Baird Market & Investment Strategy

Investment Strategy Outlook

April 11, 2016

Please refer to Appendix Important Disclosures.

Breadth Improves But Evidence Still Neutral
Highlights:
Fed Pursuing Slow Cycle For Rate Hikes
Rising Inflation Could Put Upward Pressure On Bond Yields
Earnings Headwind Subsiding, But Stock Valuations High
Presidential Election Cycle Warns Of More Volatility

Outlook Summary
Weight of the Evidence Neutral
Valuation Excesses Have Not Been
Relieved
U.S. Large-Caps Showing Leadership
Versus Small-Cap & The World
Cyclical Sectors Joining Relative

The persistent weakness that marked the first six weeks of the first quarter
Strength Leadership Group
was followed by persistent strength in the second six weeks, with the S&P
Bullish Breadth Divergences Could
500 rallying into positive territory for the year by the end of March. Over the
Signal That Sustainable Low Is In Place
past month investor sentiment has shifted from bullish to neutral as
widespread investor pessimism has waned. Offsetting the downgrade in
sentiment has been an upgrade in Breadth (which moved from bearish to neutral). This keeps the overall weight of the evidence at
neutral. Improving breadth does not preclude periods of consolidation or weakness, but it does set up the chance to see
bullish divergences on the next pullback. In other words, we are in a better position now to look for evidence that a cyclical low
is indeed in place.
Excessive valuations remain a significant headwind for stocks. We would add to this concern evidence that households remain fully
exposed to stocks and cash does not
appear to be building on the
Indicator Review
sidelines. The good news from a
valuation perspective is that the
headwind to earnings growth from
strength in the dollar is fading, and as
we move through 2016 this could
actually become a tailwind. To gain
confidence that any rebound we see
in earnings is more than just
currency-related volatility, we would
like to see better top-line growth.
For now, the neutral message from
the weight evidence argues for
continued caution and suggests we
could see a resurgence in volatility as
we move towards summer.

Bruce Bittles

William Delwiche, CMT, CFA

Chief Investment Strategist

bbittles@rwbaird.com
941-906-2830

Investment Strategist
wdelwiche@rwbaird.com
414-298-7802

10R.17

Federal Reserve Policy is neutral.

Global central bank actions and
commentary have fueled financial
market volatility. While overseas the
discussion is mostly focused on the
degree of additional easing that might
take place, the conversation in the U.S.
is on the pace of policy tightening
(euphemistically
referred
to
as
normalization). The latest dot-plot from
the FOMC shows that the onceexpected four rate hikes in 2016 have
been cut in half. If the consensus view at
the FOMC is correct and the Fed raises
rates twice in 2016 (on top of the 25
basis point hike in December), this
would fit with previous Slow Cycles.
While the overall pattern for such cycles
is for stocks to do relatively well, both
slow and fast tightening cycles are
marked
by
heightened
volatility,
especially over the first six months.
Source: Ned Davis Research

While the Fed has focused on

preparing the market for interest rate
hikes, the 10-year Treasury Note yield
has continued to move lower. After
beginning the year near 2.25%, the
yield on the 10-year T-Note is currently
more than 50 basis points lower than
that. While the Fed is alternately
credited and blamed for low longerterm bond yields, the yield has stayed
roughly within the bounds of what
might be considered normal based on
historical determinants of fair value.
Importantly, the largest single driver of
bond yields over time has been core
inflation. We are now seeing inflation
rates start to drift higher and this
could mean upward pressure on
bond yields as we move through
2016.
Source: Ned Davis Research

Investment Strategy Outlook

Economic
Fundamentals
remain
While economic growth
Bullish.
remains shy of robust, early-year
concerns about recession appear to
have been misplaced. Labor market
trends remain strong, with initial jobless
claims near their lows and labor force
participation seeing an upswing. The
ranks
of
the
unemployed
are
increasingly composed of those who
willingly left their previous job, a sign of
economic strength and opportunity.
Even within the manufacturing sector
there is evidence of improvement. While
the headline ISM number has seen a
modest bounce in recent months,
beneath the surface the rebound has
been
impressively
broad.
The
percentage of industries reporting
growth has expanded from less than
30% in late 2015 to 67% in March.
Source: Ned Davis Research

Valuations are still Bearish. Stocks

remain expensive by most measures,
especially those based on actual,
reported earnings. On a median P/E
basis, stocks are more expensive
now than at any point in the past
decade. While not necessarily arguing
for near-term weakness, elevated
valuations do argue for tempering
forward-return expectations. The good
news from a valuation perspective is
that stocks could soon enjoy a
currency tailwind, and expectations for
earnings growth continue to be
ratcheted lower. It is important to
remember that valuation relief need not
only come from price correction, it can
also come from earnings improvement.
An upside surprise from earnings could
start to relieve valuation excesses.

Source: Ned Davis Research

Robert W. Baird & Co.

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Investment Strategy Outlook

Sentiment is now Neutral. We have

begun to see some pockets of optimism
replace the excessive and widespread
pessimism that emerged over the first
six weeks of 2016. Optimism has yet
to be intensive enough to show up in
a sustained fashion in the sentiment
composites. While the bulk of the rally
off of the February low has been met
with skepticism and caution, recent
weeks have seen inflows into equity
funds and active investment managers
taking on more equity exposure (the
NAAIM exposure index is at its highest
level in nearly a year). While these
shorter-term sentiment indicators are no
longer a tailwind for stocks, they are
also not (yet) a headwind.

Source: Ned Davis Research

One area of concern from a sentiment

perspective is the lack of available
cash on the sidelines. While weekly
mutual fund flow data gives the
impression that cash is being amassed
in great quantities, a signficant amount
of the outflows from equity mutual
funds is actually staying in equities,
just moving to ETFs. As as result,
cash levels remain near their lows
and household exposure to equities
remains near its highs. Just as
elevated valuations tend to be followed
by muted forward returns, elevated
exposure by households to equities
tends to be followed by sub-par stock
market returns. This could add
volatility to what is already a noisy
investing environment.

Source: Ned Davis Research

Robert W. Baird & Co.

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Investment Strategy Outlook

Seasonal Patterns and Price Trends

remain neutral. An array of breadth
thrusts seen over the past month
suggests stocks could continue to build
on the rally off of the February lows. But
price momentum has started to cool
and
the
second
quarter
in
presidential election years is one of
the weakest of the entire four-year
cycle. The star in the chart to the right
shows where we are currently in the
cycle. Given the fractured nature of the
current Presidential election (with both
parties still dealing with contentious
primary campaigns), it would not at all
be surprising to see continued noise and
volatility in stocks. The good news is that
once some clarity to the election
outcome emerges, stocks could benefit
from a protracted seasonal tailwind.
Source: Ned Davis Research

The Tape (Breadth) is now neutral.

The expansion in industry group
breadth has been encouraging. The
percentage of industry groups in
up-trends has surpassed the peak
seen in late 2015. Given that the
early-2016 low was underneath the
2015 low, however, an all-clear signal
is lacking. The degree of breadth
improvement may best be seen on any
weakness that emerges this summer.
A higher low on the industry group
trend indicator would be strong
evidence that a cyclical low is indeed in
place. We have also been encouraged
by the expansion in the number of
issues on the NYSE and NASDAQ that
are making new 52-week highs.

Robert W. Baird & Co.

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Investment Strategy Outlook

While the overall weight of the

evidence is still neutral, there are still
areas of relative leadership for
investors to focus on. U.S. large-cap
stocks remain in relative up-trends
versus the rest of the world (as shown in
the chart to the right) and versus
domestic small-caps. In the current
environment the potential benefits of
diversification
gained
by
adding
overseas exposure does not seem to
offset risks from relative weakness,
poorer growth prospects and currencyrelated volatility.
For investors who are maintaining
international equity exposure we would
tilt away from developed markets and
toward emerging markets.
Domestically, small-caps are lagging
large-caps both in terms of relative
price trends but also industry group
leadership.

Source: Stock Charts

The volatility that was seen in the first

quarter does not appear to have fully
run its course, so maintaining
elevated
cash
levels
seems
appropriate.
Gold has had a big rally to begin 2016
(up nearly 20%). This seems mostly to
have stopped or stalled the down-trend
that was in place. It is premature to
conclude that a sustained up-trend is
emerging.
In terms of sectors: Utilities and
Telecom have been resilient (aided by
low interest rates) even as more
cyclical leadership has emerged.
Industrials have strengthened and are
part of the leadership group, as is the
Information Technology sector. Both
Energy and Materials have bounced

Source: Baird. Ranking of 1 indicates best relative strength; ranking of 10 indicates worst relative
strength.

off of their lows, but only Materials has

seen a significant increase in relative
strength.
Relative
weakness
in
Financials remains a concern for the
broader market.

Robert W. Baird & Co.

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Investment Strategy Outlook

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 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 Portfolio

Mix: Stocks /
(Bonds + Cash)

All Growth

100 / 0

Capital Growth

80 / 20

Growth with
Income

60 / 40

Income with
Growth

40 / 60

Conservative
Income

20 / 80

Capital
Preservation

0 / 100

Risk Tolerance

Strategic Asset Allocation Model Summary

Emphasis on providing aggressive growth of capital with high

Well above average fluctuations in the annual returns and overall market value of the
portfolio.
Emphasis on providing growth of capital with moderately high
Above average
fluctuations in the annual returns and overall market value of the
portfolio.
Emphasis on providing moderate growth of capital and some
Average
current income with moderate fluctuations in annual returns and
overall market value of the portfolio.
Emphasis on providing high current income and some growth of
Below average
capital with moderate fluctuations in the annual returns and
overall market value of the portfolio.
Emphasis on providing high current income with relatively small
Well below average fluctuations in the annual returns and overall market value of the
portfolio.
Emphasis on preserving capital while generating current income
Well below average with relatively small fluctuations in the annual returns and
overall 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 in
determining if an adjustment to your strategic asset allocation is appropriate in your situation.

Asset Class /
Model Portfolio
Equities:
Suggested allocation
Normal range
Fixed Income:
Suggested allocation
Normal range
Cash:
Suggested allocation
Normal range

Robert W. Baird & Co.

All Growth

Capital Growth

Growth with
Income

Income with
Growth

Conservative
Income

Capital
Preservation

95%
90 100%

75%
70 - 90%

55%
50 - 70%

35%
30 - 50%

15%
10 - 30%

0%
0%

0%
0 - 0%

15%
10 - 30%

35%
30 - 50%

45%
40 - 60%

50%
45 - 65%

60%
55 85%

5%
0 - 10%

10%
0 - 20%

10%
0 - 20%

20%
10 - 30%

35%
25 - 45%

40%
15 - 45%

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Investment Strategy Outlook

ROBERT W. BAIRDS INVESTMENT POLICY COMMITTEE

Bruce A. Bittles
Managing Director
Chief Investment Strategist

B. Craig Elder
Director
PWM Fixed Income Analyst

Jay E. Schwister, CFA

Managing Director
Baird Advisors, Sr. PM

Kathy Blake Carey, CFA

Director
Associate Director of Asset Mgr Research

Jon A. Langenfeld, CFA

Managing Director
Head of Global Equities

Timothy M. Steffen, CPA, CFP

Director
Director of Financial Planning

Patrick J. Cronin, CFA, CAIA

Director
Institutional Consulting

Warren D. Pierson, CFA

Managing Director
Baird Advisors, Sr. PM

Laura K. Thurow, CFA

Managing Director
Co-Director of PWM Research, Prod & Svcs

William A. Delwiche, CMT, CFA

Director
Investment Strategist

Appendix Important Disclosures and Analyst Certification

This is not a complete analysis of every material fact regarding any company, industry or security. The opinions expressed here reflect our
judgment at this date and are subject to change. The information has been obtained from sources we consider to be reliable, but we cannot
guarantee the accuracy.
ADDITIONAL INFORMATION ON COMPANIES MENTIONED HEREIN IS AVAILABLE UPON REQUEST
The indices used in this report to measure and report performance of various sectors of the market are unmanaged and direct investment in
indices is not available.
Baird is exempt from the requirement to hold an Australian financial services license. Baird is regulated by the United States Securities and
Exchange Commission, FINRA, and various other self-regulatory organizations and those laws and regulations may differ from Australian
laws. This report has been prepared in accordance with the laws and regulations governing United States broker-dealers and not Australian
laws.
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 for
which Robert W. Baird Limited (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, 15
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 "Professional"
investors under MiFID and to persons in the UK falling within articles 19, 38, 47, and 49 of the Financial Services and Markets Act of 2000
(Financial Promotion) Order 2005 (all such persons being referred to as relevant persons). Accordingly, this document is intended only for
persons regarded as investment professionals (or equivalent) and is not to be distributed to or passed onto any other person (such as
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 and
avoidance 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 the
applicable 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 recommendation
contained in the research report does not have regard to the specific investment objectives, financial situation and the particular needs of
any individuals. You are advised to exercise caution in relation to the research report. If you are in any doubt about any of the contents of
this 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, which
may differ from Australian laws. This document has been prepared in accordance with FCA requirements and not Australian laws.

Robert W. Baird & Co.

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