Investment Strategy Outlook September 30, 2015

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1 Baird Market & Investment Strategy Investment Strategy Outlook September 30, 2015 Please refer to Appendix Important Disclosures. Investors Turn Fearful Highlights: Widespread Pessimism Turns Weight of Evidence Neutral Risks of Further Significant Downside Are Diminishing Seasonal Patterns Supportive of Q4 Rally Waiting on Broad Market Improvement Outlook Summary Evidence Improving, but All-Clear Signal Has Not Been Seen Still Waiting on Positive Breadth Divergences and Rally Follow-Through Small-Caps Faltering; Technology And Utilities Showing Strength As we write this, the lows for this correction may or may not be in place. But Economic Trends Continue Slow the goal of our weight of the evidence approach is not to pick specific Improvement turning points in the stock market, but to gauge and then manage risk. With investors turning increasingly fearful, pessimism appears to have gotten excessive enough to upgrade our view of sentiment from neutral to bullish (sentiment is a contrarian indicator, with the rule being to lean against the crowd at extremes). This moves the overall weight of the evidence from a cautious/mildly bearish stance to neutral. While the evidence is improving we have not yet seen confirmation from the breadth indicators suggesting that stocks are getting back in gear to the upside. Given the strong downside momentum that has emerged over the past six weeks, waiting for evidence of rally sustainability and broad participation is important before becoming more confident that a fourth quarter rally is emerging. While widespread pessimism may help limit (in degree and duration) any additional Indicator Review weakness that is seen the near term, we have yet to see evidence that a sustained advance is upon us. Coming into 2015 the primary concern was excessive valuations and while prices have corrected, earnings have not matched expectations, and so valuations remain elevated. Better growth from the economy could help fuel earnings growth going forward, but that is a process that takes time to unfold. For now, we continue to expect further testing and volatility until we get some positive breadth divergences. Bruce Bittles Chief Investment Strategist bbittles@rwbaird.com William Delwiche, CMT, CFA Investment Strategist wdelwiche@rwbaird.com Intended for thellams@rwbaird.com only. Property of Baird. Contact Baird for permission to share. 10R.17

2 The S&P 500 continues to work through a consolidation and testing phase that appears similar to what we saw in October. So far the late-august lows have provided support, but based on the 2011 case, a lower low would not be surprising. If such an event would signal final investor capitulation and provide positive breadth divergences, it could actually be welcome fuel for a fourth quarter rally. Also worth noting, we have not yet seen our weekly momentum indicator turn higher. Source: StockCharts Federal Reserve Policy is neutral. The Fed passed on raising interest rates in September, citing primarily uncertainty in global financial conditions. However, the consensus at the Fed (and the view of Fed Chair Janet Yellen) is that conditions will warrant a rate hike yet this year. We believe that a rate hike would be positive for stocks in that it would provide the Fed with some credibility (doing what many believe it said it would), some independence (not being seen as being pressured by the IMF, World Bank, or others) and some evidence of confidence in the robustness of the economy. The problem in the near term is that the bond market is already tightening financial conditions as corporate bond yields have started to rise.

3 Economic Fundamentals remain bullish. The United States remains a bright spot among an increasingly challenging global environment. Evidence so far, however, is encouraging in that the fall-out from slowing growth in China is mostly limited to commodity-based economies. Moreover, as confidence in the recovery continues expanding a virtuous cycle of self-fulfilling prophecy can emerge. The expectation of better growth ahead can help lead to better growth (when the expectations being measured are consumers or business CEO s, not economists or Fed officials). Source: Ned Davis Research Valuations remain bearish. Stock prices have corrected, but the lack of earnings growth has limited the gains seen from a valuation perspective. The good news is that with profit margins near record levels (and even better than what appears on this chart when the energy sector is excluded) it would not take much improvement in sales growth to see earnings recover. Source: Ned Davis Research Robert W. Baird & Co. Page 3 of 8

4 Investor Sentiment is bullish. Last month we kept sentiment at neutral even though some of the short-term measures of sentiment had showed signs of excessive pessimism. We cited a lack of longer-term bearishness and a seeming mismatch between investor sentiments and investor actions. That has now changed. The Investors Intelligence data shows that the ratio between bulls and bears has moved to a level last seen in To be more specific, the latest data shows 25% bulls and 35% bears. The 10 point spread in favor of bears is the most since the October 2011 lows. Not only have investors and newsletter writers expressed a more cautious outlook, their actions have matched their words. Equity mutual fund outflows have nearly matched the pace seen in None of this means that a final surge in in pessimism associated with investor capitulation will not be seen, but it does suggest downside risks are diminishing as investors look substantially sold-out. Source: Ned Davis Research Robert W. Baird & Co. Page 4 of 8

5 Seasonal patterns are neutral. Just as September has a history of seasonal weakness, October has a reputation for providing good lows in advance of what is usually a seasonally strong period around year-end. Given the strong downside momentum that we have seen in stocks, we are taking a patient view with respect to seasonal patterns. But by the end of the month we should have a better feel for whether seasonal tendencies are holding true to form. Source: Ned Davis Research Breadth remains bearish. We have not seen strong evidence that the broad market is getting back in gear. The percentage of industry groups in up-trends has continued to contract (now less than one in four is trending higher). The Value Line Geometric Index shows just how much damage has been done to the median stock. The index, a proxy for the median stock in the stock market, is 17% off its high from earlier this year and is back to mid-2013 levels. The first step in getting a better breadth backdrop would be to see more than one upside breadth thrust that breaks downside momentum. So far, this has been lacking. Source: StockCharts Robert W. Baird & Co. Page 5 of 8

6 In terms of equity allocation, we continue to favor large-caps over smallcaps. Small-caps moved into the lead off of the October 2014 lows, but that rally peaked around mid-year and since then large-caps have gained strength. While the first quarter was marked by strength overseas, since then the longer-term trend favoring U.S. leadership has re-asserted itself. We expect that trend to remain in place into year-end and would continue to tilt equity portfolios toward the United States and away from international exposure. We would continue to actively tilt away from emerging market exposure. Source: Stock Charts Source: Baird The top of the sector rankings have been stable in recent weeks, with the consumer-related areas (Discretionary and Staples) showing leadership. Utilities and Technology have gained strength, while Health Care has been stumbling (after being a leader for much of the year, it is the third-worst performing sector over the past three months). The Biotech sector has come under pressure recently, and it seems to be following the pattern of the Semiconductor and Broker/Dealer groups (other former leaders that have been undergoing absolute and relative price corrections). Overall, the relative strength rankings provide a disciplined way to gauge the sustainability of relative rallies that emerge at the sector-level. Robert W. Baird & Co. Page 6 of 8

7 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 All Growth 100 / 0 Well above average Capital Growth 80 / 20 Above average Growth with Income Income with Growth Conservative Income Capital Preservation 60 / 40 Average 40 / 60 Below average 20 / 80 Well below average 0 / 100 Well below average Strategic Asset Allocation Model Summary Emphasis on providing aggressive growth of capital with high fluctuations in the annual returns and overall market value of the portfolio. Emphasis on providing growth of capital with moderately high fluctuations in the annual returns and overall market value of the portfolio. Emphasis on providing moderate growth of capital and some 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 capital with moderate fluctuations in the annual returns and overall market value of the portfolio. Emphasis on providing high current income with relatively small fluctuations in the annual returns and overall market value of the portfolio. 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 amongst 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 % 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 & Co. Page 7 of 8

8 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 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, CFA Director Managing Director Managing Director Institutional Consulting Baird Advisors, Sr. PM Co-Director of PWM Research, Prod & Svcs William A. Delwiche, CMT, CFA Director Investment Strategist Appendix Important Disclosures Disclaimers 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. Foreign and emerging market securities may be exposed to additional risks including currency fluctuation, political instability, foreign taxes and regulations and the potential for illiquid markets. Historically, small and mid-cap stocks have carried greater risk and have been more volatile than stocks of larger, more established companies. ADDITIONAL INFORMATION ON COMPANIES MENTIONED HEREIN IS AVAILABLE UPON REQUEST. The Dow Jones Industrial Average, S&P 500, S&P 400, MSCI EAFE, Lehman U.S. Aggregate Benchmark, Lehman Municipal Bond Benchmark, Russell 1000, Russell Mid Cap, Russell 2000, and Russell 3000 are unmanaged common stock indices used to measure and report performance of various sectors of the stock market; 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 2015 Robert W. Baird & Co. Incorporated. Other Disclosures UK disclosure requirements for the purpose of distributing this research into the UK and other countries for which Robert W Baird Limited holds an ISD passport. This report is for distribution into the United Kingdom only to persons who fall within Article 19 or Article 49(2) of the Financial Services and Markets Act 2000 (financial promotion) order 2001 being persons who are investment professionals and may not be distributed to private clients. Issued in the United Kingdom by Robert W. Baird Limited, which has an office at Finsbury Circus House, 15 Finsbury Circus, London EC2M 7EB, and is a company authorized and regulated by the Financial Conduct Authority. For the purposes of the Financial Conduct Authority requirements, this investment research report is classified as objective. Robert W Baird Limited ("RWBL") is exempt from the requirement to hold an Australian financial services license. RWBL is regulated by the Financial Conduct Authority ("FCA") under UK laws and those laws may differ from Australian laws. This document has been prepared in accordance with FCA requirements and not Australian laws. Robert W. Baird & Co. Page 8 of 8