Investment Strategy Outlook - Mid-Year Update

7/25/2019 Investment Strategy Outlook - Mid-Year Update

1/11

Please refer to Appendix Important Disclosures.

2016 At The Half: Contrasts and Consistency

Highlights:

Fed Continues to Struggle with Messaging

Prospects for Economy May Be Better Than Assumed

Despite Rally, Equity Funds Continue to See Outflows

Breadth Offering More Support This Year Than Last

2016 has been a study in both contrasts and consistency. Contrast can be

seen in the performance of the stock market over the course of the first half.

Near the mid-way point of the first quarter, the S&P 500 had posted a year-

to-date decline of more than 10%. By the end of the quarter, however, the

S&P 500 was back in positive territory for the year. Since then the S&P 500

has oscillated within a narrow 75 point range, echoing the price action that was seen over the course of the first half of 2015.

The consistencies and contrasts extend beyond the movement of popular stock market averages. While the fundamenta

situation is little changed, technical conditions now are quite different from 2015. The Fed continues to offer mixed signals

and struggle with communication while its actual policies have not become a headwind. The economy, while poised for growth

continues to struggle to build momentum and valuations remain stretched, with corporate fundamentals not matching price

performance.

Investors continue to have elevated

exposure to equities but optimism

has been slow to build even as

stocks have rallied off of their lows

From a seasonal perspective, clarity

around the outcome of this fall's

elections could be a tailwind fo

stocks, provided off course, that we

do not get any more NOISE (News

driven One-time Important Strategic

Events). While NOISE tends to be

just noise, getting through it can add

to volatility. The marked

improvement in the broad marke

is a s ignificant difference between

2015 and 2016 and could be a

source of support if noise levels

do become elevated.

Investment Strategy OutlookJune 24, 2016

Baird Market & Investment Strategy

Outlook Summary

Weight of the Evidence Turns MildlyBullish

Valuation Excesses Have Not BeenRelieved; Exposure to Equities Still High

Breadth Tailwind Supportive of Stocks

U.S. Leadership Intact, With Focus OnMid-Caps

Rising Inflation A Risk for Bonds

Bruce BittlesChief Investment [email protected]

William Delwiche, CMT, CFAInvestment [email protected]

Indicator Review

Fundamental Factors

Federal Reserve Policy Neutral 0

Economic Fundamentals Bullish +1

Valuations Bearish -1

Techn ical Factors

Investor Sentiment Neutral 0

Seasonal Patterns/Trends Neutral 0

Tape Bullish +1

Weight of the Evidence = Mildly Bullish +1

10R.17


2/11

Investment Strategy Outlook

Robert W. Baird & Co. Page 2 of 1

The weekly chart of the S&P 500

provides a nice visual representation of

the contrast and consistency that we are

discussing. For all the noise that can

be seen on a day-to-day basis, theS&P 500 continues to move within a

well-defined trading range(as seen in

the top portion of the chart to the right)

that is nearly two years old. From a

momentum perspective (seen at the

bottom of the chart), 2016 could hardly

be more different that 2015. While it is

too early to conclude that a new

momentum up trend has emerged in

2016, it does look like the downtrend

that was in place last year has been

broken. In other words, the consistency

suggested by the continuation of the

trading range environment may gloss

over improvements that are being seen

beneath the surface.

Federal Reserve Policy remains

neutral. Actual monetary policy has

not become a headwind for stocks.

After the 25 basis point rate hike in

December, the Fed has been on hold

and the median projection among

FOMC members is that only 50 basis

points of tightening will be seen in

2016 (down from an early year

expectation of 100 basis points of

tightening). The Fed has been able to

take a wait-and-see approach to rate

hikes because inflation remains

relatively benign.But when one looksacross several inflation indexes (the

chart here shows different takes on the

CPI), it appears that inflation has

started to move off its lows.The yearly

change in the median CPI, for

example, is now above 2.5%, the

highest level since 2008.

Source: Ned Davis Research

Source: StockCharts


3/11



Despite this up-tick in inflation, fixed income investors have

pushed bond yields lower in 2016, with the most recent drop in

yields coming as macro-related uncertainties have intensified in

June. Low yields around the world have helped keep demand

for U.S. Treasuries relatively robust. But the gyrations seen in

the yield on the 10-year T-Note this year reflect our view on why

Fed policy is currently neutral.While the Fed has not yet

raised rates in 2016, it has, through various media, hinted

that it would at upcoming meetings. These hints have

helped produce spikes in bond yields, which have then

reversed once it became clear that the Fed was not yet

ready to act.

The issue for the Fed is that its intention to be transparent

and open has the effect of providing more noise and

uncertainty for stocks and bonds.At this point, less might be

more when it comes to Fed communications. This might mean

fewer Fed officials giving speeches and doing away with (or

reducing the frequency off) the now quarterly Summary

Economic Projections released in conjunction with FOMC

meetings. While it might seem useful to know what members of

the Fed are forecasting for growth, inflation and the path of

interest rates, this should be tempered by the realization that

forecasts are rarely correct. On the positive side, the recent

lowering of the long-rung expected growth for the economy

could provide a lower threshold for the economy to get over.

Source: StockCharts


4/11



Economic Fundamentals are still

bullish. Growth has been weaker than

expected to start 2016, but that has

been a recurring theme over the course

of the last few years. Domestic demand

(the bottom clip in the chart to the right)

has been a bit more robust that overall

GDP growth, but after posting better

than average growth in five of six

quarter, growth in domestic demand has

slipped over the past six months. The

good news from a growth perspective

is that real-time tracking of second

quarter activity suggests growth has

rebounded and the numbers for the

first half overall will not be out of linewith what has been seen in recent

years.

A hotly debated economic topic in the

first half of 2016 has been the decline

in productivity growth. While it has

come into focus this year, the trend

has really been deteriorating since

2000. That was about the same time

that actual growth started to fall short

of economist expectations. Growth

began exceeding expectations in the

early 1980s, which according to this

chart was the same time that the trend

in productivity growth began to

improve. Weakness in productivity

growth may just be part of a seculartrend for the economy and if long-

term conditions in the economy are

improving, productivity growth (and

economic growth overall) could soon

surprise on the upside.




5/11



One of the reasons suggested for weak

productivity growth is the relative lack of

investment that has been taking place in

the economy. While investment shrank

to nearly zero after each of the past

two recessions, more recently it hasrebounded and is at a historically

high level relative to GDP. Looking

again at 1980 as an example, the

cumulative effect of investment spending

took time to manifest itself in productivity

growth and economic growth. It is not

clear that the same will not hold this time

around. That this is not being widely

forecast does not, in ou r mind, make

it less likely to happen. In fact, with

businesses now facing rising labor costs

and having trouble hiring skilled workers,

investment spending could accelerate in

coming quarters.

There are numerous ways to discuss

the health of the labor market.

Unfortunately, the headline generating

monthly payroll data might be one of

the least useful. The last two data

points in that survey have been

disappointing and this has helped fuel

speculation that the recovery in the

labor market is running out of steam

(this appears to have played a part in

the Feds decision not to raise rates in

June). Wage growth (as measured by

the Federal Reserve Bank of Atlanta)

seems to suggest the opposite. Wagegrowth is accelerating for all

workers, especially for those who

are switching jobs. This seems

consistent with an economy that is

finding its footing and continuing to

show improvement. It may also help

put upward pressure on inflation.

Source: Federal Reserve Bank of Atlanta



6/11



Valuations are bearish.The median P/E ratio for stocks in the

S&P 500 is at its highest level in over a decade. Historically,

valuations do tend to trend higher over the course of a secular

bull market. But at this point it appears that prices have gotten

ahead of fundamentals.

Valuations are poor timing indicators a stock (or market) that

is expensive can get more expensive, and one that is cheapcan get cheaper still. Over the longer term, however, valuations

are a good indicator of risk. When stocks are cheap (by

historical standards) forward returns tend to be robust.

When stocks are more expensive forward returns tend to

be depressed. As seen in the chart to the left, based on

average 10-year earnings, the S&P 500 is currently in the most

expensive quintile and forward returns under such conditions

have tended to be weak.

The good news from a valuation perspective is that some of the

fundamental headwinds may be diminishing and earnings

growth could soon rebound. Forecasts for earnings are as

notoriously unreliable as forecasts for growth, but there is still

some reason for optimism. Earnings revisions are starting to get

tweaked higher, and the U.S. Dollar is now declining on a

year-over-year basis, which has historically been a strong

tailwind for earnings growth. The valuation excesses

described on the previous page could as easily be resolved

through improving fundamentals as through price weakness.

Source: StockCharts


7/11



Investor sentiment is neutral.The weakness early in 2016 led

to an explosion of pessimism that has not been fully unwound.

Even as stocks have rallied, optimism has been slow to build

and funds have continued flow away from equities (and toward

bonds). The pace of outflows has been intense, rivaling on

a 4-week basis the outflows seen in 2008 and 2000.This has

historically been bullish for stocks.

The skeptic might argue that mutual funds are in secular

decline, and investors increasingly favor ETFs. This is true to a

degree, but the pace inflows to ETFs has not matched the pace

of outflows from mutual funds. There have been only three

weeks over the course of the first half of 2016 in which the

combined ETF + Mutual Fund flows were positive by more than

just a marginal amount for U.S. equities. The tone was set

early in the year as stocks swooned and investors have not

yet found reason to shift funds back toward equities. If that

happens in the second half, it could be a tailwind for

stocks.

Despite the weekly data showing persistent outflows from

equities, aggregate exposure to stocks across all ETFs and

mutual funds remains elevated by historical standards.

Exposure to equities is just below its recent peak and cash

levels have scarcely risen off of their lows. For all the near-

term fear and uncertainty that has been expressed in 2016,

there is little evidence of a meaningful build in cash on the

sidelines.On possible explanation may be that while the fund

flow data (even when aggregated to include mutual funds and

ETFs) is measured in hundreds of millions and billions, total

assets are measured in trillions. While the flows get the

headlines, they are simply not making much of a dent in overall

exposure. In the same way the elevated valuations have a

depressing effect on future stock market returns, so too has

elevated exposure to equities. The chart to the right shows a

strong inverse correlation between the percent of household

financial assets in equities and forward returns for the S&P 500

(shown on the right axis, and inverted to facilitate the

comparison). While the latest update to this data shows that

exposure to equities has been reduced slightly in recent

quarters, it remains elevated by historical standards.

Seasonal patterns are neutral. The intense focus that

seasonal patterns have received in recent years has reduced

some off their effectiveness. But we

believe there is still information in them

and history remains the only guide we

have. While the first quarter was a

clear aberration in terms of the degree

of the move, it was not totally out of

character with historical election year

patterns. Nor for that matter has the

second quarters range-bound drift.Looking ahead, seasonal patterns

suggest stocks could drift higher

until the presidential election really

heats up this fall and the pattern

after that could depend on which

candidate appears to have the upper

hand.

Breadth has turned bullish with the

average stock leading the popular

averages.This is in marked contrast to

2015. Last year, the S&P 500 was upon the year because of the so-called

FANG stocks. In 2016, it is the

opposite. The S&P 500 is positive on

a year-to-date basis despite

weakness in the FANGs. Those four

stocks are down an average of 3% in

2016, while the remaining stocks in the

S&P 500 are up an average of more

than 5% this year A market that isSource: Ned Davis Research


8/11



narrowly supported is vulnerable if the

few leaders stumble, while a market that

is broadly supported can usually find

another sector or stock to pick up the

leadership baton.

Another way to view this change in

leadership is by comparing theperformance of the S&P 500 (which is

cap-weighted) to an equal-weight

version of the index. That is represented

in this chart. The ratio in the middle clip

rises when the equal-weight index is

leading and falls when the cap-weighted

index is leading. The contrast between

2015 and 2016 is significant and

suggests the S&P 500 enters the

second half of 2016 with strong

underlying support. This could be a

tailwind despite some of the

fundamental uncertainties that have yet

to be resolved. Or especially if those

fundamental uncertainties move toward

resolution.

Industry group trends quickly turned

higher early this year and have

continued to improve even as the

S&P 500 has consolidated its gains.

While back to the level seen in early

2015 (and not yet matching the broad

strength seen in 2013 and the first half

of 2014), the direction now versus a

year ago is completely different. Then,

rallies were joined by fewer and fewer

groups still in up-trends, while now,

more and more stay robust even if the

overall S&P 500 is not going

anywhere.

One final difference between 2015 and

2016 to point out here is the number of

stocks making new 52-week highs and

lows. Similar to the industry group

trend indicator above, the number of

stocks making new highs is not yet

back to the levels seen in 2013, but it

is expanding and has broken the

dominant trend from 2015. Perhaps

more importantly, the number of

issues making new lows has

remained muted.In the second half of

2015 and opening weeks of 2016,


9/11



weakness in the S&P 500 was quickly

joined by an expansion in the new low

list. That is not happening now, and is

bullish for stocks.

What to Do (or Where to Go):

- While the weight of the evidence has

turned more bullish, risks (as

represented by high valuations and fully

exposed investors) remain elevated. As

such maintaining higher-than-normal

levels of cash may not be

unwarranted.

- With inflation creeping higher, bond

yields could follow suit. Optimism in

bonds is elevated and investors have

flocked to bond funds in the first half of

2016. Tactical investors may want to

tilt away from bonds (perhaps use

these funds to build cash positions).

- In terms of equity exposure, we have

continued to see U.S. leadership relative

to the rest of the world. While global

macro uncertainties are adding to

volatility, the trend favoring the U.S.

remains intact.

- Domestically, small-caps have gained

strength relative to large-caps, both atthe index-level and within our industry

group rankings. Given the

convergence of longer-term trend-lines

and other mixed signals between

large-caps and small-caps, we would

tilt domestic equity exposure toward

mid-caps.

- From a sector perspective, global

uncertainties and a thirst for yield has

helped keep defensive areas like

Consumer Staples and Utilities in theleadership group. More recently we

have seen more cyclical areas of the

market, like Energy, Materials and

Industrials move into the leadership

group, where we expect them to

stay in the second half o f 2016.

Source: Stock Charts


10/11



BAIRD STRATEGICASSETALLOCATION MODEL PORTFOLIOS

Baird offers six strategic asset allocation model portfolios for consideration (see table below), four of which have a mix of equity and

fixed income. An individuals personal situation, preferences and objectives may suggest an allocation more suitable than those shown

below. Please consult a Baird Financial Advisor in determining an asset allocation that will meet your needs.

Model PortfolioMix: Stocks /

(Bonds + Cash)Risk Tolerance Strategic Asset Allocation Model Summary

All Growth 100 / 0 Well above averageEmphasis on providing aggressive growth of capital with highfluctuations in the annual returns and overall market value of theportfolio.

Capital Growth 80 / 20 Above averageEmphasis on providing growth of capital with moderately highfluctuations in the annual returns and overall market value of theportfolio.

Growth withIncome

60 / 40 AverageEmphasis on providing moderate growth of capital and somecurrent income with moderate fluctuations in annual returns andoverall market value of the portfolio.

Income with

Growth

40 / 60 Below averageEmphasis on providing high current income and some growth ofcapital with moderate fluctuations in the annual returns and

overall market value of the portfolio.

ConservativeIncome

20 / 80 Well below averageEmphasis on providing high current income with relatively smallfluctuations in the annual returns and overall market value of theportfolio.

CapitalPreservation

0 / 100 Well below averageEmphasis on preserving capital while generating current incomewith relatively small fluctuations in the annual returns andoverall market value of the portfolio.

Bairds Investment Policy Committee offers a view of potential tactical allocations among equity, fixed income and cash, based upon a

consideration of U.S. Federal Reserve policy, underlying U.S. economic fundamentals, investor sentiment, valuations, seasonal trends

and broad market trends. As conditions change, the Investment Policy Committee adjusts the weightings. The table below shows both

the normal range and current recommended allocation to stocks, bonds and cash. Please consult a Baird Financial Advisor indetermining if an adjustment to your strategic asset allocation is appropriate in your situation.

Asset Class /Model Portfolio

All Growth Capital GrowthGrowth with

IncomeIncome with

GrowthConservative

IncomeCapital

Preservation

Equities:

Suggested allocation 95% 75% 55% 35% 15% 0%

Normal range 90 100% 70 - 90% 50 - 70% 30 - 50% 10 - 30% 0%

Fixed Income:


Normal range 0 - 0% 10 - 30% 30 - 50% 40 - 60% 45 - 65% 55 85%

Cash:


Normal range 0 - 10% 0 - 20% 0 - 20% 10 - 30% 25 - 45% 15 - 45%


11/11



ROBERT W.BAIRDS INVESTMENT POLICY COMMITTEE

Bruce A. Bittles B. Craig Elder Jay E. Schwister, CFAManaging Director Director Managing DirectorChief Investment Strategist PWM Fixed Income Analyst Baird Advisors, Sr. PM

Kathy Blake Carey, CFA Jon A. Langenfeld, CFA Timothy M. Steffen, CPA, CFPDirector Managing Director Director

Associate Director of Asset Mgr Research Head of Global Equities Director of Financial Planning

Patrick J. Cronin , CFA, CAIA Warren D. Pierson, CFA Laura K. Thurow, CFADirector Managing Director Managing DirectorInstitutional Consulting Baird Advisors, Sr. PM Director of PWM Research, Prod & Svc

William A. Delwiche, CMT, CFADirectorInvestment Strategist

Appendix Impor tant Disclosures and Analyst Certi fi cation

This is not a complete analysis of every material fact regarding any company, industry or security. The opinions expressed here reflect ojudgment at this date and are subject to change. The information has been obtained from sources we consider to be reliable, but we canguarantee the accuracy.

ADDITIONAL INFORMATION ON COMPANIES MENTIONED HEREIN IS AVAILABLE UPON REQUESTThe indices used in this report to measure and report performance of various sectors of the market are unmanaged and direct investmenindices is not available.

Baird is exempt from the requirement to hold an Australian financial services license. Baird is regulated by the United States Securities aExchange Commission, FINRA, and various other self-regulatory organizations and those laws and regulations may differ from Australilaws. This report has been prepared in accordance with the laws and regulations governing United States broker-dealers and not Australlaws.

Copyright 2016 Robert W. Baird & Co. Incorporated

Other Disclosures

United Kingdom (UK) disclosure requirements for the purpose of distributing this research into the UK and other countries fwhich Robert W. Baird L imited ( RWBL ) holds a MiFID passport.

This material is distributed in the UK and the European Economic Area (EEA) by RWBL, which has an office at Finsbury Circus House, Finsbury Circus, London EC2M 7EB and is authorized and regulated by the Financial Conduct Authority (FCA).

For the purposes of the FCA requirements, this investment research report is classified as investment research and is objective.

This material is only directed at and is only made available to persons in the EEA who would satisfy the criteria of being "Professioninvestors under MiFID and to persons in the UK falling within articles 19, 38, 47, and 49 of the Financial Services and Markets Act of 20(Financial Promotion) Order 2005 (all such persons being referred to as relevant persons). Accordingly, this document is intended only persons regarded as investment professionals (or equivalent) and is not to be distributed to or passed onto any other person (such persons who would be classified as Retail clients under MiFID).

Robert W. Baird & Co. Incorporated and RWBL have in place organizational and administrative arrangements for the disclosure aavoidance of conflicts of interest with respect to research recommendations.

This material is not intended for persons in jurisdictions where the distribution or publication of this research report is not permitted under tapplicable laws or regulations of such jurisdiction.

Investment involves risk. The price of securities may fluctuate and past performance is not indicative of future results. Any recommendatcontained in the research report does not have regard to the specific investment objectives, financial situation and the particular needs any individuals. You are advised to exercise caution in relation to the research report. If you are in any doubt about any of the contentsthis document, you should obtain independent professional advice.

RWBL is exempt from the requirement to hold an Australian financial services license. RWBL is regulated by the FCA under UK laws, whmay differ from Australian laws. This document has been prepared in accordance with FCA requirements and not Australian laws.

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Investment Strategy Outlook - Mid-Year Update