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Paul Flood Market Commentary May 18, 2013 Yes, There is Upside to Stocks BUT let’s take a deep breath for a correction. The market (S&P 500) has appreciated by close to 17% YTD but it seems that over the shorter term it is ahead of itself. Business fundamentals are not meaningful supportive for this annualized pace. After a shorter-term pull back, stocks could very offer 20%-30% upside over the next year or so. Just as we have experienced the worst recession since the 1930’s in 2008-2009, we also may be setting the stage for the greatest recovery in as many years.

Critical factors driving longer-term optimism include: 1) Historically low rates in the US and Europe as far as the eye can see 2) high liquidity within the corporate and banking sector.

• But a word of shorter term caution. The market may be over extended. In light of flat S&P reported revenue growth to date, the S&P stock index has appreciated by over 17%. The recent economic slow down will continue over the next year as fiscal tightening takes its toll. Rising unemployment in the government sector will challenge the Fed’s unemployment target. Economists estimate that that the belt tightening of the government’s sequestration will cut GDP growth by about .5% and reduce payroll employment by 300,000-750,000. Wall street earnings estimates for the S&P are probably a

little high. As estimates ratchet down the market will have the excuse to correct from today’s levels. That being said, Treasury bond rates will remain low. This will provide relative dividend support to the stock market, while offering a low cash flow discount rate to the market. High global central bank liquidity is keeping interest rates low and will support the markets well in to an extended economic recovery period.

The dollar should be slowly trending upward relative to Euro and the Yen, as it is the prettiest girl at the ugly party. There remains a case for stocks that have a dividend yield above the 10-year treasury rate at 1.80%. Beyond the most obvious high yielding sectors like banks (emerging from the rubble and capital ratios improving) and utilities (traditional safe havens), consider defensive staples with reasonable yield protection, and well positioned foreign businesses that have upside potential over the next few quarters. The stock screen shows Coca-Cola, GE, McDonalds and PepsiCo.

A quick look at year to date markets: Year to Date 2013. • All equity market indices have turned in

exceptionally strong results year to date. The S&P 500, Dow Jones Industrials and the Russell 2000 indexes have each returned close to 18%.

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• This is in spite of a weak 2.5% GDP growth rate for Q1, stubbornly high unemployment rates, and soft (+2.5%) S&P revenue growth. Euro MSCI Stock Index has gained close to 13% or about 10% in US dollar terms.

• In the S&P 500 three top performing sectors YTD, include: Health Care (+23%) and financials (+21%). The lagging sectors are Information Tech (+10.4% -AAPL is the drag) and Materials +9.2%.

• Morningstar fund performance YTD data shows that Mid-Cap Funds are the best performers-+23%. Small-Cap Growth Funds are the worst (+14.7%). Generally Value has out performed Growth YTD

Fixed Income Markets: • Short -term interest rates are low (close to zero) and are expected to remain at these levels for the foreseeable future. •

To date US Treasury bonds (Barclay’s Capital index) have been flat across the yield curve. Long-term investment grade corporate bonds (Merrill Lynch

Index) have returned 2.7%. The Merrill Lynch High Yield Index has returned about 5.5%

The 10-year treasury has been range bound between 1.6%% and 1.9% for most of the year, and has been drifting down as of late. Given the Fed’s unemployment focus and the fact the Fed Chairman recently stated his concern for fiscal drag, we would not be surprised to see further declines in the 10 Treasury bond. More Fed bond buying could very well be coming beyond the $85 billion per month.

Notice yield spreads on BBB rated bonds over the 10 year are under just 200 basis points. There is a little room for further tightening in spreads and better performance. The real story continues to be tightening spreads in the Hi Yield and leveraged loans markets, where tight supply and strong demand are driving spreads lower.

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Company fundamentals for the broad stock market remain sketchy But Cash balances remain stong:

Cash: As of the end of Q1, FactSet estimates that the major non-financial companies in the S&P index have over $1.2 trillion of cash on their balance sheets. Recent data from the Federal Reserve (Flow of Funds- Z.1 Table B.102) collaborates the cash hoard. The report estimates that balance sheet cash (short term liquid deposits) of Non-financial Businesses has grown by 5% over the past year to about $1.4 trillion.

Although just about 60% of the cash is held outside of the US, that still leaves about $500 billion to distribute to shareholders without regard to repatriation taxes. Continue to expect companies like Pfizer, and IBM, TRW and Kellogg’s to return the cash to shareholders in the form of dividend increases, and share buybacks. Smaller and Mid-cap companies with high cash levels, stable earnings and low levels of debt may be targets or may be forced in to going private.

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Expect Capital Expenditures of S&P Companies to be flat in 2013, given sluggish revenue growth. This will allow for greater free cash flow.

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Earnings: S&P EPS grew by less than 1% to $96.82 in 2012. Bottoms up estimates suggest that earnings should grow by over 14% to $110 in 2013. The consensus numbers however have been declining steadily over the past few months, given the sluggishness in global economy. NOTE THAT 2012 CONSENSUS EPS ESTIMATES IN MAY OF 2011 WAS $111. GIVEN THE SLUGGISHNESS IN THE GLOBAL ECONOMY estimates for 2013 and 2014 will probably continue to fall. This is a replay last year’s trend. We expect a very modest single digit growth for EPS in 2013. Based on current consensus estimates the market is at a slight discount to the longer-term average. Based on current consensus estimates the market is at a slight discount to the longer-term average.

At about 15x Next Twelve Months (NTM) PE the market seems just about fairly valued. But the real story over the next year or 2 remains DIVIDENDS.

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Dividend Yield: In May of 2011 S&P dividend yield was just about 2%. As we mentioned in our previous commentary (May 2011), we expected dividends to increase by 10%-15% from 2011 levels. Indeed this what has been a key driver of overall market returns. Although not in a straight path, note that from May 2011 to May of 2013 the S&P appreciated from 1320 to 1660 (+25%) while dividends per share increased by about 25% from $25 to $32. As this math suggests the dividend yield is still just about at 2%. This is very much in-line with the historic average - exceptions being the depth of recession and the peak of the bubble years. Expect dividend payout to increase modestly in light of lower earnings growth (+6%-7%) and little need for major capital expenditure growth. Expect payout to increase from 33% rate to 34-35%, which are more in line with historic averages. Dividends will probably grow 13-15% this year to $35 per share.

IF Investors get encouraged about 2014 earnings prospects later in 2013 and in to 2014, the dividend yield could very well approach 1.75%. This could push the market into the 2,000 range by mid to late 2014. THERE IS 20-30% UPSIDE FROM 1,660. We would be especially aggressive buyers on a mid-year correction! Our time horizon is 2014- 2015.

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The Market has rallied by about 16% YTD. The performance is exceptional in light of the sluggish overall economy over the past few months. Expect a pull back over the next month or 2.

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Expect Cash returned to shareholders to continue to grow over the next few years, driven by increased dividend payout and modest share repurchases.

S&P 500

MARKET DIVIDENDS BUYBACKS DIVIDENDS TOTAL CASH

VALUE $ BILLIONS $ BILLIONSPLUS

BUYBACKS RETURNED TO

Quarter End S&P INDEX $ BILLIONSTRAILING 12

MONTHSTRAILING 12

MONTHSTRAILING 12

MONTHSSHAREHOLDERS PER S&P SHARE

CASH RETURN

YIELD

12/31/07 1468 $12,867.85 $245.38 $588.88 $834.26 94.29 6.4203/31/2008 1323 $11,510.68 $248.78 $585.08 $833.86 94.79 7.1706/30/2008 1280 $11,162.57 $251.29 $515.23 $766.52 87.51 6.8409/30/2008 1166 $10,181.46 $251.88 $433.23 $685.11 78.47 6.7312/31/2008 903 $7,851.81 $247.29 $339.64 $586.93 67.37 7.4603/30/2009 798 $6,927.59 $237.32 $256.52 $493.84 56.69 7.1106/30/2009 919 $8,044.82 $223.00 $192.81 $415.81 47.72 5.1909/30/2009 1057 $9,336.51 $208.77 $137.95 $346.72 39.69 3.7512/31/2009 1115 $9,927.54 $196.95 $137.65 $334.60 38.03 3.4103/31/2010 1169 $10,560.00 $194.50 $162.13 $356.63 40.11 3.4306/30/2010 1031 $9,322.58 $197.30 $215.57 $412.87 46.06 4.4709/30/2010 1141 $10,336.29 $201.37 $260.28 $461.65 51.21 4.4912/31/2010 1258 $11,429.83 $205.83 $298.82 $504.65 55.72 4.4303/31/2011 1326 $12,069.31 $212.62 $396.13 $608.75 66.88 5.0406/30/2011 1320 $12,015.34 $221.56 $365.00 $586.56 64.44 4.8809/30/2011 1131 $10,299.31 $229.31 $403.85 $633.16 69.53 6.1512/31/2011 1258 $11,384.96 $239.22 $405.08 $644.30 71.17 5.6603/31/2012 1408 $12,726.02 $247.23 $405.08 $652.31 72.17 5.1306/30/2012 1362 $12,301.68 $255.79 $399.53 $655.32 72.55 5.3309/30/2012 1440 $12,874.99 $264.56 $402.04 $666.60 74.56 5.1812/31/2012 1426 $12,742.45 $279.18 $387.35 $666.53 74.60 5.235/17/2013 price, 12/2013CF's est. 1660 $14,787.82 $315.47 $391.05 $706.52 79.08 12/31/2014 $356.48 $392.43 $748.91 83.8212/31/2015 $402.83 $387.28 $790.10 88.43

ASSUME TOTAL CASH RETURN GR. RATE '13= 6.0% ASSUME GR. RATE '14= 6.0%ASSUME GR. RATE '15= 5.5%

S&P 500 TOTAL CASH RETURNED TO SHAREHOLDERS= CASH DIVIDENDS AND SHARE BUYBACKS

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OPERATING AS REPORTED CASH

Historic Payout is 38%, Excl.12/08 SALES

QUARTER EARNINGS EARNINGS DIVIDENDS PEREND PER SHR PER SHR PER SHR SHARE12/31/2000 $13.11 $9.07 $3.98 0.303 $191.0303/31/2001 $10.73 $9.18 $3.78 0.352 $186.0706/30/2001 $9.02 $4.83 $3.84 0.425 $183.0309/30/2001 $9.16 $5.23 $4.14 0.452 $178.6812/31/2001 $9.94 $5.45 $3.98 0.401 $189.1003/31/2002 $10.85 $9.19 $3.77 0.348 $167.2006/30/2002 $11.64 $6.87 $4.15 0.356 $175.3309/30/2002 $11.61 $8.53 $3.90 0.336 $166.1212/31/02 $11.94 $3.00 $4.26 0.356 $165.9403/31/2003 $12.48 $11.92 $3.92 0.314 $171.2106/30/2003 $12.92 $11.10 $4.09 0.316 $181.1509/30/2003 $14.41 $12.56 $4.32 0.300 $179.6012/31/03 $14.88 $13.16 $5.06 0.340 $178.8503/31/2004 $15.87 $15.18 $4.56 0.287 $187.3306/30/2004 $16.98 $15.25 $4.66 0.275 $193.6409/30/2004 $16.88 $14.18 $4.88 0.289 $197.0612/31/04 $17.95 $13.94 $5.33 0.297 $210.1403/31/2005 $18.00 $16.85 $5.34 0.297 $206.1006/30/2005 $19.42 $18.29 $5.36 0.276 $214.8009/30/2005 $18.84 $17.39 $5.43 0.288 $220.9012/31/05 $20.19 $17.30 $6.08 0.301 $232.5203/31/2006 $20.75 $19.69 $5.91 0.285 $229.8006/30/2006 $21.95 $20.11 $6.02 0.274 $234.7109/30/2006 $23.03 $21.47 $6.09 0.264 $239.8012/31/06 $21.99 $20.24 $6.87 0.312 $248.2003/31/2007 $22.39 $21.33 $6.52 0.291 $242.4806/30/2007 $24.06 $21.88 $6.69 0.278 $255.6309/30/2007 $20.87 $15.15 $6.90 0.330 $258.8112/31/07 $15.22 $7.82 $7.62 0.501 $268.1603/31/2008 $16.62 $15.54 $7.09 0.427 $265.7206/30/2008 $17.02 $12.86 $7.10 0.417 $278.5309/30/2008 $15.96 $9.73 $7.04 0.441 $268.0012/31/08 -$0.09 -$23.25 $7.15 -79.489 $230.2103/30/2009 $10.11 $7.52 $5.96 0.590 $221.8006/30/2009 $13.81 $13.51 $5.44 0.394 $223.2409/30/2009 $15.78 $14.76 $5.35 0.339 $227.3412/31/09 $17.16 $15.18 $5.66 0.330 $236.0203/31/2010 $19.38 $17.48 $5.46 0.282 $232.3806/30/2010 $20.90 $19.68 $5.58 0.267 $236.7509/30/2010 $21.56 $19.52 $5.66 0.263 $240.8412/31/10 $21.93 $20.67 $6.03 0.275 $252.7303/31/2011 $22.56 $21.44 $6.16 0.273 $250.8906/30/2011 $24.86 $22.24 $6.49 0.261 $263.3109/30/2011 $25.29 $22.63 $6.50 0.257 $265.9912/30/11 $23.73 $20.64 $7.28 0.307 $272.643/30/12 $24.24 $23.03 $7.09 0.292 $267.336/29/12 $25.43 $21.62 $7.45 0.293 $268.039/28/12 $24.00 $21.21 $7.77 0.324 $268.9912/31/12 $23.15 $20.65 $8.93 0.386 $288.033/28/13 $25.96 $24.18 $7.95 0.306 $271.04

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S&P Dow Jones IndicesS&P 500 QUARTERLY DATA

S&P 500 EPS Dividend Payout Dividend

2012 96.82 0.32 31.252103est. 103.60 0.35 36.26

S&P Price Target at 2.25% Dividend Yield= 1,611.52S&P Price Target at 2.00% Dividend Yield= 1,812.95S&P Price Target at 1.50% Dividend Yield= 2,417.27

Average : 1,947.25Current Price= 1660.00

Expected Upside@ 2% or Lower Dividend Yield = 2115.11 27% =Expected Gain

Note: 103.6 EPS Est for 2013 is about 5% below Consensus. Expect slower global macro activity to be similar to 2012

Historic Payout is 38%. Expect payout to increase modestly from 32% to 35% over the next year or so.

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Low Interest Rates as Far as the Eye Can See:

- In an effort to spur economic growth, reduce unemployment to 6.5% and combat the threat of deflation (Japanese style), the Federal Reserve has pushed short-term rate to levels well below 1%. These rates have not been seen since the late 1930’s and early 1940’s. Moreover the latest Quantitative Easing ($85 billion monthly purchase program) will continue to keep a ceiling on 10-year Treasury bond rate in the 2% range. The markets are adjusting to this new reality, which will probably persist for a few years. Policy is encouraging investors to move out on the risk curve in to higher yielding corporate debt and dividend paying stocks.

- Excess bank reserves at $1.8 billion are high and provide ample fuel for lending and economic expansion.

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Yield Spreads between BBB corporate bonds and 10 treasury Bonds has declined to about 150 basis points. This compares to the historic spread of 190 basis points.

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Relative to 2008, the supply of hi-yield paper is shrinking at a time when investors are demanding higher yield. Issuers are in control and covenants are light.

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High Yield corporate bonds spreads over Treasuries are just under 500 basis points. History shows that this spread can continue to narrow to closer to a 300 to 400 range over the next few years.

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Excess Reserves at close to $1.8 billion (over 10% of GDP) provides ample room for bank lending to spur economic activity.

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Recent bank survey suggests that lending officers are still willing to lend to consumers

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Bank Capital ratios have improved:

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Return on Bank Assets can improve as lending pick up over the next few years, as lending volumes pick up.

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Economy: Expect continued sluggish GDP growth in 2013. Given government spending cuts over the course of the year it is difficult to imagine meaningful improvement over 2012.

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Unemployment: The graph below shows the unemployment rate for April 2013 at 7.5%. This rate is still well above the Federal Reserve’s target of 6.5%. A reduction from current 7.5% level implies about 1 million of new jobs (net of labor force growth) would have to be added to bring the unemployment rate down to the target level. Private employment must pick up the slack in the Government sector.

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The first graph is the Employment Payroll Survey of Non-Farm Payrolls. This continues to improve. Since 2011 about 5 million payrolls have been added. However the second graph shows Government payroll continues to decline. Expect acceleration in the decline in Government over the next year or so, as budgetary constraints are imposed. Expect slower overall improvement of payrolls over the next year or so.

Government Payrolls are declining

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S&P 500 Earnings Estimates will continue to decline from $109 to closer to $104 over the next few months. Despite this Dividends can still increase with a combination of modest earnings growth, higher dividend pay-out, and cash on the balance sheet.

CONCLUSION: Expect the stock market to suffer a pull back form today’s 1,660 level. The 17% price appreciation of the S&P 500 is a bit much over such a short time period. While we believe the market can reach 2,100 (+25%) over the next 1-2 years and there is ample global central bank liquidity, realistic company earning expectations are not supportive over the shorter term. Overall first quarter 2013 EPS are up just about 7% and revenues are flat. After a mid-year pull back expect investors to focus on dividend paying stocks that have the capacity to increase payout ratios over the next year or two. Expect dividend growth of 13%-15% per annum over the next year or 2.

About the Author: Paul Flood has over 20 years of experience in the financial markets and investing. He has held positions as an economic analyst, fixed marketing specialist, and as a fundamental sector portfolio manager, and analyst. He holds an undergraduate degree from Columbia University and an MBA from Columbia Business School in New York. He also taught at Rutgers Business School.

OBSERVATION Q1,'13 EST Q2,'13 EST Q3,'13 EST Q4,'13 EST 2013 EST3/30/12 $27.19 $29.27 $30.27 $31.18 $117.916/29/12 $27.45 $28.97 $30.04 $31.28 $117.759/28/12 $26.98 $28.43 $29.10 $30.45 $114.96

12/31/12 $26.18 $27.84 $28.52 $29.63 $112.173/28/13 $25.49 $27.46 $28.43 $29.76 $111.14current $25.74 $26.69 $27.86 $29.40 $109.69

* Source: S&P