic growth, company earnings and investor confidence. Other items we worry about are: A U.S. economy where economic growth is either too slow (putting pressure on company earnings) or too fast (implying inflationary pressures that could lead to price-earnings multiple contraction). Escalation of the Russia-Ukraine conflict resulting in further regional instability, additional country involvement and/or slowing in the rate of global economic growth. Economic slowing among emerging markets in general and China in particular. As the world s second largest economy behind the United States, it is hard to envision accelerating global economic growth without meaningful participation from China. Deterioration of U.S. company profit margins, currently near 50-year peak levels, partially the result of lean cost structures and low wage growth. At present, as long as interest rates and energy costs remain relatively low, earnings hold up and wage growth remains measured, it seems plausible for margins to hold up as well. Increased policy risk in Washington post-midterm elections, when lawmakers presumably focus less on collaboration and more on brinksmanship as attention shifts toward items such as debt ceiling and tax and entitlement reform. 60 50 Average 40 30 20 1936 1947 1958 1969 1980 1991 2002 2013 Source: Strategas Research Partners Important disclosures provided on page 6. Page 5

Conclusion We expect equities to continue to trend higher throughout the remainder of, but at more moderate levels than what was experienced in 2013. Most notably, is proving to be a transition year with price appreciation driven more by earnings versus Federal Reserve-driven liquidity and price-earnings multiple expansion. While geopolitical risks are elevated and the Fed is signaling that it will likely raise rates sometime in 2015, which also implies underlying economic growth and rising company earnings, we believe the drivers for higher equity prices remain intact: Valuation, while elevated, remains fair and not at extremes. Sentiment is generally favorable, driven by the wealth effect associated with higher stock prices and the housing recovery. Inflation is low, providing justification for price-earnings ratios at or near current levels. The health of the U.S. and global economies remain a nearterm wildcard. We expect to glean increased visibility into the pace of U.S. and global economic growth as the second quarter progresses. We continue to favor the risk/reward profile of cyclical sectors and companies that historically benefit from a slowly improving economy such as industrials, technology, financials, healthcare, and select materials and consumer discretionary companies. Our current price target for the S&P 500 is 2,030 based on a price-earnings multiple of 17.5 times our earnings estimate of $116. Contributed by: Terry D. Sandven Chief Equity Strategist U.S. Bank Wealth Management reserve.usbank.com Investments are: Not a Deposit Not FDIC Insured May Lose Value Not Bank Guaranteed Not Insured by Any Federal Government Agency This commentary was prepared on April 2, 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. U.S. Bank is not responsible for and does not guarantee the products, services or performance of third party providers. 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. 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