Your SlideShare is downloading. ×
2012 Economic and Stock Market Outlook - Dec. 2011
Upcoming SlideShare
Loading in...5

Thanks for flagging this SlideShare!

Oops! An error has occurred.


Introducing the official SlideShare app

Stunning, full-screen experience for iPhone and Android

Text the download link to your phone

Standard text messaging rates apply

2012 Economic and Stock Market Outlook - Dec. 2011


Published on

Summarizes Baird's outlook for the economy and stock market for 2012.

Summarizes Baird's outlook for the economy and stock market for 2012.

Published in: Economy & Finance, Business

  • Be the first to comment

  • Be the first to like this

No Downloads
Total Views
On Slideshare
From Embeds
Number of Embeds
Embeds 0
No embeds

Report content
Flagged as inappropriate Flag as inappropriate
Flag as inappropriate

Select your reason for flagging this presentation as inappropriate.

No notes for slide


  • 1. Through the Looking-Glass,Heading Toward a Better Tomorrow2012 Economic and Stock Market OutlookBruce Bittles William Delwiche, CMT, CFAChief Investment Strategist Investment wdelwiche@rwbaird.com941-906-2830 414-298-7802
  • 2. A message from Baird’s CEO, Paul PurcellExtreme market volatility turned 2011 into a wild ride for many investors. And, with the Presidentialelection on tap for 2012, we may not begin to see clarity around many of the domestic unknownsfueling that volatility until November. Then, of course, there’s the eurozone to consider.This is not to say investors might be better off spending the year on the sidelines. As we’ve seen,market volatility swings both ways, and an informed strategy built on sound principles and with theflexibility to capitalize on opportunities as they arise will be critical to successful wealth management.The insights on the following pages are designed to help you understand Baird’s perspective onthe market environment, and where we see both opportunities and challenges ahead. These ideascome from our leading minds on the economy and investing and they are consistent with thedisciplined, risk-managed approach we’ve taken to keep Baird strong and stable for clients like youthrough unquestionably trying times.If you have any questions about the implications for your specific situation and portfolio, please donot hesitate to contact your Baird Financial Advisor.We thank you for the trust and confidence you have placed in us. Please know that we strive to earnthem every day. Paul E. Purcell Baird Chairman, President & Chief Executive Officer 2
  • 3. Through the Looking-Glass, HeadingToward a Better TomorrowIn the Lewis Carroll classic, Alice, fresh off her adventures in Wonderland, finds herselfone snowy evening wondering about life on the other side of the mirror that hangsover the fireplace. She climbs atop the mantelpiece and discovers that she can step 2012 Outlook Summarythrough into a looking-glass world. Once there, Alice encounters a reality that is Risk on S&P 500 to 1000,anything but normal. Left is right, forward is backward and a new set of rules applies. Reward to 1400.We too find ourselves pulled into a new environment, one that if not so real wouldseem to be a farce. Consider these situations, that we have seen in 2011: Election and European Debt Uncertainties Are Dominant Risks in First-Half. Headwinds• A country gets its sovereign debt downgraded, but yet yields on that debt Could Abate Later In The Year. fall sharply. GDP Outlook – Lack of Income• The parliament in the second-poorest (based on per capita output) country in the Gains Could Cap U.S. Growth At EU (Slovakia) casts the final and decisive vote for a European stability fund that at 2%. Europe In Recession. the time seemed crucial to the ongoing viability of the EU and the euro. After first rejecting the measure, the Slovakian parliament in the end approved it. Secular Base-Building Means Volatility Unlikely To Ebb;• The United States, which has funded operations of late more by continuing Manage Portfolios For Risk As resolutions than a comprehensive budgeting process, and has had to borrow 38 Well As Return. cents on every dollar spent over the past three years (in the process accumulating $4 trillion in new debt), is now lecturing the EU and its member countries on the need for fiscal reform and getting debt and deficits under control.10-Year T-Note Yield and Trend S&P Downgrades U.S. Debt Rating 3
  • 4. This is our “looking-glass” world of must be addressed. Marginal rates on protecting the value of the It is not normal – in a new sense need not be flat, but they should be Raising short-term interest ratesor old – but is real. It is not permanent as low as possible. High marginal rates would reward domestic savers andbut it persists, and we must operate make the U.S. dollar more attractive,within it. Just as Alice had to learn how rather than just a haven in periods ofto negotiate her way across the chess stress. Federal Reserve policy in recentboard and toward her destination, so It is not as though years has gone from counter-cyclicallytoo must we navigate the financial the U.S. economy has providing the punch bowl in badmarkets. Even as we look forward and nothing going for it. times and removing it in good times,move toward a better tomorrow, we There have been areas to seemingly augmenting the boom/ of improvement in theconfront our current reality. bust cycle. Later, we will look more economy in 2011 thatAs we consider that better tomorrow, closely at what the Federal Reserve could bode wellwe see changes just over the horizon and other central banks are doing, and for 2012.that could reflect a secular shift what we expect them to do. In termsfor the economy and the financial of what they should do, protecting themarkets. Right now, the need for value of the dollar and having a lesschange is being recognized primarily are a disincentive to production. More active role in the economy are the grass-roots level, so figuring effective, and fairer, “simplification” Government spending/entitlementout the exact scope and timing of would come from reform in the reformthat change will take more time, as calculation of taxable income and tax credits. It is here that favors to In the wake of the inability by thewill convincing the powers that be special interests create complications, Congressional super committeeof the need for change. The major distortions and a deep sense of to make even token budget cutsgrass-roots efforts that have emerged unfairness. A similar story is seen in and with seemingly little impetusacross the country over the past the corporate tax code – rates in the toward extending the payroll taxcouple of years (principally, the Tea U.S. are among the highest in the cuts that expire at the end of thisParty movement and, more recently, world, and the code is full of loopholes year and next, the federal budgetOccupy Wall Street) are, in our view, for favored industries. We are past deficit is, on paper, poised to improvedifferent manifestations of a similar the point where solutions are found dramatically. This outlook is based,sentiment. Underlying both is the in slogans or temporary measures. though, on the budgeting assumptionsense that the current political/ Comprehensive reform is needed, and that tax increases and budget cutseconomic/corporate structure needs the proposals by the Simpson-Bowles will have no impact on economicmassive reform, beginning with a or Domenici-Rivlin commissions are activity. This is almost certainly not thedisentangling of special interests and good starting points. We also need case. Rather than back-dooring ourentrenched politicians. to move beyond the point where the way to an improved fiscal situationAspects of this change include: on paper, we need comprehensive removal of special breaks counts as aTax reform tax increase. reform of government spending and entitlements. A Federal Reserve officialThere is little doubt that the U.S. tax Monetary policy recently pegged the unfunded liabilitycode needs reform. It is hopelessly Dysfunctional fiscal policy has put the from Medicare alone at $70 trillion –complex, doles out favors to special onus of action on the Federal Reserve. vastly higher than the current totalinterests, and has a distortionary If Fed Chairman Ben Bernanke is to government debt outstanding. This iseffect on production and investment. be taken at his word, there is a strong a structural deficit issue that a cyclicalCurrent complications in the tax desire on the part of the Fed to cede economic recovery is not going to solve.code make “simple” ideas appealing, the mantle of “economic/financial In some ways, the lack of a superbut reform must not be premised on market savior.” One way to do this is committee deal may actually be asimple alone. Issues of fairness also to focus more of the Fed’s energies long-term positive. It has been our 4
  • 5. 12-Month Total Federal Receipts and Outlaysview that the worst-case outcome and the mandates associated with above can help build a base for thewould be a perceived solution that it are a legacy of Iowa’s historical economy from which a robust, self-actually did nothing, or that the role as an early participant in the sustaining recovery can emerge. Thatsequestration rule (the mandated presidential candidate nomination is the better tomorrow that we see. Webudget cuts starting in 2013) would process. Modern corn-farming, will get there, but patience along thejust be reversed. At this point neither ironically enough, is petroleum- way is required. Admittedly, the electionof these outcomes has been realized, intensive, and corn is ill-suited to the of 2012 may delay near-term progress,so there is still an awareness of the production of ethanol. When it is all but it may also help crystallize, in theneed for actual reform. Hindering said and done, corn-based ethanol electorate and politicians, long-termthe process has been the breakdown may actually consume more energy goals. With the Democrats looking backin the level of trust in Washington, than it produces. Ethanol is much at 2008 as their mandate for changeD.C., and because of this, no one more effectively derived from sugar and the Republicans seeing 2010 asappears willing to take the first step. cane, but Brazilian-produced sugar their call to action, the 2012 electionsThe solution must be comprehensive cane-based ethanol faces tariffs, and set up as a tie-breaker of sorts. We’ll talkand likely lies somewhere toward the in some cases, corn-based ethanol is more about the expected effect of themiddle (between the loosely outlined legislatively required. While alternative election on the financial markets whenproposals on either side). Importantly, forms of energy may eventually be we consider the seasonal patterns in thean honest solution needs to tackle viable, they are not now, particularly weight of the evidence section below.sacred cows for both parties. at the scale needed. Natural gas, For now, particularly as we consider however, is a proven fuel source, and is the financial markets, we remainEnergy policy readily available in the United States. on the other side of the mirror.The United States lacks a cohesive An energy policy focused on the Like Alice, we are trying to makeenergy policy, relying on an domestic production and distribution sense of our own Tweedledum andamalgamation of reactive regulations, of natural gas would help secure a Tweedledee. At this point, gettingunsupported mandates, political cheap and reliable source of energy our hands on a vorpal sword withfavors/subsidies, and ideals that for the country. which to slay the Jabberwocky wouldare unmet in reality. Take ethanol Changes along the lines discussed be particularly useful. We are facedfor example: corn-based ethanol 5
  • 6. NYSE Daily Breadth Ratioswith the question of whether, in the to the market. They are now relatively nearly 30% in that time period. Hascurrent environment, the usefulness common, and little is gained from the rally seen since the early Octoberof long-used indicators has changed. their observation. low been a bear market rally or hasAs long as macro uncertainties remain Our basic premise remains this: the it represented a new cyclical bullelevated and liquidity continues secular bear market that has been market? For now the jury is still out,to ebb and flow in an exaggerated in place for over a decade is intact. but absent conclusive broad marketmanner, volatility in the market is likely Cyclical trends emerge and fade. evidence that points to a change into remain elevated. In part, we risk The cyclical bull market that emerged the primary trend, we assume thatover-reading changes in the indicators off of the March 2009 lows ended in the previous trend is intact. For 2012,(i.e., they still work, but not necessarily 2011. The pertinent question now is our working assumption is that thein the way we have expected), and in whether the cyclical bear market that cyclical bear may re-emerge in the firstpart, certain indicators are less useful. was in place in the middle part of half, with market conditions growingTrading days on which up volume 2011 has run its course. From its April more favorable in the second halfoutpaced down volume by more than peak at 1364 to its October trough of the year. These ongoing cyclical10 to 1 (and vice-versa) used to be at 1099, the S&P 500 fell more than swings accompanied by unrelentingrarities, and offered important signals 19%. The small-cap Russell 2000 fell volatility represent a period of secularS&P 500 Index x10 6Source: MetaStock
  • 7. base building. As we make progress Indicator Reviewon the secular issues outlined above,the probability of a meaningful secular Fundamental Factorslow emerging increases. Federal Reserve Policy Bullish +1While we have expectations of what Underlying Economic Fundamentals Bearish -1might happen, we need to balance Valuations Neutral 0this with our observable reality. Werely on our weight-of-the-evidence Technical Factorsapproach to do so. Heading into Trends/Seasonal Tendencies Bullish +12012, the weight of the evidence is Investor Sentiment Bullish +1mildly bullish. Federal Reserve policy, Tape/Breadth Bearish -1sentiment, and seasonal trendssupport higher stock prices, while Weight of the Evidence Mildly Bullish +1poor economic fundamentals andbroad market divergences couldweigh on stocks. Valuations are neutral 2011 has seen a coordinated effort by increasingly dependent on Fed-from a cyclical perspective. Putting the Federal Reserve and other global supplied liquidity. The Fed continuesthis into context for our 2012 outlook, central banks to ease the liquidity to discuss exit strategies, the firststocks could work higher into January, strains that have emerged in Europe. of which would be to allow naturalbut the path forward from there will This effort, while ensuring sufficient contraction of its balance sheet asrely on the evolution of the sentiment dollar-funding as the European banks its fixed income holdings come toand breadth data. A surge in optimism come under pressure, is a short- maturity. For now, however, this is acould reduce the opportunity for rally, term liquidity mechanism that is theoretical discussion, and the nextwhile improvements in the broad designed to prevent a seizing up of step is likely to be more interventionmarket could help fuel further gains the financial markets. Indicators of rather than less.and signal confirmation of a cyclical financial stress improved followingbull market. this joint intervention. The reaction inFederal Reserve policy is bullish the commodity markets to this news The Fed’s strategy suggests that this may be the first of appears to be an effortWhile we have already reviewed our several coordinated efforts that, we to buy the economy asperspective on what the Fed should expect, will culminate in a third round much time as possiblebe doing, we need to consider what of quantitative easing domestically to right itself and beginit is doing and what we expect and more active intervention by to move back towardit will do. The acronym-intensive the ECB. Even before the November trend growth.intervention in the markets that the announcement on swap rates, theFederal Reserve pursued in 2008/2009 Federal Reserve was floating trialhas been replaced by more direct balloons for QE3, with the most overt While the Fed has its hands on theintervention, the buying of Treasurys being the dissenting vote at the money supply levers, its crystal ball isand mortgage securities.The second November FOMC meeting calling for far from omniscient. The Fed (and mostround of quantitative easing (QE2) more easing by the Fed. economic forecasters) has consistentlywas wrapped up by mid-2011, butwas soon followed by a program The Fed’s strategy appears to be overestimated the strength of the lengthen the maturity of the an effort to buy the economy as economy in recent quarters. The Fed’sFed’s Treasury holdings (Operation much time as possible to right itself January 2011 estimates for growthTWIST), with the Fed also declaring its and begin to move back toward were for better than 3.5% growthexpectation that short-term interest trend growth. The problem is that in 2011 and nearly 4% growth inrates will remain low into 2013. Late- the economy and the markets are 2012. By November, those estimates 7
  • 8. Federal Reserve Bank Credithad been revised down to 1.7% commodity and/or stock bubble to market (to say nothing of the lackgrowth for 2011and 2.7% growth in build rather than the emergence of of fiscal clarity/leadership out of2012 (expectations for 2013 growth sustainable growth. Ultimately, the Washington, D.C.).were revised down from 4.2% to world economies will have to stand The ongoing source of consternation3.2%). The Fed’s expectation for the on their own, unsupported by central is elevated debt and deficit levels.unemployment rate in 2012 rose from banks. Getting to that point will While we are hopeful that increaseda January 2011 estimate of 7.8% to a require time, but getting there will be awareness will bring about realNovember estimate of 8.6%. The point important. For now, though, we see change (the first step to solving ahere is not to bash the Fed’s ability to little evidence that the Federal Reserve problem is admitting that you haveforecast economic variables. Precise will be able to back away from its one), the path forward is not easy.forecasting tends to be a futile exercise, active role. Further easing is likely, and Academic studies have shown thatand one in which we do not engage. this is bullish (at least near-term) for historically there are four mainRather, the Fed has consistently stocks and gold. avenues for governments to reduceoverestimated its ability to back away high debt/GDP ratios: robust nominal Economic fundamentalsfrom active intervention in the market growth, higher taxes, default, and/or remain poorand support of the economy. inflation. The key, in our view, is robust Growth in Europe has stalled, andWe do not believe that another nominal growth, and from a policy a continent-wide recession may beround of bond-buying by the Fed (or perspective that should be the focus emerging. Emerging economiesECB) represents a long-term path to in both the United States and Europe. remain vulnerable to the cumulativeprosperity, but it may be necessary Absent an expanding economy, higher effects of interest rate hikes and(particularly in Europe) to prevent taxes and/or budget cuts (the austerity weakness in their end markets. Thefurther destabilizing. It is much measures that are being pursued United States economy is beset bymore likely that flooding the system aggressively throughout Europe and weak aggregate demand, persistentwith dollars and euros will allow a more hesitantly in the United States) unemployment and a weak housing 8
  • 9. Total Credit Market DebtAs a percentage of GDPare unlikely to achieve success. They outside of Germany, and probably in Europe remains in doubt. Whatare contractionary in nature, and it even when Germany is included). is clear, though, is that the time hasis much more difficult to reduce the This has brought to the surface come to address the actual issues, notoverall debt to GDP ratio when the design flaws within the structure just hold summits and release vaguedenominator (GDP) is declining. Better of the EU. While monetary policy is communiqués. More work needs towould be an effort to limit the growth coordinated, fiscal policy remains be done on determining a path toin the numerator (particularly over the discrete. With both strong and weak solvency, which likely means a morelonger term) while stimulating growth alike using the same currency, there concerted effort to recapitalize thein the denominator (particularly in is cajoling and resurgent nationalism. banking system and shore up liquidity.the near term). Importantly, growth in Investors in the U.S. have learned Absent confidence that there is anGDP must outpace growth in debt if more about the local politics of ultimate backstop – not to preventthe overall ratio is to decline. This is a Slovakia, Greece, and Italy (to name losses from occurring but to ensureprocess, not an event, and takes time a few) than many would have cared orderly operations – rumors and fearsto evolve. The policy improvements to. While no system of government will lead to ongoing turmoil, whichthat we described at the outset would is perfect, the strains in Europe have can be seen in the recent spikes inbe important steps in the process of exposed one of the weaknesses of a sovereign debt yields across Europe.supporting nominal growth in the parliamentary government. The lack Data in the United States show aeconomy and limiting the growth of of an independent executive makes moderate firming in activity in thedebt. For now, the growth outlook politically unpopular decisions harder fourth quarter of 2011. Much ink hasremains uneven, with risks skewed to to sustain. While the first half of 2011 been spilled discussing whether thethe downside. was marked by the Arab Spring that United States is just lagging Europe’sWhile the European Commission’s saw the collapse of governments decline into recession, or whetherforecast for growth in the euro area on the southern shore of the there has actually been a for +0.5% in 2012 (down from Mediterranean Sea, the latter half of the As a history professor once remindeda previous estimate of 1.8%), the year saw the collapse of governments us (in the context of the Frenchdata being seen at the end of 2011 on the northern shore (there must be revolution), events throughout historyincreasingly suggest that the area is something in the water). happen in real-time as decisions areslipping into recession (almost certainly As we move into 2012, the outcome made, and the course that we can look 9
  • 10. European Sovereign Debt YieldsSource: FactSetback on now was not preordained financial market disruptions – could well for 2012. Liquidity is returningor necessarily inevitable. Likewise, weigh on the United States, as could and credit market conditions havethe outcome for the United States the expiration of the payroll tax cut at improved considerably. Further,economy in 2012 is largely contingent the end of 2011 and continued lack of the housing market may finally beon events that have not yet occurred, fiscal policy leadership. hitting bottom. Inventories of newalthough its weakened state leaves It is not as though the U.S. economy and existing homes for sale remainit vulnerable to shocks. Spillover has nothing going for it. There have elevated, and this could continueeffects from Europe – not so much been areas of improvement in the to weigh on construction activity.poor economic growth, but rather economy in 2011 that could bode However, the ratio of the medianMedian Existing Home Price vs. Median Income 10
  • 11. home sale price to median income the “extra” hours of each day gained 2011. While households would like tohas dropped to a historically low by not working (i.e., time that would pay down debts, they are not willinglevel, and the Obama administration be spent at work if employed), only to do so at the expense of eating orhas unveiled new efforts to support 1% goes towards looking for a job, purchasing necessities (a vague termthe housing market through the while 30% goes toward extra sleep which changes with every generation).reworking of current mortgages. and watching T.V. This goes beyond This has put downward pressurePrograms of this nature have been just inter-generational resentments. on the savings rate and delayedannounced in the past, but have Unemployed workers, of all ages, face improvements in the householdproduced little in terms of results. skill degradation, which accelerates balance sheet. Renewed efforts atWhile hopeful that this latest program over time and hampers the underlying household austerity will re-emerge aswill find broader implementation dynamism of our economy (not only the income picture improves.(as is its design), we are cautious are current skills lost, but new ones aregiven the lack of follow through seen not learned on the job). Rather thanon this front. The Federal Reserve’s having the government acting as aefforts to keep mortgage rates low venture capitalist and investing in From a seasonalare also supportive. Concerted unproven (and perhaps ultimately perspective, the popularprogress in easing the debt burdens untenable) technologies, an aggressive averages could well be dominated by next year’sof homeowners would be good news investment in job-training and presidential election.for the economy and probably more education may be more worthwhile.stimulative than short-term tax cuts. Just as debt is an issue at the nationalThe household sector in the United level, so too is it a problem at theStates faces a looming structural household level. While more work has Business activity re-accelerated inissue – nearly one in five workers been achieved by households than late 2011, spurred by a relieving ofunder the age of 25 is unemployed. the government in terms of reducing mid-year supply constraints and asThis becomes a generational issue debt loads, this process has fallen prey businesses moved ahead of the year-as the older workers begin to view to the unevenness of the economic end expiration of related tax credits.the younger generation as lazy, and recovery and overall disappointing job Much has been made of the strengththe younger generation becomes growth. Poor job growth has translated of corporate balance sheets and thediscouraged. Recent research from the into a stalling in income growth. Real amount of cash they have on hand.NBER (National Bureau of Economic disposable personal income fell in While this in part reflects a newfoundResearch) supports these views. Of both the second and third quarters of conservatism in corporate finance,Unemployment RateMonthly and 12-Month Average 11
  • 12. Real Disposable Personal Incomeit may also reflect a lack of global Further, capital spending is a function weigh on growth in 2012 as federalgrowth opportunities. Moreover, the of corporate sentiment. Companies and local governments cut back onimprovement in the corporate balance that are optimistic about the future spending. This can best be seen insheet may not be as significant as will tend to invest. CEO confidence has the employment data. Gone are themany believe. Corporations are awash declined sharply in recent quarters, days in which government payrollsin cash, but non-financial corporate and this may weigh on business consistently expanded and when adebt levels remain high. Short-term spending in 2012. government job lasted a lifetime. Overdebt has declined relative to cash, Even aside from policy actions (or the past twelve months (Decemberbut also relative to longer-term debt. inactions), government will likely 2010 – November 2011), private sectorEquipment and Software Expenditures vs. CEO Confidence 12
  • 13. payroll gains averaged 150,000 per 1.8% in November 2010 to 5.1% in buying Treasurys and debt continuingmonth, while government at all levels May 2011 (near the culmination of to act as an anchor, there is unlikely totrimmed payrolls by 25,000 jobs per QE2), before falling back to 2.1% be much sustainable upward pressuremonth. While having more resources in October 2011 (the most recent in yields. Beyond the Fed, though, pastdevoted to the private sector is data available). This can also be buyers of U.S. government debt seemultimately a good thing for the seen in inflation expectations. The less inclined to add to their positions.economy, the transition exacerbates University of Michigan’s five-year The Fed’s efforts to spur growth bythe over-supply in the labor market inflation expectation figure has hardly keeping interest rates low have beenand could weigh on growth in 2012. budged over the past couple years, devastating to savers, who must nowInflation – The ending of the debt remaining well-anchored even as move into riskier assets to find yield.super-cycle and trends in globalization the Fed has dramatically expanded Valuations are neutralare both strongly deflationary (to its balance sheet. Given the view by some at the Federal Reserve (including Overall economic growth remainsclarify, the inter-connectedness of the Chairman Bernanke) that for the uneven, but corporate earnings haveglobal economy is deflationary for conduct of monetary policy, economic remained strong, generally meetingdeveloped countries; it is inflationary expectations matter more than recent or exceeding elevated expectations.for emerging economies). Moreover, observations, it is possible that the Over the long run, earnings growthweakness in aggregate demand Fed would tolerate (if not welcome) is going to match overall economicand excess supply in the domestic higher inflation in the short term if growth, although in the short termlabor market are also helping expectations do not rise. This would divergences can emerge and persist forcontain inflation. One area in which help support nominal growth. While a time. This strength in the E of the P/Ewe have largely agreed with the another round of quantitative easing ratio has allowed our most preferredFederal Reserve is that the threat in 2012 would likely lead to a greater valuations to remain near or slightlyof deflation has been greater than swing in recorded inflation, we do not below their long-term medians. Whilewidely appreciated, and that the view it as a sustainable threat to the not arguing that a secular low hasaforementioned counterweights economy at this point. been made, valuations do not currentlykeep near-term upswings in inflation present a headwind to stocks. In afrom being persistent. That was Bond yields – Short-term interest rates continuing positive, expectations forseen in 2011. The six-month change remain near zero, while the 10-year future earnings growth are moderating.(annualized) in the CPI rose from T-Note yield is near 2.0%. With the FedMichigan 5-year Inflation Expectations 13
  • 14. S&P 500 Index vs. Median Expected Earnings GrowthStocks tend to fare best when not ability to surprise on the upside. top line. With profit margins now atsaddled with high expectations The divergence between overall record levels, it seems unlikely thatfor earnings growth. This is not a growth and corporate earnings can this engine of growth will remain asreflection on analysts’ abilities to be explained by expanding profit robust as in recent years. This wouldforecast earnings growth, but rather a margins. That is, earnings growth increase the need to expand therecognition that elevated expectations at the bottom line has not been revenue line to fuel earnings growth.leave little margin for error and less driven by gains in revenue at the We believe that it is in the corporateS&P Industrial Average & Profit Margin 14
  • 15. sector that the seeming disconnect putting it to work. We will be watching confidence about whether we arebetween higher commodity prices for an expansion in the net issuance of experiencing a typical rally within aand moderate inflation gets resolved. corporate equities, as this could cause cyclical bear market (those tend to beLackluster final demand and weak excessive supply, which would be a sharp moves that fail in key resistanceincome growth could make it difficult headwind for stocks. Not only would levels), or are indeed in the earlyto pass higher costs on to consumers, it reveal renewed (perhaps excessive) stages of a cyclical bull market thatleaving corporations to absorb the optimism in the corporate sector, but could enjoy further upside. A breakhigher commodity costs that have would put more pressure on earnings by most indexes below their 50-daybeen seen and could continue to be and valuations. averages would suggest the former;seen as central banks ease monetary Right now, our preferred valuation a decisive break above their 200-daypolicy. Therefore, not only does measure, which looks at trailing averages would point to the latter.continued expansion in profit margins earnings, shows that stocks are near Our long-term regression-based trendseem unlikely, but they could actually fair value. Longer-term measures that indicators are also mixed at present.contract somewhat moving forward. look at normalized earnings offer a From a seasonal perspective, theCorporations have been buying back more cautious outlook. popular averages could generally betheir stock in recent quarters, pushing dominated by next year’s presidentialthe net issuance of corporate equities Seasonals/trends election. The cycle composite that wein to negative territory. Even without Seasonals/trends are bullish into like to review as a potential roadmapany improvement in its aggregate year-end 2011, before becoming more suggests stocks could fare well intofinancial situation, reducing the mixed in 2012. The trend indicators January, face growing headwindsnumber of shares of a company will are mixed. While the popular averages as we move from primary electionsimprove per share metrics, including are generally trading above their toward the general election, andearnings per share and price. This 50-day averages, which are generally then rally as the uncertainty overtrend reflects general cautiousness now rising, they are below their the outcome of the election fades.on the part of companies – choosing 200-day averages, which are falling. Historically, the market has faredto return cash to investors rather than By mid-January, we may have more better in election years when theS&P 500 Index vs. NDR Cycle Composite 15
  • 16. incumbent is re-elected (+12% similar juncture), and incumbents campaign against a “do-nothing”on average) versus when he is have been defeated when the Republican party that does notunseated by a challenger (-3%). This unemployment rate has been well deserve the presidency, as well as thetendency, though, is likely not a below current levels. While much personal failings of the actual preference for incumbents, can change between now and the This provides a disincentive to theas much as a reflection on the election, if voters are going to reward President and Democrats in Congresseconomic circumstance that led to an an improving economy, those gains to getting anything accomplished (i.e.,incumbent’s re-election/defeat. would likely need to be seen in the the do-nothing label cannot stick ifPresidential elections in which there near future – after the first quarter things are indeed being done). Thisis an incumbent and a challenger of 2012 it may be too late to change scenario means that we could be incan generally be boiled down to two economic perceptions. for an especially negative presidentialbasic questions: 1. Do voters approve The strategy for the Republican campaign that could exacerbate theof the incumbent’s handling of the challenger, whoever it ends up being, normal seasonal tendencies.economy? and 2. Can voters see the will likely be to hammer on President Investor sentimentchallenger as “presidential”? If the Obama’s handling of the economy. Investor sentiment, as we moveanswer to the first is “yes,” the second Not only could this depress sentiment into 2012, is mildly bullish. Investordoes not matter and the incumbent (recall the mid-2011 malaise that optimism tends to swell as we moveis likely to win. If, on the other hand, accompanied the debt-ceiling debate), from one year to the next, so thethe answer to the first is “no,” the but it provides Republicans in Congress sentiment surveys that we watch on asecond question becomes the key – a with a disincentive to try to accomplish weekly basis could move higher into“yes” answer gives the presidency to anything between now and the election January without offering much of athe challenger and a “no” allows the lest it provide the president with a headwind for stocks (as of this writing,incumbent to keep his job despite tailwind for his re-election campaign. they show a mostly even mix betweenpoor marks. Unable to campaign on the strength bulls and bears). The key over theNow, a year ahead of the election, of the economy, President Obama’s near term will be the reaction of thePresident Obama gets generally re-election hopes may hinge on sentiment indicators to movementspoor marks on his handling of the portraying the challenger as insufficient in prices – price declines that areeconomy (recent polls show him to the office of president. Here, the met with a surge in pessimism arewith a favorability rating in the low hope will likely be to tie the challenger unlikely to persist, while rallies that40’s, below even Jimmy Carter at a to the Republicans in Congress and attract elevated levels of optimism areStock Market and Investor Sentiment 16
  • 17. vulnerable to reversal. We’ll continue to this desire to move away from breadth confirmation of a cyclicalto watch sentiment on a weekly basis stocks. On an anecdotal level, we bull market. Also, the number ofas we read the various sentiment hear of an increasing reluctance to issues making new highs versus newsurveys as well as the options data. maintain exposure to a stock market lows has been trending lower and isTwo longer-term sentiment indicators that appears to be schizophrenic at inconsistent with a cyclical bull marketdeserve mention here. First, mutual best and may just simply be chaotic. at this point.funds are fully invested (according Prudent regulation (such as something The risk-on/risk-off nature of theto data from ICI, the mutual fund that puts high-frequency trading firms stock market and the tendency forcash/asset ratio near the end of 2011 more in the camp of market makers) (nearly) everything to move in thewas just above its all-time low near may help restore investor confidence same direction has an impact on our3.1%), which could limit the ability and encourage increased, long-term breadth measures. As we mentionedof institutional buyers to step into involvement in the stock market. previously, 10-to-1 days are soweak markets to support prices. This is Breadth indicators common now as to be practicallyfurther exacerbated by a demand for meaningless. In recent months, it Breadth indicators are bearishredemptions by mutual fund investors has been the rule, rather than the entering 2012. An expansion in rally(again according to ICI, equity mutual exception, that 80% to 90% of the S&P participation at an issue, industry-funds have seen net outflows in every 500 is moving in the same direction on group or world market level wouldmonth since May). Second, we are in a any given day. It appears that this may support the view that the 2011 cyclicalperiod of secular shift away from the reduce some of the leading tendencies bear market has indeed run its course.stock market on the part of individual in the breadth indicators, but does not That has not yet been seen. In fact,investors. Eventually this will be bullish cancel the need to see confirmation thus far the breadth indicators havefor stocks (once the final investor has from the breadth indicators to gain been much more consistent withfinally washed his hands of stocks and confidence that movements in the the continuation of the cyclical bearvows never to buy one again), but in indexes are significant. into the first half of 2012. We arethe meanwhile it weighs on equities. Aside from the indicators mentioned particularly watching our measure ofInvestors continue to realize that they above, we are watching three the percentage of industry groups inwere overinvested in stocks, bearing areas of the market in particular for up-trends, which historically needsmore risk than was appropriate. The confirmation of what we see in the to get decisively above 65% to signalvolatility in the market has addedS&P 500 and Industry Group Breadth 17
  • 18. S&P 500: the Financials sector, small- dynamic approaches to asset market re-emerges, tilt toward morecap stocks and China. If two of these allocation that recognize that risk cyclical areas and those that wouldareas get (decisively) back in gear, we and risk tolerances are not static. benefit from a near-term ebbing inwould have increased confidence that Allocations to all asset classes volatility (high-yield corporate debt,rallies seen in the S&P 500 can persist. (including cash) should be actively for one).Absent that, and without an expansion decided upon, and they will fluctuate • Emerging markets have better growthin the percentage of industry groups (within bounds) as market conditions prospects and better balance sheetsin up-trends, we remain cautious. change. One of the byproducts of (generally) than their developed the current environment is the risk- counterparts, yet remain vulnerablePortfolio implications and on/risk-off tendency of the market. to market forces in the developedexpectations The risk-on/risk-off dynamic and world. We believe investors shouldWhile hopeful about tomorrow and the high correlations it engenders increase exposure there once a cyclicalthe prospect for secular change, for are a primary reason to focus on upswing is we remain in a basing period that portfolio risk in the first place. Inis inherently high-risk as the market • For investors looking to diversify periods of stress, correlations acrossswings between cyclical bull and bear. equity exposure away from the U.S., risky asset classes converge and theThe emergence of elevated levels of we generally would look towards other expected benefits of diversificationvolatility adds to the risk. Investors, countries that use dollars (Canada, fade. Effectively identifying shiftsprofessional or amateur, cannot Hong Kong, Singapore, and Australia). between these regimes can allow(and should not attempt to) manage Economic and financial conditions in investors to more successfully manageportfolios for the three- to four-week these countries are among the best risk. From a trading perspective,rallies and declines that have in the in the world. The caveat is that all this is done by looking at the co-past taken months or quarters to are influenced by movements in the movements of various indexes andemerge. Much of the market action commodity markets, which could add asset classes. From an investingon a day-to-day basis is just noise that to their volatility. perspective, this means watching forneeds to be filtered out. The remaining breadth confirmations/divergences • In the end, investors must rememberinformation, if there is any, can be and identifying periods of excessive that return (either price appreciationreacted to. In this secular environment, optimism and pessimism. or dividend yields) and risk areinvestors should focus on managing directly correlated. Managing for riskrisk, not chasing returns. The coming So, then, what is an investor to do means not chasing returns.secular upswing will be the time to in 2012?focus on returns. • We continue to view gold as an important component within a Since the individual goals of eachThis is not to say that investors should diversified portfolio. The secular up- investor vary, we encourage youhide their money under their mattress trend appears to be intact, and we to contact your Baird Financialand do nothing for the duration of the believe gold is likely to be a primary Advisor in early 2012 to discuss thesecular bear market that emerged a beneficiary from a more active implications of this market outlookdozen years ago. In fact the contrary European Central Bank and U.S. on your own portfolio and wealthmay be true. First of all no one Federal Reserve. management plans.knows when the next bull marketwill emerge. Second, managing for • We believe you should use the firstrisk rather than return addresses half of the year (assuming the 2011motivation, not action. Finally, even cyclical bear market is intact) to focuswithin the long-term trading range on defensive allocations, includingthat we find ourselves in, cyclical lower-beta, higher-quality sectors ofopportunities emerge. the market and high-grade corporateWe continue to view favorably debt. If and when a cyclical bull 18
  • 19. Important DisclosuresDisclaimersThis is not a complete analysis of every material fact regarding any company, industry or security. The opinions expressed here reflect our judgment atthis 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 andregulations and the potential for illiquid markets. Historically, small and mid cap stocks have carried greater risk and have been more volatile than stocksof 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 thestock 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 ExchangeCommission, FINRA, and various other self-regulatory organizations and those laws and regulations may differ from Australian laws. This report has beenprepared in accordance with the laws and regulations governing United States broker-dealers and not Australian laws.Copyright 2011 Robert W. Baird & Co. Incorporated.Other DisclosuresUK disclosure requirements for the purpose of distributing this research into the UK and other countries for which Robert W Baird Limited holdsan 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 MarketsAct 2000 (financial promotion) order 2001 being persons who are investment professionals and may not be distributed to private clients. Issued inthe United Kingdom by Robert W Baird Limited, which has offices at Mint House 77 Mansell Street, London, E1 8AF, and is a company authorized andregulated by the Financial Services Authority. For the purposes of the Financial Services Authority requirements, this investment research report isclassified as objective.Robert W Baird Limited (“RWBL”) is exempt from the requirement to hold an Australian financial services license. RWBL is regulated by the FinancialServices Authority (“FSA”) under UK laws and those laws may differ from Australian laws. This document has been prepared in accordance with FSArequirements and not Australian laws.©2011 Robert W. Baird & Co. Incorported. Member SIPC. MC-34114. #1444