Investment Strategy Outlook - Seeking Alpha

Please refer to Appendix – Important Disclosures.

Amid Uncertainty, Reasons for Encouragement

Highlights: • Fed Strikes a Dovish Tone for Now • Animal Spirits at Risk of Evaporating • Earnings Beat Rates Turning Lower • Optimism Emerging After Evidence of Panic • Seasonal Strength Being Challenged • Breadth Thrusts Not Being Followed by Better Trends

When stocks are declining, large prices moves are discussed in terms of seeing “increased volatility” but when prices rebound by a similar degree such language is usually discarded. In reality, it is two sides of the same coin. In the current case, the sharp rebound in stock prices in January (the S&P 500 rallied nearly 8%) was largely a function of the even larger decline seen in December (when the S&P 500 fell 9%). Longer-term trends can provide context at a time when day-to-day price moves can appear dizzying. The S&P 500 spent all of January inside of the bounds established in December (a so-called “inside month”). As welcome and impressive

as the January gains were, it would be premature to conclude that the longer-term trend has shifted. Rather, stocks appear to have enjoyed a sentiment-fueled bounce rather than rallying on evidence of fundamental improvement.

The weight of the evidence moved to neutral in early January after finishing 2018 with a message of caution. While the weight of the evidence has improved, the evidence in hand does not allow us to conclude that the cyclical bear market has run its course. In the wake of the nearly straight line move off of the December lows, more time and testing will be needed to determine whether the rally has been a prelude to a meaningful re-test or the first leg higher in a new cyclical bull market.

Investment Strategy Outlook February 7, 2019

Baird Market & Investment Strategy

Outlook Summary

Weight of evidence neutral as breadth

thrusts help stabilize market.

Stocks have rallied but re-test of 2018 lows cannot be ruled out.

Global economic conditions deteriorating; conditions in U.S. appear more resilient.

Fed suggests patient approach, but

market hearing only a dovish message.

Bruce Bittles Chief Investment Strategist [email protected] 941-906-2830

William Delwiche, CMT, CFA Investment Strategist [email protected] 414-298-7802

Indicator Review

Macro Factors (What Could Happen)• Federal Reserve Policy Neutral 0• Economic Fundamentals Bullish +1• Valuations Bearish -1

Market Factors (What Is Happening)• Investor Sentiment Neutral 0• Seasonal Patterns/Trends Neutral 0• Tape (Breadth) Neutral 0

Weight of the Evidence = Neutral 0

10R.17

mailto:[email protected]

mailto:[email protected]

Investment Strategy Outlook

Robert W. Baird & Co. Page 2 of 8

The weekly chart for the S&P 500 puts some of the recent price moves in context. The January price rally has brought the index back into a support/resistance range that had been intact prior to the December weakness. Price swings within this range can likely be discounted as noise, while moves outside of the range (above 2800 or below 2600) could provide more meaningful evidence of the underlying trend. Importantly, the trends from both a momentum and overbought/oversold perspective remain consistent with an ongoing cyclical bear market. The divergences that emerged over the course of 2018 have not been resolved. The lack of positive divergences from a momentum and breadth perspective at the December lows suggest it is more likely than not that the S&P 500 could re-test its December lows.

Federal Reserve Policy is neutral. In addition to dealing with the official Federal Reserve mandate of balancing economic growth and price stability, Fed Chairman Jay Powell is finding himself having to navigate public comments from his predecessor at the Fed (Janet Yellen) and President Trump as well as stock market volatility. After raising rates four times in 2018, the Fed’s latest summary of economic projections (released after the December 2018 FOMC meeting) suggested that the Fed Funds rate remained shy of neutral and that another two rate hikes were likely in 2019. In the wake of the first FOMC meeting of 2019, Powell appeared to dramatically shift course. The message to the market now seems to be that the rate normalization process is substantially complete, the pace of balance sheet drawdowns could be tweaked and it is uncertain whether the next move in rates will be higher or lower.

Source: StockCharts



The absence of updated economic projections from the Fed makes it difficult to determine whether perceived shift toward a more dovish stance is a messaging effect or if expectations for the economy and interest rates underwent a meaningful shift in the six weeks between the December and January FOMC meetings. The March release of new economic projections will help clarify that. Additionally, if incoming inflation data (we are watching the yearly change in the median CPI, shown on the previous page) runs hotter than expected it could put pressure on the Fed to strike a more hawkish tone. Further, a resumption in the up-trends in bond yields and/or copper prices could suggest there is more room for continued tightening than what is currently priced into the market. The futures market has a 28% chance of a rate cut by the end of 2019.

Economic Fundamentals remain bullish. While global economic risks are rising, conditions in the U.S. remain on relatively firm footing. Some slowing in growth is expected in 2019; this comes after two years of consistently accelerating growth. While global weakness is a headwind for U.S. growth, it would be quite rare for it to pull the U.S. into a recession. Given the global headwinds, some degree of patience by the Fed is likely a good thing. A more pressing concern for the U.S. economy is evidence that business and consumer confidence is waning. The “why” behind this retrenchment (there are myriad possible explanations) is not as important as whether this is a short-lived blip or a more meaningful evaporation of the animal spirits that have supported growth in recent years.

Source: Ned Davis Research

Source: StockCharts



Valuations remain bearish. We can think of valuations from two perspectives – whether what is currently priced into the market is being realized and where price and earnings are relative to their historical relationship to each other. In terms of whether current expectations are being realized, we are watching both the path of earnings expectations as well as the percentage of earnings reports that are surpassing those expectations. Earnings expectations for 2019 are being revised lower, and earnings for the first quarter are expected to be below their year-ago level. We are also seeing a dramatic drop-off in the earnings beat rate. After more than a year of 75% to 80% of reports beating expectations, the beat rate in Q4 has dropped to 72%. Stocks have tended to struggle when the beat rate is below where it was a year ago (as is now the case).

From a price-earnings perspective, 2018 provided some good news on valuation. After making an all-time high in February 2018, the Value Line P/E ratio (which blends trailing and expected numbers in its earnings component) moved sharply lower over the course of the year. It briefly approached a level that is more supportive of stock price appreciation, but the combination of a price rally and downward revisions to earnings expectations produced a sharp rebound in the P/E ratio. Taken altogether (and in light of other P/E ratios) the valuation picture is likely still a headwind for stocks.





Sentiment is neutral, though the optimism that has returned as stocks have rallied is approaching elevated levels. The good news from a sentiment perspective is that there was evidence of a meaningful panic at the December lows (investor panic is an important part of the bottoming process). This can be seen through the lens of equity fund flows, with outflows over a four-week period approaching $100 billion. While outflows have ebbed in 2019, inflows have not been seen on an aggregate basis (in contrast to January 2018 which experienced a surge in equity fund inflows). On a more cautious note, we are seeing evidence of increased optimism in the sentiment surveys. As an example, the NAAIM Exposure index has climbed all the way back to where it was as stocks were peaking in September.

Seasonal Patterns are neutral. At this point in the presidential cycle, seasonal patterns are typically considered a bullish tailwind for stocks. The three quarters that include the final quarter of the mid-term election year and the first half of the pre-presidential election year are the strongest in the entire cycle. Two caveats are keeping us from expecting that situation to play out in the current environment. First, the fourth quarter of 2018 posed a serious challenge to this trend. If typical seasonal strength is emerging, we would expect to see more leadership from small-caps. Second, seasonal strength in the stock market heading toward the presidential election usually gets fuel from monetary and fiscal policy stimulus. That stimulus is missing in the current environment.





Breadth is neutral. Coming into 2019, breadth was considered bearish. The bounce off of the Christmas Eve low was strong enough to produce a series of breadth thrusts and that helped shift breadth to neutral. Breadth thrusts have been seen on indicators based on the 10-day advance/decline ratio and the percentage of stocks trading above their 10-day averages. The percentage of stocks trading above their 50-day averages has soared, but remains shy of the 90% threshold for signaling a breadth thrust. While breadth thrusts do not preclude re-tests, their track record in terms of signaling more favorable environments for stocks is impressive. As an example, of the 18 breadth thrusts signaled by a surge in the percentage of stocks above their 50-day averages, all 18 have been followed by higher prices a year later, with an average gain that is twice the typical experience of the S&P 500.

There is a risk in the current environment that the prices swings of December and January have skewed these thrust indicators. So while we have upgraded breadth from bearish to neutral, we have stopped shy of suggesting it is bullish. In large part this reflects the absence of meaningful improvement in longer-term trends. Weakness in late 2018 from a price perspective was anticipated by deterioration in the percentage of global markets with rising 200-day averages. This warned that risks were rising, so we will watch it for evidence of improvement. So far that has not been seen. We would also expect confirmation from our industry group trend indicator and an expansion in the percentage of stocks trading above their 200-day averages.





BAIRD STRATEGIC ASSET ALLOCATION 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 individual’s 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 Portfolio Mix: Stocks / (Bonds + Cash) Risk Tolerance Strategic Asset Allocation Model Summary

All Growth 100 / 0 Well above average Emphasis on providing aggressive growth of capital with high fluctuations in the annual returns and overall market value of the portfolio.

Capital Growth 80 / 20 Above average Emphasis on providing growth of capital with moderately high fluctuations in the annual returns and overall market value of the portfolio.

Growth with Income 60 / 40 Average

Emphasis on providing moderate growth of capital and some current income with moderate fluctuations in annual returns and overall market value of the portfolio.

Income with Growth 40 / 60 Below average

Emphasis on providing high current income and some growth of capital with moderate fluctuations in the annual returns and overall market value of the portfolio.

Conservative Income 20 / 80 Well below average

Emphasis on providing high current income with relatively small fluctuations in the annual returns and overall market value of the portfolio.

Capital Preservation 0 / 100 Well below average

Emphasis on preserving capital while generating current income with relatively small fluctuations in the annual returns and overall market value of the portfolio.

Baird’s 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 in determining if an adjustment to your strategic asset allocation is appropriate in your situation.

Asset Class / Model Portfolio All Growth Capital Growth Growth with

Income Income with

Growth Conservative

Income Capital

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: Suggested allocation 0% 15% 35% 45% 50% 60% Normal range 0 - 0% 10 - 30% 30 - 50% 40 - 60% 45 - 65% 55 – 85% Cash: Suggested allocation 5% 10% 10% 20% 35% 40% Normal range 0 - 10% 0 - 20% 0 - 20% 10 - 30% 25 - 45% 15 - 45%

ROBERT W. BAIRD’S INVESTMENT POLICY COMMITTEE

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

Kathy Blake Carey, CFA Jon A. Langenfeld, CFA Timothy M. Steffen, CPA, CFP® Director Managing Director Director Director – PWM Research & Planning Head of Global Equities Director of Advanced Planning Patrick J. Cronin, CFA, CAIA Warren D. Pierson, CFA Laura K. Thurow, CFA Director Managing Director Managing Director Institutional Consulting Baird Advisors, Sr. PM Director – Wealth Solutions & Operations

William A. Delwiche, CMT, CFA Managing Director Investment Strategist



Appendix – Important Disclosures and Analyst Certification

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