Baird March 18, 2011 - investment-strategy-outlook

8/7/2019 Baird March 18, 2011 - investment-strategy-outlook

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Market StrategyMarch 18, 2011

Investment Strategy Outlook

Bruce Bittles William Delwiche, CMT, CFAChief Investment Strategist Investment [email protected] [email protected] 414.298.7802

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Please refer to Appendix Important Disclosures.

Focus On Risk Management

Highlights: Dollar Loses Favor as Safety Trade Inflation Outlook Remains Benign Economic Growth Improving Investors Turning Cautious Breadth Indicators to Be Tested

With the stock market having now experienced its first 5% correctionsince last August (nearly three times the average length between suchpullbacks), the question of the persistence of cyclical bull market isagain arising. While secular risks remain high (one need only scanthe headlines for at least a handful of realized and potentialtrouble spots), the weight of evidence remains bullish and therally, now entering its third year looks to be intact. The strength of the rally will be evident on any rebound oncethe current pullback runs its course. A failure of index gains to be matched by broad market participation (and confirmation) would represent an important change in character of the rally and could suggest that upside potential in the indexes is limited. While the weight of the evidence is bullish, the secular environment is such that investorsshould focus on risk management, and not be unduly focused on chasing returns.

Risk management can havetwo components: decisionsabout where to invest, andthe duration of thatinvestment decision. Theseare the essential aspects of atactical strategy. As opposedto a traditional buy-and-holdapproach, tactical strategiesidentify periods of higher riskand lower risk and allowportfolio allocations tofluctuate. This can meantilting toward higher betaareas of the market during

rallies, and increasing cashpositions and/or tilting towardlower beta areas of themarket during periods ofweakness or uncertainty.While average equity exposure over time may not vary between a static buy-

Outlook Summary

Marketweight Exposure to Stocks,Underweight Bonds

Secular Risks Unabated

Aging Cyclical Bull Retains Benefit of theDoubt

S&P 500 Support Near 1225;Resistance Near 1300

Mid-caps, Energy and Industrials in theLead

J J A S O N D 2 0 07 A M J J A S O N D 20 08 M A M J J A S O N D 2 00 9 M A M J J A S O N D 2 01 0 A M J J A S O N D 2 011 A M

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10 and 40-Week Moving Averages

S&P 500 (.SPX)

Created in MetaStock from Equis International


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and-hold approach and dynamic tactical approach, asset preservation in periods of stress (i.e., effective risk management)can help boost portfolio returns during rallies .

At a basic level, tacticalinvesting can be thought of asshifting between cash (a safeinvestment) and stocks (riskyinvestments). This calculusappears to be undergoingsomething of a transition ascash, which for domesticinvestors has usually meant theU.S. dollar, appears to be losingsome of its global stature. Thedollar remains, for now, thedominant global currency, but at

the margin, demand isweakening and investors arelooking elsewhere. We havediscussed this in the past as itrelates to gold, which seems to have moved from aparticipant in the commodity markets to a participant inthe currency markets as investors have shunned papercurrencies generally in favor of hard assets. Now,however, the dollar appears no longer to be thepreferred flight to safety vehicle even among papercurrencies. From the point of view of the financialmarkets, one of the most intriguing developmentsseen amidst the recent turmoil in the Mid East and

the cascading tragedies in the Japan has been therelative weakness of the U.S. dollar. Past periods ofglobal uncertainty have usually been accompanied bystrength in the dollar investors have sought the safetyof that currency until the dust settles and the global viewbecomes more certain. Now, we are seeing the dollar make new cyclical lows and investors are seeking safety in other currencies, notably the Swiss Franc and the Japanese Yen. Remarkably, the yen surged in the weekfollowing the Japanese earthquake/tsunami even as the

Bank of Japan injected trillionsof yen into the market.

What then is behind theweakness in the U.S. dollar? Inthe short-to-intermediate term,foreign central banks have beenbuying fewer U.S. TreasuryNotes and more activelyhedging their current exposureto U.S. Treasuries bydiversifying their currencyholdings. They have increasedtheir holdings in gold as well as

other currencies. Over thelonger term, investors maywell be seeing the structuralbudget deficits of the U.S.Federal government andconcluding that the supply ofdollars in circulation will haveto increase to meet theseexpected liabilities.


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Our view is that this is bestviewed as a currency issue,not an inflation issue . Whilean excess supply of dollars inthe domestic economy is aprerequisite for inflation, it is not

sufficient for inflation. To getsustainable increases in theprice level, wage growth wouldhave to accelerate. We have noevidence that this is currentlyoccurring, especially with theconsiderable slack still in thelabor market. Moreover, evenwith the foreign buyers paringback their Treasury purchases,bond yields have remainedrelatively low, with the yield onthe benchmark 10-year T-Noteranging between 3.25% and3.75%. With the U.S. economystill debt-based (progress hasbeen made in this regard, but itremains slow and uneven), higher yields right now areunsustainable as it would make servicing the debt morecumbersome. Higher inflation expectations that filterinto bond yields would likely result in a slowing ineconomic growth stemming demand and raisingagain the specter of deflation (which we continue toview as a more substantial long-term threat thaninflation).

As a currency issue, the excess supply of dollars is

manifested as higher commodity prices (items priced indollars will see their prices go up if the dollar goesdown). The domestic economic impact, all else beingequal, will be similar to a tax on consumers and tighterprofit margins for corporations (to the extent they areunable to pass prices through to consumers). In thecurrent environment, higher commodity costs aremore likely to be impediments to growth thancatalysts for inflation.

Tactical investors may want to expand their decision treeto include gold along with stocksand cash as they are makinginvestment decisions. Moresophisticated investors mayeven look for opportunities togain exposure to foreigncurrencies that are assumingthe role once played by the U.S.dollar.

Secular headwinds notwith-standing, our review of theindicators suggests that thebenefit of the doubt remainswith the bulls. The FederalReserve is still bullish, seasonalpatterns/trends are supportive,and the broad market has yet toshow the kind of divergencesthat typically precede asignificant market top.Sentiment indicators haveshown more pessimism and

Indicator Review

Fundamental Factors

Federal Reserve Policy Bullish +1

Underlying Economic Fundamentals Neutral 0

Valuations Neutral 0

Technical Factors

Investor Sentiment Neutral 0Trends/Seasonal Tendencies Bullish +1

Tape/Breadth Bullish +1

---------------------------------- ----------- -----

Wei ght of the Evidence Bullish +3


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skepticism among investors,although these results remainpreliminary. In several ways,the March correction places aburden on the bulls. A quick return to optimism and/or a

failure for the broad market to improve with the indexes on any rallies would suggest that the final chapters of the cyclical rally that just celebrated its second anniversary are being written.

Federal Reserve policy:Bullish. In its latest statementthe Fed acknowledged therecent rise in commodity pricesand the upward movement ininflation expectations. However,

it continues to expect inflationtrends to remain subdued. Thisis in line with our view that anynear-term whiffs of inflationwould likely not be sustainable given the debt situationand the excess capacity in the labor market. Even withimproving economic data, the Fed will likely complete itsplanned asset purchases ($600 billion of longer-termTreasury securities) announced last fall as the secondround of quantitative easing (QEII). These purchasesshould be completed by mid-year, and the wild card iswhat happens to bond yields and economic growth asthe Federal Reserves support is removed. Our

expectation is that growth will slow, and the fourthquarter of the year may bring increased chatter aboutQEIII.

Economic Fundamentals: Neutral. Near-term growthis improving, although trouble spots remain. Theunemployment rate has come down considerably inrecent months (from 9.8% in November to 8.9% inMarch). Weekly initial jobless claims are in a down-trendas the pace of layoffs slows. Payroll growth has been

uneven and well belowhistorical trends, but the patternhas now turned positive.Regional and nationalmanufacturing surveys showsthat business activity remainsrobust, and one of the upsidesto a weaker dollar is increaseddemand for exports. Thehousing market remains aprimary area of concern, andthe sharp drop in residentialconstruction activity in February(largely undoing the surge seen

in January) is not encouraging.The uncertainty surroundingJapan could put strains onglobal growth in the near term,both from a lack of demand aswell as potential supplydisruptions. While the Japaneseeconomy is not dynamic interms of growth, it is still the


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third-largest economy in theworld. It is too early to be able to fully assess the economic impact of the recent events in that country, but our best guess right now is that it modestly

dampens global growth for a quarter or two, before rebuilding efforts begin in earnest. Thisassumes a satisfactoryresolution to the breakdownsseen at the nuclear powerplants.

Valuations: Neutral. Stocksare not cheap, nor are theyexpensive. The price/earningsratio, based on trailing actualearnings for the mediancompany in the S&P 500 is little

changed from a month ago andis near its long-term average.Our most important take awayfrom the valuation indicators is that there is littleevidence that a secular page has been turned. Wecontinue to view the rally as cyclical in nature, and withinthe context of a longer-term secular bear market.

Investor Sentiment: Neutral. The March sell-off hasbeen accompanied by more skepticism and pessimism,although optimism has not sufficiently waned to suggestthat investor sentiment has turned bullish. We have seenincreased demand for protective puts (pushing the

CBOE put/call ratio over 100%), a surge in the VIX fearindex to its highest level since July, and shifts in theweekly surveys from bulls to bears. The latest data fromthe AAII shows the most bears and fewest bulls sincelate last summer (when stocks were undergoing that lastcorrection of at least 5%), and the NAAIM survey ofactive investment managers showed that in the secondweek of March, average equity exposure for thesemanagers dropped from 75% to 41%, with thedistribution shifting significantly toward the bears.

Optimistic managers kept theirequity exposure elevated. Thislingering bullishness can alsobe seen in the InvestorsIntelligence data, whichcontinues to show more thantwice as many bulls as bears(this survey tends to move moreslowly, so reversals could beupcoming, which would makethe overall sentiment picturemore bullish).

Seasonal Patterns/Trends:

Bullish. The compositeseasonal pattern, whichaggregates the 1-year, 4-year(Presidential) and 10-yearcycle, suggests stocks couldmake a significant peak in thethird quarter of this year. Withthe last round of FederalReserve intervention due to bewrapped up by the end of June,


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we could see this peak prior towhat the cycle anticipates(perhaps in the secondquarter). While this provides aroad map of sorts, we mustrespond to the signals being

given by the market. The short-term trend and momentumindicators have weakenedduring the March sell-off. Thelonger-term trends remainstrong. All 30 of the primary andsecondary domestic marketindexes we track have seentheir 50-day averages remainabove their 200-day averages.At this point, pullback hasrelieved widespreadoverbought conditions ratherthan doing significantdamage to the trends. Thereis a fine line between the two,but we do not believe we havecrossed it. On a relative basis the trends for large-capslook more favorable than those for small-caps, while thetrend in the S&P 500 is more favorable than the trend inthe NASDAQ Composite. These conditions are moretypical of the later stages of cyclical rallies than the earlystages.

Broad Market: Bullish. The broad market indicatorsremain bullish, although the true test of their resiliencywill be forthcoming. Divergences between the indexes

and their underlying breadth measures on any ralliesthat emerge would suggest a significant weakeningin the health of the bull market. We will be watchingtwo sets of breadth indicators in particular: thepercentage of industry groups in uptrends and theadvance/decline lines for the S&P 500, 400, and 600.Divergences between the advance/decline lines andtheir respective indexes, or divergences among theadvance/decline lines would represent a change in

character. Likewise, an inability

of any index rally to draw broadsupport at the industry grouplevel will be viewed as suspect.Right now the breadthindicators remain strong, asthey peaked in line with theindexes. Ensuing rallies may provide clues for how much further this cyclical bull market can run.


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BAIRD S TRATEGIC ASSET ALLOCATION MODEL P ORTFOLIOS Baird offers six strategic asset allocation model portfolios for consideration (see table below), four of which have a mix of equity andfixed income. An individuals personal situation, preferences and objectives may suggest an allocation more suitable than those shownbelow. Please consult a Baird Financial Advisor in determining an asset allocation that will meet your needs.

Model Portfolio Mix: Stocks /

(Bonds + Cash)Risk Tolerance Strategic Asset Allocation Model Summary

All Growth 100 / 0 Well above averageEmphasis on providing aggressive growth of capital with highfluctuations in the annual returns and overall market value of theportfolio.

Capital Growth 80 / 20 Above averageEmphasis on providing growth of capital with moderately highfluctuations in the annual returns and overall market value of theportfolio.

Growth withIncome 60 / 40 Average

Emphasis on providing moderate growth of capital and some currentincome with moderate fluctuations in annual returns and overallmarket value of the portfolio.

Income withGrowth 40 / 60 Below average

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

ConservativeIncome

20 / 80 Well below averageEmphasis on providing high current income with relatively smallfluctuations in the annual returns and overall market value of theportfolio.

CapitalPreservation 0 / 100 Well below average

Emphasis on preserving capital while generating current income withrelatively small fluctuations in the annual returns and overall marketvalue of the portfolio.

Bairds Investment Policy Committee offers a view of potential tactical allocations amongst equity, fixed income and cash, based upon aconsideration 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 boththe normal range and current recommended allocation to stocks, bonds and cash. Please consult a Baird Financial Advisor indetermining if an adjustment to your strategic asset allocation is appropriate in your situation.

Asset Class / Model Portfolio All Growth Capital Growth

Growth withIncome

Income withGrowth

ConservativeIncome

CapitalPreservation

Equities:Suggested allocation 95% 80% 60% 40% 20% 0%Normal range 90 100% 70 - 90% 50 - 70% 30 - 50% 10 - 30% 0%

Fixed Income:Suggested allocation 0% 10% 30% 40% 45% 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. BAIRDS INVESTMENT P OLICY COMMITTEE

Bruce A. Bittles William A. Delwiche, CMT, CFA Timothy M. Steffen, CPA, CFP

Managing Director First Vice President Senior Vice President Chief Investment Strategist Investment Strategist Financial-Estate Planning ManagerTimothy P. Byrne, CFA Todd K. Parrish Laura K. Thurow, CFAManaging Director Senior Vice President Senior Vice President Director of PWM Research, Prod & Svcs PWM Equity Analyst Co-Director of PWM ResearchPatrick J. Cronin, CFA, CAIA Warren D. Pierson, CFA Robert J. Venable, CFASenior Vice President Managing Director Managing Director Institutional Consulting Baird Advisors Co-Head Global Equities


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Robert W Baird & Co Page 8

Appendix Important Disclosures

Disclaimers

This is not a complete analysis of every material fact regarding any company, industry or security. The opinionsexpressed here reflect our judgment at this date and are subject to change. The information has been obtained fromsources 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, politicalinstability, foreign taxes and regulations and the potential for illiquid markets. Historically, small and mid cap stocks havecarried 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, LehmanMunicipal Bond Benchmark, Russell 1000, Russell Mid Cap, Russell 2000, and Russell 3000 are unmanaged commonstock indices used to measure and report performance of various sectors of the stock market; direct investment in indicesis 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 andregulations may differ from Australian laws. This report has been prepared in accordance with the laws and regulationsgoverning United States broker-dealers and not Australian laws.

Copyright 2011 Robert W. Baird & Co. Incorporated.

Other Disclosures

UK disclosure requirements for the purpose of distributing this research into the UK and other countries forwhich 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 theFinancial Services and Markets Act 2000 (financial promotion) order 2001 being persons who are investmentprofessionals and may not be distributed to private clients. Issued in the United Kingdom by Robert W Baird Limited,which has offices at Mint House 77 Mansell Street, London, E1 8AF, and is a company authorized and regulated by theFinancial Services Authority. For the purposes of the Financial Services Authority requirements, this investment researchreport is classified as objective.

Robert W Baird Limited ("RWBL") is exempt from the requirement to hold an Australian financial services license. RWBLis regulated by the Financial Services Authority ("FSA") under UK laws and those laws may differ from Australian laws.This document has been prepared in accordance with FSA requirements and not Australian laws.

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