situation analysis u.s. equities midyear update...economic growth in developing countries, such as...

U.S. Equities Midyear UpdateExecutive summary

Equities are entering the second half of 2015 by struggling to maintain their swagger. On average, investors appear to be on edge and in disbelief, lacking conviction as to the most prudent near-term course of action following lackluster year-to-date performance, mixed signals of economic growth, uncertainties surrounding Greece, and ramping expectations that a Federal Reserve (Fed) rate hike is imminent. As we transition to the second half of the year, mindful that volatility is apt to increase as we move closer to a likely Fed move, in our view, equities remain a buy-the-dips, grind-higher market. Our bias remains with cyclical sectors and companies, such as Information Technology, Industrials and Financials. Our 2015 S&P 500 price target is 2,225.

First half 2015 in review

By many measures, performance in the first half of 2015 was, on average, lackluster and below historical levels. In general, international outperformed domestic stocks, small companies modestly outperformed large-cap companies, and sector performance leadership was largely inconclusive between cyclical versus defensives, with a bias toward cyclical outperformance. The plunge in oil prices, rise of the U.S. dollar, adverse weather, West Coast port strikes, anticipation of a future Fed rate hike, and ongoing crisis in Greece were among items weighing on earnings, investor sentiment and overall market performance.

To a large degree, equity price trends in the first half of 2015 were symptomatic of a split-personality market, with sentiment frequently shifting from optimism to angst, often based on the economic release du jour.

Market and sector performance

IndexPrice

6/30/15

20152014 1Q 2Q YTD*

S&P 500 2,063.11 11.4% 0.4% -0.2% 0.2%Dow Jones Industrials 17,619.51 7.5% -0.3% -0.9% -1.1%Russell 2000 1,253.95 3.5% 4.0% 0.1% 4.1%MSCI EAFE 1,842.46 -7.2% 4.2% -0.5% 3.8%

MSCI Emerging Markets 972.25 -4.8% 1.9% -1.1% 1.7%

Sectors of the S&P 500 Weight

Information Technology 19.6% 18.2% 0.2% -0.2% 0.0%Financials 16.6% 13.1% -2.5% 1.2% -1.3%Healthcare 15.4% 23.3% 6.2% 2.4% 8.7%Consumer Discretionary 12.8% 8.0% 4.4% 1.6% 6.0%Energy 7.9% -10.0% -3.6% -2.6% -6.0%Consumer Staples 9.4% 12.9% 0.4% -2.4% -2.1%Industrials 10.1% 7.5% -1.4% -2.8% -4.1%Materials 3.1% 4.7% 0.4% -1.0% -0.6%Utilities 2.9% 24.3% -6.0% -6.7% -12.3%Telecommunication Services 2.3% -1.9% 0.3% 0.4% 0.6%

Source: FactSet Research Systems. *Data: 6/30/15; excludes dividends.

Important disclosures provided on page 8.

Equities have largely been a split-personality market during the first half of 2015, with sentiment shifting from optimism to angst, often based on the economic statistic du jour.

As we begin the second half of 2015, the wall of uncertainty appears elevated, warranting a bias toward caution, but the macro and fundamental backdrops seem supportive of higher equity prices.

Investment products and services are:

NOT A DEPOSIT NOT FDIC INSURED MAY LOSE VALUE NOT BANK GUARANTEED NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY

SITUATION ANALYSIS

• Market and sector performance. Performance leadership was varied throughout the first and second quarters, with the performance of international equities being among the greatest surprises at midyear.

– Developed international led performance throughout most of the first half, advancing 3.8 percent as of the end of June. Central bank easing and signs of economic stabilization in both the eurozone and Japan are among reasons driving this favorable performance.

– Equally noteworthy was the first-half returns of the MSCI Emerging Markets index, up a modest 1.7 percent, after retreating from nearly double-digit gains earlier in the year. The less sanguine second quarter returns in the emerging markets segment is partially attributed to a slowing in the pace of economic growth in developing countries, such as China and Russia.

– In the United States, overall first-half performance largely trended below historical levels. The U.S.-oriented S&P 500, Dow Jones Industrial Average and Russell 2000 ended midyear up 0.2 percent, down 1.1 percent and up 4.1 percent respectively, with four of 10 sectors posting positive gains. Among sectors, Healthcare and Consumer Discretionary are leading performance, up 8.7 percent and 6 percent respectively, while the bond-like Utilities sector continued to lead performance to the downside, declining 12.3 percent.

• Technical influences. U.S. equities are beginning the second half of 2015 trending in a relatively tight band around the 50-day moving average and near all-time highs of 2,130.82 reached on May 21, 2015. Since the financial crisis in 2008, the popular index has trended generally plus/minus 3 percent around its 50-day moving average. While past trends are no assurance of future outcomes, technically, equities seem within a “zone of ok,” implying a generally improving risk/reward profile when trading at or below the 50-day moving average.

S&P 500: price vs. moving average

Sep2013

Dec2013

Mar2014

Price

200-day moving average

50-day moving average

Jun2014

Sep2014

Dec2014

Mar2015

Jun 152015

2200

2100

2000

1900

1800

1700

1600

1500

Price

Source: Bloomberg. Data as of 6/15/15.

Second-half 2015 outlook

We are maintaining our constructive outlook for equities through year-end and into 2016, believing that the Goldilocks-like environment of moderate growth and benign inflation remain intact. Near term, volatility is apt to increase in July and August as investors navigate through the historically slow “dog days of summer,” await second quarter results, and transition closer to a likely Fed rate move.

• Buy-the-dips, grind-higher market. The fundamental backdrop remains supportive of higher equity prices. Importantly, inflation remains restrained; earnings are increasing; valuations, while stretched, remain short of extremes; and the list of compelling alternatives appears limited.

– Restrained inflation. By many measures, inflation remains mostly restrained which, in our view, is paramount to supporting equities at current levels. The Consumer Price Index (CPI) and average hourly earnings are trending near the Fed’s targeted long-term 2 percent level. In the absence of widespread inflation, current price-earnings multiples seem warranted, or at least justified, based on historical trends.


SITUATION ANALYSIS | U.S. Equities Midyear Update

A review of inflation patterns

2007 2008 2009 2010

CPI (core)

CPI (exc. Food & Energy)

2011 2012 2013 2014 Apr 302015

6%

5%

4%

3%

2%

1%

0%

-1%

-2%

-3%

Source: Capital Economics. Data period: 7/01/07-4/30/15.

– Increasing earnings. Equities remain an earnings-driven market, and an improving economy and higher earnings are required to drive equities still higher, in our view. At midyear, consensus estimates are for earnings growth in 2015 over 2014 levels of roughly 5 percent. Outlooks and expectations for 2016 are considerably more sanguine, with earnings growth projected in the 12 percent range over year-ago levels. We suspect expectations for 2016 will be tempered some as we approach year-end 2015.

– Tolerable valuations. Valuations remain stretched yet short of extremes. On the margin, valuation gives us reason for pause as stocks appear priced-to-perfection, with a margin of error that continues to narrow. At midyear 2015, the S&P 500 traded at roughly 18.5 and 18.0 times trailing 12-month and current year estimates, respectively. Price-earnings multiples of 20 times or higher would constitute more extreme levels, in our view. Importantly, valuation can be a poor timing tool as markets can remain over- or under-valued for prolonged periods.

S&P 500 P/E with long-term average

1950 1960 1970 1980 1990 2000

Average

2010

30x

25x

20x

15x

10x

5x

Source: Strategas Research Partners. Data: trailing 12-month basis through 6/30/15.

– Few compelling alternatives. The list of compelling alternatives to equities remains limited, with select stocks providing both income and appreciation potential. As of June 30, according to FactSet Research Systems, 34 percent of S&P 500 companies have dividends yielding above the 10-year Treasury yield of 2.4 percent, providing investors with both income and price appreciation potential.

• Mindful of near-term headwinds. As we move through the early weeks of the second half, complacency, apathy and uncertainty are apt to be more the norm as investors navigate the “dog days of summer,” await second quarter results and transition closer to a likely Fed rate move in September.

– Seasonal tendencies for underperformance. The summer months are historically among the worst-performing months of the year before rallying towards year-end. According to Strategas Research Partners, since 1950, the large cap-oriented S&P 500 has posted positive gains during the summer months in roughly 50 percent of the time, considerably below early- and late-year levels. Additionally, according to S&P Capital IQ, the same seasonal tendencies apply to the small cap-oriented Russell 2000.



– Fed rate decision remains an overhang. Improving employment data, jobless claims, retail sales and sentiment trends provide anecdotal evidence of recent economic data pointing toward an improving economy, presumably warranting something other than crisis-level rates and justifying the Fed to soon begin the rate normalization process. While the consensus base-case is for the Fed to raise rates in September, perhaps more important than the initial rate hike is the pace, which we expect to be slow, measured and implemented over an extended period. Nevertheless, at a minimum, a rate hike represents change, which introduces uncertainty, often resulting in market volatility.

Remaining 2015 Federal Open Market Committee (FOMC) meetings

July 28-29

September 16-17*

October 27-28

December 15-16*

*These meetings include summaries of economic projections and press conference.

• Navigating a transitioning market. While the macro and fundamental backdrops appear supportive of higher equity prices, facets of the environment appear on the cusp of change. Compared to the first half of 2015, the second half of the year seems likely to be characterized as a period of transition, which may be associated with uncertainty and elevated levels of market volatility.

– U.S. economic growth appears to be strengthening, warranting something other than crisis-level interest rates.

– An improving jobs market is likely to add to downward pressure on margins, which is a potential headwind to earnings growth.

– Global oil supply/demand metrics are widely expected to become clearer as the year progresses.

– Political influences are apt to become more significant toward year-end as the field of U.S. presidential candidates narrows.

– The negotiations with Greece and its creditors remain a work in progress, with the outcome having the potential to negatively weigh on the pace of global economic growth.

• Inflationary indications. Since the financial crisis in 2008, our thesis has been that it is hard to envision widespread inflation in an environment where the unemployment rate has trended above the longer-term

Next few months tend to be a coin toss

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

80%

75%

70%

65%

60%

55%

50%

45%

40%

62%

55%

69%

57%

52%54%

55%

45%

60%

66%

77%

S&P

500

% o

f pos

itive

mon

thly

retu

rns

Source: Strategas Research Partners. Data through year-end 2014.

Average rolling six-month small-cap price returns

Jan-Ju

nFe

b-Jul

Mar-Au

gAp

r-Sep

May-Oct

Jun-Nov

Jul-Dec

Aug-J

anSe

p-Feb

Oct-Mar

Nov-Ap

rDec-

May

12%

10%

8%

6%

4%

2%

0%

2.0%

10.5%

Source: S&P Capital IQ. Data period: 6/30/79-4/24/15.

– Second quarter results likely to set tone. Second quarter results are likely to set the tone for performance leading into year-end. First quarter results were hampered by the negative effects of the plunge in oil prices and rising dollar. Of debate is the degree to which consensus estimates for the second quarter and 2015 have been reset too low. Economic stabilization in international-developed countries, such as the eurozone, and a slowing in the pace of the rising dollar may present a favorable backdrop for earnings surprises. In the past, upside earnings surprises have typically been associated with advancing equity prices.



• Oil prices. Oil remains an unknown. Global oil supply/demand metrics are widely expected to become clearer as the year progresses, perhaps providing stability and a degree of visibility into future oil prices, as well as share prices of companies within and around the oil patch. On the margin, crude oil prices could remain near current levels into year-end. While U.S. rig counts are off significantly from recent highs, and while the rate of U.S. production is beginning to wane—typically a positive backdrop for the sector—production per rig in the United States remains relatively high and OPEC production has increased, adding to global supply and putting down pressure on prices. We see this pattern continuing into year-end.

U.S. oil and gas rig counts

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

2500

2000

1500

1000

Source: Bloomberg. Data as of 6/12/15.

• Political influences. Political influences are apt to become more significant toward year-end as the field of U.S. presidential candidates narrows. This presumably implies increased brinksmanship and political wranglings, which may weigh on investor sentiment as we look to 2016 and the national elections.

Sector preferences

We are maintaining our cyclical bias, favoring sectors and companies that tend to perform well during an improving, slow-growth, low-inflationary environment. However, should the pace of economic growth accelerate or decelerate, the sectors likely to outperform will differ. As such, with the investment environment arguably becoming more difficult, sector and stock selection are growing in importance. We envision three scenarios unfolding over the second half and into 2016.

historical level while annualized wage growth remains under 2 percent. In the absence of inflation, current market multiples are arguably warranted.

– At present, modest inflationary indications are beginning to surface, evidenced by the modest increase/flat trend line of average hourly earnings reflected in the May and June employment reports. This implies that wage growth appears to be firming, and elevates the importance of the monthly jobs reports as one measure of inflation leading up to the September FOMC meeting.

– While considerable price-earnings multiple expansion beyond current levels is increasingly unlikely, it also seems unlikely that considerable price-earnings multiple contraction is in the offing near term. Importantly, as illustrated and asserted by Strategas Research Partners, S&P price-earnings multiples have historically trended in the 17 times range during periods when inflation has trended between zero and the 4 percent level without significant contraction.

Average S&P 500 P/E by CPI year-over-year tranche (1950-current)

-2-0% 0-2% 2-4% 4-6% 6-8% 8-10% 10-12% 12-14%

20x

18x

16x

14x

12x

10x

8x

6x

4x

Source: Strategas Research Partners. Data as of 4/01/15.

S&P P/E points change before and after Fed rate hike (next 12 months)

Date of first raise -6 mos -3 mos +3 mos +6 mos +12 mos

Jan 1987 -1.7 -1.3 -0.2 1.0 -2.7

Mar 1988 3.4 -0.2 0.0 -0.6 -3.5

Feb 1994 -0.4 -0.1 -1.4 -1.7 -1.3

Jun 1999 -1.0 -0.5 -2.4 0.5 9.2

Jun 2004 1.6 0.9 -0.9 -0.1 1.5

Average 0.4 -0.2 -1.0 -0.2 0.7

Source: Strategas Research Partners. Data as of 3/31/15.



S&P 500 performance before and after first Fed tightening

Date of first raise -6 mos -3 mos +3 mos +6 mos +12 mos

Mar 1983 27.0% 8.8% 9.9% 8.6% 4.1%

Jan 1987 0.2% 7.9% 19.1% 21.2% 2.6%

Mar 1988 -19.8% 4.1% 6.0% 5.4% 13.3%

Feb 1994 4.7% 2.7% -3.9% -2.4% 1.9%

Jun 1999 11.7% 6.7% -6.6% 7.0% 6.0%

Jun 2004 2.6% 1.3% -2.3% 6.2% 4.4%

Average 4.4% 5.2% 3.7% 7.7% 5.4%

Source: Strategas Research Partners. Data as of February 2015. Past performance is no guarantee of future results.

– Financials. We continue to warm to this sector, believing that an improving economic backdrop presents a favorable environment for loan growth, and a modest uptick in interest rates will help net interest margins and overall profitability of the sector. Additionally, improved consumer credit quality and balance sheet metrics for many companies in this sector have improved in recent months.

– Healthcare. This is a sector for all seasons, comprised of both defensive- and more growth-oriented companies. In our view, this warrants at least market-weight exposure to the sector in most phases of the economic cycle. For the longer term, we favor companies at the forefront of innovation (such as biotechnology), leaders in emerging markets, and those growing sales and profits with products or services that reduce healthcare inflation.

• Scenario #1: slow growth, tame inflation. Our base case is the global economy continues along a trajectory of slow but improving economic growth, with inflationary pressures, particularly in the United States, remaining generally restrained justifying the Fed to begin the rate normalization process, with subsequent rate hikes being made in small increments. As such, among our favored sectors would be Information Technology, Financials, Industrials, Healthcare and, to a degree, Consumer Discretionary.

– Information Technology. Technology remains a sector favorite, particularly when looking to 2016 and beyond. Technology is a pro-growth sector that stands to benefit from higher capital expenditure spending. On balance, companies within the sector have strong free cash flow, mounting cash levels, and appear well positioned for dividend growth, share buybacks and/or acquisition potential.

– Industrials. Many industrial companies have been negatively impacted year to date by the effects of lower energy prices and a rising dollar, both weighing on first quarter earnings. Our attraction to this sector is somewhat of a near-term contrarian call given that, to a degree, many of these headwinds remain. The longer-term value-add profile of many companies within this sector has appeal, believing, too, that the sector may perform well as the global economy improves, along with price stabilization within the energy patch.

Sector performance during periods of rising interest rates (annualized)

Sector9/30/93 to 11/30/94

12/31/95 to 8/31/96

9/30/98 to 1/31/00

5/31/03 to 6/30/06

12/31/08 to 12/31/09

7/31/12 to 12/31/13

Average (sorted)

Technology 19.4% 20.8% 83.5% 6.1% 59.9% 17.4% 34.5%Discretionary -2.9% 10.9% 33.3% 7.5% 38.8% 35.4% 20.5%Materials 8.2% 9.3% 8.4% 15.5% 45.2% 22.0% 18.1%Industrials -3.5% 13.8% 20.6% 13.9% 17.3% 30.2% 15.4%S&P 500 -1.0% 8.9% 26.7% 9.4% 23.5% 22.9% 15.1%Healthcare 16.9% 8.5% 5.2% 2.3% 17.1% 29.5% 13.3%Financials -12.4% 14.7% 14.9% 9.3% 14.8% 32.6% 12.3%Energy -4.4% 9.2% 10.7% 27.9% 11.3% 16.7% 11.9%Staples 11.5% 13.4% -4.1% 6.4% 11.2% 13.8% 8.7%Telecom -13.4% -19.6% 31.7% 7.0% 2.6% 0.1% 1.4%Utilities -20.3% -7.4% -1.5% 13.3% 6.8% 0.3% -1.5%

Source: Strategas Research Partners. Data as of February 2015. Past performance is no guarantee of future results.



Conclusion

We are maintaining our constructive outlook for equities, believing that the Goldilocks-like environment of modest growth and restrained inflation remains intact, thus providing a favorable macro and fundamental environment for equities to grind higher in the second half of 2015 and into 2016.

• While performance has lagged year to date, for the most part, the environment remains favorable for equities since inflation remains restrained; interest rates are low; valuations, while stretched, are short of extremes; and the list of attractive alternatives appears limited.

• Near term, uncertainty is on the rise, potentially fueling higher-than-average market volatility as stocks appear priced-to-perfection, with a margin of error that continues to narrow. Additionally, investor angst is apt to increase in July, August and September as investors navigate through the historically slow “dog days of summer,” await second quarter results, and transition closer to a likely Fed rate move, presumably following the Federal Open Market Committee (FOMC) meeting on September 16-17.

• In aggregate, we continue to project a total return for the S&P 500 in 2015 in the range of 7 percent to 9 percent, based on earnings growth of approximately 5 percent, dividend income of roughly 2 percent, and limited price-earnings multiple expansion. We are maintaining our cyclical bias, favoring sectors and companies that tend to perform well during an improving, slow-growth, low-inflationary environment, such as Information Technology, Industrials, Financials, and to a degree, Healthcare and Consumer Discretionary. Our year-end price target for the S&P 500 is 2,225, based on a multiple of 19 times our 2015 earnings estimate of $117. Higher-than-expected earnings would present upside to our price target.

– Consumer Discretionary. This is a diverse sector, with many sub-industries. On balance, while the sector was among the best performing in the first half of 2015, we continue to believe that there is more upside to the sector, based on expectations for increased consumer spending, driven by improving employment and sentiment conditions as well as the residual effects of relatively low energy prices and an improving outlook for housing.

• Scenario #2: accelerating inflation. Faster-than-expected inflationary tendencies would likely elevate the wall of worry, serving as the basis for the Fed to move more quickly than anticipated and in greater increments. This is a least-favored outcome. It would put pressure on the broad equity market, presumably resulting in the end of the current seven-year bull market, because concerns of valuation would mount and price-earnings multiples contract. In this scenario, sectors we see that would likely post favorable relative performance include the defense-oriented Consumer Staples sector, defensive sub-sectors within Healthcare and Materials, including hard metals, such as gold. Bond-like sectors, such as Utilities and Telecommunication Services, would likely suffer. We view this scenario as being plausible but not probable.

• Scenario #3: economic weakness. Slower-than-expected economic growth, both in the United States and abroad, would fuel deflationary concerns, putting downward pressure on interest rates, weigh on earnings growth, and serve as a basis for muted equity returns. We think economic weakness would imply continuation of the low interest rate environment, benefiting bond-like sectors, such as Utilities and Telecom, as well as select subgroups within Healthcare. It would also elevate the importance of being sector agnostic in favor of investing in companies across all sectors with unique or competitive advantages. We view this scenario as also being plausible but not probable.



reserve.usbank.com

Contributed by: Terry D. Sandven Chief Equity StrategistU.S. Bank Wealth Management

This commentary was prepared July 1, 2015, 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. 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. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Indexes shown are unmanaged and are not available for investment. The S&P 500 Index is an unmanaged, capitalization-weighted index of 500 widely traded stocks that are considered to represent the performance of the stock market in general. The Dow Jones Industrial Average (DJIA) is the price-weighted average of 30 actively traded blue chip stocks. The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, and is representative of the U.S. small capitalization securities market. The MSCI EAFE Index includes approximately 1,000 companies representing the stock markets of 21 counties in Europe, Australasia and the Far East. The MSCI Emerging Markets Index is designed to measure equity market performance in global emerging markets.

Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. The value of large-cap stocks will rise and fall in response to the activities of the company that issued them, general market conditions, and/or economic conditions. Stocks of small-capitalization companies involve substantial risk. These stocks historically have experienced greater price volatility than stocks of larger companies and may be expected to do so in the future. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible difference in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.

© 2015 U.S. Bank N.A. (7/15)


situation analysis u.s. equities midyear update...economic growth in developing countries, such as...

Documents