U.S. Equities Hitting All-Time Highs. Now What?Executive summary

U.S. equities have recently been at all-time highs, leaving many clients wondering what to do next. We’ve been receiving questions such as:

• Whatkeydrivershavebeenpushingequitypriceshigher?

• Whatimpactarecurrenteconomicindicatorshavingonequityreturns?

• Whatistheoutlookforyear-end2013andinto2014?

• Howmay2014possiblydifferfrom2013?

Inthispaper,weshareviewsaboutthecurrentequitymarketenvironmentandoutlineourperspectivesonwhatmaylieahead.

2013 performance

Theyear-to-dateperformanceofU.S.equitieshasbeensuperbandremarkablyresilient.Lookingback,it’simportanttorememberthatthisyearstartedwithconcernsaboutthefiscalcliff,sequestrationandtheimpactthatbudgetcutsandhigherpayrolltaxesmighthaveontheeconomy.Inaddition,therewerepreliminarydebtceilingdiscussionsandgeopoliticalissuessurroundingeventsinEgyptandSyria.Totopthingsoff,werecentlyexperiencedapartialgovernmentshutdown.Yet,throughitall,theS&P500isupover20percent(year-to-datethrough October30)andhastouchedall-timepricehighsduringOctober.Lookingdeeper, nineof10sectorsintheS&P500areupover10percentandfiveof10sectorsareupover25percent.So,bymostmeasures,performanceofU.S.equitieshasexceededexpectations.

Market and sector performance

The performance of U.S. equities has been extremely strong so far in 2013.

• We continue to believe that equities are reasonably valued and may be positioned to do well for the remainder of the year.

• The degree of upside potential for equities is likely to be more moderate in 2014.

• Our current portfolio guidance recommends a modest overweight position in equities.

Total ReturnPrice 2013

Index 10/30/13 Q1 Q2 Q3 YTD (10/30/13)

S&P 500 1763.31 10.0% 2.4% 4.1% 23.6%Dow Jones Industrials 15618.76 11.3% 2.3% 1.0% 19.2%Russell 2000 1105.50 12.0% 2.7% 8.5% 30.2%MSCI EAFE 1893.68 4.4% -2.1% 9.8% 18.1%MSCI Emerging Markets 1042.75 -1.9% -9.1% 4.8% -1.2%

Sectors of the S&P 500 Weight

Information Technology 17.8% 4.2% 1.2% 5.4% 17.4%Financials 16.7% 10.9% 6.8% 1.9% 26.5%Health Care 12.9% 15.2% 3.3% 5.9% 32.5%Consumer Discretionary 12.4% 11.8% 6.4% 6.7% 33.3%Energy 10.5% 9.6% -0.9% 4.0% 18.4%Consumer Staples 10.4% 13.8% -0.2% -0.6% 21.3%Industrials 10.3% 10.1% 2.2% 7.4% 28.1%Materials 3.3% 4.2% -2.4% 8.9% 16.3%Utilities 3.3% 11.8% -3.7% 0.5% 11.4%Telecommunication Services 2.6% 8.2% -0.1% -5.3% 9.8%

Source: FactSet

Important disclosures provided on page 5.

SITUATION ANALYSIS

Influences pushing equity prices higher

Thestrongequityperformancein2013,inourview,canlargelybeattributedtothreeimportantdrivers:FederalReserve(Fed)-drivenliquidity,price-earningsmultipleexpansionandeconomicimprovement.

• Fed-driven liquidity:Fed-drivenliquidityisafancywayofsayinglowinterestrates.TheFed’scurrentprogramtopurchase$85billionpermonthinTreasuriesandmortgage-backedsecurities,oftenreferredtoasquantitativeeasing(QE),isdesignedtodojustthat—keepinterestrateslow,particularlylong-datedmaturities,intheinterestofpromotingeconomicactivityandinflatingassetprices.Thishashelpedpushequities to higher levels.

Fed liquidity expansion helped lift stock market

2009 2010 2011 2012 Oct2013

S&P

500

pric

e le

vel

1,800

1,600

1,400

1,200

1,000

800

600

Federal Reserve – total assets ($ in m

illions)

$4,000

$3,500

$3,000

$2,500

$2,000

$1,500

Source: FactSet; data: October 25, 2013

• Price-earnings expansion: Equitieshavebenefitedfromprice-earningsmultipleexpansion,whichissimplyhowmuchinvestorspayfor$1ofcompanyearnings.Historically,duringtimesofsimilareconomicconditions(suchasinthe1960sandearly1970s)thatnumberhasrangedbetween15to18times.Atthestartof2013,theconsensuswasthatamultipleof14to15timeswasappropriate,butastheyearhasprogressedandthemarketworkedthroughoneheadlineafteranother,expectationsforahighermultiplealsoclimbedtoapointwhereamultipleinthe16to17timesrangewasconsideredbothappropriateandwarranted.

• Economic improvement: The U.S. economy has shownsignsofimprovementthroughouttheyear—inareassuchashousing,employment,retailsalesandmanufacturingconfidence—whichhashelpedmoveequitypriceshigher.Thelevelofimprovement,

however,remainsaworkinprogress.OfdebateiswhethertheeconomyisstrongenoughtooperateonitsownwithoutassistancebytheFed.

Key economic drivers

Amongkeyeconomicdriversimpactingequitypricesarehousing,employment,retailsalesandmanufacturing.The general conclusion is that these areas are all showing signsthateconomicimprovementisoccurring.

• Housing:Homesalesareupandhousingstartsremainbelowcapacity,buthomebuilderconfidence(asmonitoredbytheNationalAssociationofHomeBuildersIndex)indicatesweshouldexpectrisingactivityinthisarea.Theoutlookforhousingstillremainsfavorableasmortgageratesremainquitelowandhousingremainsaffordable.Additionally,the 50-yearannualizedrunrateofhousingstarts,accordingtotheCensusBureau,isapproximately 1.5millionunits,considerablyabovethecurrentlevelofroughly900,000.Thisleadsustobelievethathousingappearstostillhavelegsandremainsanimportantcomponentoftheeconomy.

Housing recovery underway—still room to grow

1964 1965-1969 1970-1974 1975-1979 1980-1984 1985-1989 1990-1994 1995-1999 2000-2004 2005-2009

Average

2010-Aug2013

# of

hou

sing

sta

rts(in

thou

sand

s)

2500

2000

1500

1000

500

Source: Bloomberg; data through 8/31/13

• Employment:Ingeneral,payrollgrowthhasbeenmodest,averaging185,000jobspermonthoverthepastyear.Adisappointingincreaseof148,000jobswasrevealedbythedelayedSeptemberjobsreport.However,theunemploymentratedeclinedto 7.2percentandtemporaryemploymentincreased,whichisoftenaleadingindicatorofpermanenthires.

Important disclosures provided on page 5. Page 2

SITUATION ANALYSIS | U.S. Equities Hitting All-Time Highs. Now What?

Unemployment rate is still high, but improving

Feb2009

Feb2010

Feb2011

Feb2012

Feb2013

Aug2009

Aug2010

Aug2011

Aug2012

Aug2013

Unem

ploy

men

t rat

e

10.5%

10.0%

9.5%

9.0%

8.5%

8.0%

7.5%

7.0%

6.5%

6.0%

5.5%

5.0%

4.5%

4.0%

Source: Haver Analytics

• Retail sales: Results have been mixed. Cars, electronicsandfurnituresaleshavebeenrelativelystrong in recent months. Conversely, clothing and departmentstoresaleshavelagged.Thispresentssomeuncertaintyregardingtheupcomingholidaysalesperiod.Weknowtherehasbeensomepent-updemandforautosinrecentmonthsandfavorablefurnituresalescanpartlybeattributedtothehousingmarket.However,apparelsaleshavegenerallylaggedasconsumershaverefrainedfromoverextendingthemselves. That said, it seems too early to have agoodreadonthelevelofholidaysales.Plus,consensusexpectationsaregenerallylow.Theoutlookforholidaysalesshouldbecomemorevisibleaftermorecompaniesreportthirdquarterresultsandoffersome year-end guidance.

• Manufacturing: Manufacturingcontinuestoimproveandgainmomentum.TheInstituteofSupplyManagement(ISM)ManufacturingIndex,agaugeonmanufacturingconditions,isatatwo-yearhighlevel.Increasingdemand,bothathomeandabroad,pluslowinputcosts(suchasenergy)arehelpingdriveearningsandsharepricesofmanyindustrial-relatedcompanies.

Looking ahead

Inourview,U.S.equitiesseemlikelytotrendgenerallysidewayswithanupwardbiastowardyear-end.Aswelookfurtherinto2014,weseeU.S.equitiesmovingstillhigher,albeitatamoremoderatepacethanwhatisbeingexperiencedin2013.

• Monetary policy risk:FederalReservemonetarypolicy,includingthetimingoftaperingtheQEbondpurchasesremainsarisktoequitymarkets.FollowingtheSeptemberjobsreport,theconsensusisnowfortheFedtoannouncetaperingofQEafterthefirstof

theyearandperhapsnotuntiltheMarchFederalOpenMarketCommitteemeeting.ThismayexplainsomeofthestrengthofequitiesexperiencedinrecentdaysastherunwayforFed-drivenliquiditymaybeextendedforafewmonthslonger.Nonetheless,itisstillonlyamatteroftimebeforetheunconventionalFedmonetarystimulusends.WesuspectU.S.equitiesmayinitiallytrend downward on the news as we will be in uncharted territory.Ataminimum,taperingrepresentsachangeintrend and with change comes uncertainty, anxiety and volatility.However,wealsobelievethatanydowndraftassociatedwiththetaperingislikelytobeshort-lived.

• Data integrity:Manyreadingsorindicatorsofeconomic health were held hostage by the Washington budgetanddebtceilingimpasse.Assuch,dataqualityislikelytobequestionedforthenextcoupleofmonths because it was either not collected during the shutdownorthevalidityissuspectduetoshutdown-relatedimpacts.Wesuspectitwilltakeamonthortwoforeconomicreleasestogetagoodreadonthehealthoftheeconomy.

• Contained inflation: We believe the current environmentofbenigninflationriskprovidesafavorablebackdropforequityprices.Lookingbackatperiodsofhighinflation,suchasduringthelate1970sandearly1980swheninflationbegantoramp,interestratesincreasedandthe10-yearTreasuryyieldrosetoover14percentin1981.Duringthatperiod,price-earningsratiosfelltotheseventoeighttimesrangeatthelowpoint.Incontrast,todayinflationisbenign—infact,thereisanequalconcernofdeflation.Inthisscenario,webelieveprice-earningsratiosarelikelytostaynearcurrentlevels,witharguablystillsomeupsideroomformodestexpansion.

Inflation: None in sight

Actual Projected

2000 2004 2008

Perc

ent c

hang

e

2012 2016 2020 2024

4%

3%

2%

1%

0%

Overall

Core

Source: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis; Department of Labor; Bureau of Labor Statistics; Federal Reserve

Important disclosures provided on page 5. Page 3

SITUATION ANALYSIS | U.S. Equities Hitting All-Time Highs. Now What?

Comparing and contrasting 2013 and 2014

Lookingbeyondthenextthreetofourmonths,andassumingwegetthroughthenextroundofbudgetanddebtceilingdiscussionsinJanuaryandFebruary,aswellasthefirstroundofFedtaperingwithoutanymajordisruptions,2014islikelytodifferfrom2013inseveralways.

• Transition year: Inourview,2014islikelybeatransitionyearfortheequitymarketsduetothepotentialforchangeinFedpolicy,limitedearningsmultipleexpansionandatransitiontorevenueexpansionfromprofitmarginexpansionforcompanies.WeanticipateanendtothecurrentQEprogramin2014,althoughtheFedisunlikelytoraiseshort-terminterestrates,whichshouldtemperequitymarketgrowth.Price-earningsmultipleexpansionhasbeenaprimarydriverofequityincreasessofarin2013.Withmarketmultiplesaroundthehistoricaverage,webelievethemarketwillbeunlikelytoawardsimilarprice-earningsmultiplegrowthin2014asitdidin2013.Arguably,Fedtaperinglikelyindicatesaself-sustainingeconomicexpansion,whichshouldleadtoimprovingrevenuegrowthforcompanies,potentiallyprovidinganewpathforequitymarketappreciation.

• International boost: While there remains much uncertaintywithinternationalmarkets,wearecautiouslyoptimistic.Performancehasvariedyear-to-datewithinternationaldevelopedandemergingmarketslagginginthefirsthalfof2013.However,morerecently,developedinternationalhasrallied.SeveralU.S.multinationalcompaniesthathaveaninternationalfootprintarealsoreportingthatconditionsinEuropeareshowingmodestsignsofgrowth,whileemergingmarketsappeartobegenerallystabilizing.Ifthesetrends continue, this seemingly suggests that U.S. multinationalcompaniescouldgetaboosttoearningsin2014,atleasttoagreaterextentthanhasbeenthecasein2013.

Conclusion

TheperformanceofU.S.equitieshasbeenremarkablyresilientsofarin2013.Infact,ithasbeena“buyonthedips”equitymarketthroughouttheyearasthebroadequitymarkethasforgedthroughoneheadwindafteranother.Aswelooktowardyear-endand2014,webelievetherearereasonsforcontinuedoptimism.Manyofthedriversthatareresponsibleforpushingequitypriceshigherremaininplace—interestratesarelow,valuationisfair,inflationisbenignandsentimentisgenerallypositive.Inourview,thesedriverspresentafavorablebackdropforequitiesandarereasonsthatleadustobelieveU.S.equitieswilltrendstillhigherinto2014.Thatsaid,thedegreeofupsideislikelytobemoremoderatein2014thanthisyearasearningsaccelerationisarguablyrequiredtopushequitiestomeaningfullyhigherlevels.Forthattohappen,weneedtoseemorewidespreadevidenceofeconomicimprovementandanticipatethatglimpsesofprogresswillbeseenbythefirstquarterofnextyear.Ouryear-end2013pricetargetfortheS&P500is1760.However,weseeupsidepotentialtothe1815range,whichisroughly3percentabovecurrentlevels. Atthistime,our2014pricetargetis1900,approximately8percentabovecurrentlevels.

Important disclosures provided on page 5. Page 4

SITUATION ANALYSIS | U.S. Equities Hitting All-Time Highs. Now What?

Investments are:

NoT a DePoSIT NoT FDIC INSUReD MaY LoSe VaLUe NoT BaNk GUaRaNTeeD NoT INSUReD BY aNY FeDeRaL GoVeRNMeNT aGeNCY

This commentary was prepared on October 30, 2013 and the views are subject to change at any time based on market or other conditions. This information represents the opinion of U.S. Bank and is not intended to be a forecast of future events or guarantee of future results. It is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. U.S. Bank is not responsible for and does not guarantee the products, services or performance of third party providers. Any organizations mentioned in this commentary are not affiliates or associated with U.S. Bank in any way.

Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Indexes shown are unmanaged and are not available for investment. The S&P 500 Index is an unmanaged, capitalization-weighted index of 500 widely traded stocks that are considered to represent the performance of the stock market in general. The Dow Jones Industrial Average (DJIA) is the price-weighted average of 30 actively traded blue chip stocks. The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, and is representative of the U.S. small capitalization securities market. The MSCI EAFE Index includes approximately 1,000 companies representing the stock markets of 21 counties in Europe, Australasia and the Far East. The MSCI Emerging Markets Index is designed to measure equity market performance in global emerging markets.

Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible difference in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.

© 2013 U.S. Bancorp (10/13)

reserve.usbank.com

Contributed by: Terry D. Sandven Chief Equity Strategist

SITUATION ANALYSIS | U.S. Equities Hitting All-Time Highs. Now What?

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