Baird Market & Investment Strategy

Investment Strategy Outlook

July 5, 2017

Please refer to Appendix Important Disclosures.

Outlook Summary

2017 at the Half: Normalizing Under Uncertainty Weight of the Evidence Remains Bullish

Highlights: Valuations Excessive but Corporate

Stocks Move Higher as Noisy Calm Persists Fundamentals Improving
Fed Sticks to Normalization Plans
Second Half Seasonals Uneven But
Economy Could Finally Exceed Reduced Expectations
Trend for Stocks Still Higher
Despite Focus on Narrow Leadership, Market Breadth Strong
Global Rally Providing Diversification Benefits Exceptionally Low Volatility Not Likely
To Persist in Second Half
Surprises dominated the first half of 2017, and there is little reason to think
that the second half will be much different. That is not to say that the next Upside Economic Surprises Could
Propel Bond Yields Higher
six months will be a carbon copy of the previous six months. Rather, it is an
encouragement for investors to keep an open mind and not get locked into
believing only those things which confirm a pre-existing narrative. This stresses the importance of developing a view in light of what
could happen, but tempering that against an ongoing assessment of what actually is happening. Through the unlikely combination
of noisy calm that dominated much of the first half of the year, the weight of the evidence remained tilted toward a bullish message,
and this message is intact as we look toward the second half. Despite some data disappointments in the first half, underlying
economic fundamentals (including low inflation) remain bullish for stocks, and the stock continues to benefit from a bullish tape and
broad rally participation. Valuations remain bearish and speak to elevated risk in the current environment. The other factors are
neutral right now.

Looking ahead, we are thinking about

Indicator Review the second half of 2017 through the
lens of three primary considerations:
the ongoing impact of continued
Fundamental Factors (What Could Happen) tightening by the Fed, the outlook for
Federal Reserve Policy Neutral 0 economic growth in the second half
after a generally disappointing first half
Economic Fundamentals Bullish +1
(particularly in the U.S.), and how well
Valuations Bearish -1 the stock market is able absorb the
Technical Factors (What Is Happening) emerging leadership rotation.

Investor Sentiment Neutral 0 Despite the uncertainty in the political

environment, there are indications that
Seasonal Patterns/Trends Neutral 0 a more normal macro investing
Tape (Breadth) Bullish +1 environment may be emerging. That
could very well include an uptick in
volatility in the second half even if the
Weight of the Evidence = Bullish +1
underlying trends remain intact

Bruce Bittles William Delwiche, CMT, CFA

Chief Investment Strategist Investment Strategist
bbittles@rwbaird.com wdelwiche@rwbaird.com 10R.17
941-906-2830 414-298-7802
Investment Strategy Outlook

Whether it was overseas elections, the

timing of domestic policy initiatives, or
the scope of central bank actions, the
macro backdrop received plenty of
attention in the first half of 2017. In a
social media context, much of this
discussion could have been tagged
#uncertainty. While policy uncertainty
is a headwind for economic growth, it
actually served as a bullish influence
on the stock market, offsetting
investor sentiment measures that
were at times tilted toward excessive
optimism. The uncertainty index has
moved lower as partisanship has
remained elevated and legislative
proposals have stalled. The caveat for
the second half may be that with
expectations for the economy and
reforms out of Washington DC at a low
ebb, the opportunity for an upside
surprise has re-emerged.
Source: Ned Davis Research

For all the noise around uncertainty,

the news from the first half of 2017
was actually the remarkable lack of
volatility. Heading into mid-year, the
S&P 500 has not seen a 5% pullback
in 250 days, the longest such streak
since the mid-90s. The largest peak-to-
trough pullback on the S&P 500 in the
first half was a 2.8% decline over the
course of March and April. This is the
second smallest such pullback in
history (only the 1.7% drawdown in the
first half of 1995 was smaller). In
previous instances when the first half
of the year saw peak-to-trough
declines of 5% or less, stocks saw
above-average strength in the second
half. While stocks are overdue for a 5%
correction, such a pullback could help
provide a strong base for the next
sustained move higher.

Source: Ned Davis Research

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Investment Strategy Outlook

One of the remarkable developments in

the first half was the ability for stocks to
not see a meaningful pullback even as
economic data was consistently
underperforming expectations. The
relationship between stocks and the
economic surprises indexes is not
always one-for-one but for stocks to stay
strong in the face of a sharp
deterioration in economic data (relative
to expectations) was a pleasant surprise
in the first half of the year. It is also
worth noting that looking across these
indexes, other economies fared better
than the U.S. economy relative to
expectations. The good news is that
expectations seem to have been reset.
This provides a lower hurdle to get over
in the second half, and we could again
see upside surprises from the economy.
This, in addition to continued tightening
by the Fed could put upward pressure
on bond yields over the course of the
Source: Ned Davis Research
second half.

The Fed has already raised the fed

funds rate by 50 basis points in 2017.
According to the dot plot published by
the Fed, the median expectation
among FOMC participants is for one
more 25 basis point rate hike this year,
and a continued gradual path of policy
normalization over the next two years.
We do not see this as a precise
forecast of where rates are heading,
but rather an expression of the
Feds desire to continue to
normalize monetary policy. In the
second half of 2017 this may also
mean starting to draw down the Feds
balance sheet. So far, the Fed has
done a great job of telegraphing its
intentions and guiding market
expectations. While rates are moving
higher, the deliberate pace of
normalization has kept this from being
a headwind for stocks.
Source: Federal Reserve

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Investment Strategy Outlook

Even as the Fed has been raising

interest rates, it has been hard to argue
that it has been tightening monetary
policy. Labeling it normalization is not
just a question of semantics but reflects
the still low absolute level of interest
rates (the 3-month T-bill yield in June
rose above 1% for the first time since
2008) and while plans for its draw down
have been laid out, the Feds balance
sheet continues to show more than $4
trillion in assets. Beyond this, the
national financial conditions index,
published weekly by the Chicago
Fed, suggests that financial
conditions remain loose and, in fact,
are looser than they were when the
Fed began raising rates in December
2015.

Source: Ned Davis Research

Short-term bond yields have been

rising as the Fed has raised the Fed
funds rate, but longer-term bond yields
have not. In fact, since the December
2016 rate hike, the 3-month T-bill yield
has risen by 50 basis points, while the
10-year T-Note yield has fallen by 25
basis points. This means the yield
curve (measured here by the spread
between the 10-year T-Note yield and
3-month T-Bill yield) has fallen 75
basis points over the past six months,
and it is now approaching its lowest
level since just ahead of the financial
crisis. This has attracted attention, and
the flattening of the yield curve is
viewed by some as an ominous
indicator for the stock market and the
economy. While it bears watching, we
do not yet see this as a harbinger of
weakness. A spread of less than 0.6%
between the T-Note and T-Bill would
warrant a reassessment of this in our
Source: Ned Davis Research
view.

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Investment Strategy Outlook

The yearly change in the T-Bill yield,

however, is getting close to a bearish
signal for stocks. Stocks have
historically struggled to make headway
when the T-bill yield has risen by more
than 74 basis points (that would be three
25-basis point rate hikes). If the Feds
next rate hike is in September, that
could turn this indicator bearish on
stocks. If, however, the Fed spends the
third quarter implementing its balance
sheet reduction plan and waits until the
December FOMC meeting to raise the
fed funds rate again this indicator could
remain in neutral. In other words,
continuing to normalize policy at a
gradual rate could keep the Fed at
neutral with respect to the stock
market but accelerating its pace of
rate hikes could turn it bearish for
stocks.
Source: Ned Davis Research

The Fed is not acting in a vacuum. It

can consider the actions of other
central banks (which are also talking of
beginning to normalize policy) but
more importantly the Fed needs to
consider the underlying health of the
U.S. economy. As we mentioned
above, data for the first half was
generally disappointing. This did not
dissuade the Fed from pursuing its
plans. But economic growth will likely
have to improve in the second half if
the Fed is going to stay true to its
announced intentions/expectations.
Looking at the recent readings from
the Philadelphia Feds Business
Activity Index, a rebound in GDP
growth in the second half does not
seem out of the question.

Source: Ned Davis Research

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Investment Strategy Outlook

While economic data has been generally

disappointing in the first half of 2017,
there have been clear pockets of
strength. The aforementioned Philly Fed
index, as well as other monthly business
surveys, has showed that activity has
been relatively robust. One of the most
hopeful developments was the surge in
non-residential fixed investment
spending in the first quarter. The 11%
surge in spending was the best
quarterly increase since 2012 and
suggests that increased optimism
among CEOs and CFOs is translating
into activity. A continued manifestation
of these animal spirits could be a spring
board that provides an improved growth
trajectory for the U.S. economy going
forward. The recent lack of productivity
growth is related in part to lack of capital
deepening represented by a lack of
investment spending. That may now be
changing.

Disappointing growth is not new to

2017 it has been a feature of this
recovery from the beginning. Over
time, however, forecasts for growth
have been moving lower, as
represented in this chart from the Bank
Credit Analyst. The Feds forecasts for
growth for this year and the next to
now assume no acceleration from the
current pace. With forecasts having
caught down to reality, the opportunity
for a meaningful upside surprise
becomes more significant. This is not
just the normal fluctuations in the
economic surprise indexes, but
would represent a paradigm shift
away from the experience of the
past 15+ years (during which growth
forecasts were often wrong and
always too optimistic).
Source: Bank Credit Analyst

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Investment Strategy Outlook

The table seems to be set to finally

provide an upside surprise. While data is
seasonally adjusted, there have been
questions about residual seasonality still
appearing in first quarter growth data
(which suggests that the 1.2% growth
seen in the first quarter of 2017 may
understate the actual level of growth).
Moreover, in five of the past seven
years, growth in the second half of
the year has been stronger than in
the first half. If growth for the first half
overall comes in near 2.0%, an even
modest acceleration in the second half,
which would be consistent with recent
experience, could push growth for 2017
overall above the Feds forecast.

Source: Bank Credit Analyst

Growth trends have improved around

the world and that provides strength
to the recovery being seen in the U.S.
Nearly 90% of economies around the
world are showing positive and
accelerating growth, as measured by
country-level Purchasing Managers
Indexes. Until it faltered in April,
world trade volume had been
echoing this improvement, with the
yearly growth in trade volume
having reached its best level since
2011. The April decline was large, but
it remains too early to draw a strong
conclusion as to whether this was part
of the normal month-to-month volatility
in this series, or the beginning of a
more meaningful moderation in trade
activity. The second half of 2017 may
tell that tale.

Source: Ned Davis Research

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Investment Strategy Outlook

Another arrow in the quiver arguing for

better growth trends going forward has
been the relative stability in copper after
breaking a multi-year downtrend last
year. While copper has not made much
overall headway in 2017, it has not
broken down either. In fact momentum
still argues for a resumption of strength
following this period of consolidation.
Copper prices tend to reflect
industrial activity and the stability
seen in the first half of 2017 suggests
that the underlying economic trend
remains positive.

Source: StockCharts

While the Fed is not yet a headwind,

and economic trends remain
supportive, this is not a low-risk
environment for stocks. Valuations
have expanded in recent years as
price recovery has moved ahead of
stock market fundamentals.
Valuations are a poor timing
indicator but over time do a good
job of measuring risk. While just one
valuation measure is shown (the
median price/earnings ratio for the
S&P 500), the overwhelmingly
consistent message across valuation
measures is that stocks are expensive
relative to a variety of corporate and
economic fundamentals.

Source: Ned Davis Research

Robert W. Baird & Co. Page 8 of 16

Investment Strategy Outlook

The good news from a fundamental

perspective is corporate sales and
earnings growth has rebounded. The
first quarter saw the best sales and
earnings growth since 2011. Even with
expectations relatively high, the
percentage of companies with
positive earnings surprises in the
first quarter approached 80%, the
best showing since 2010. The
question for the rest of 2017 is whether
this represented a one (or perhaps two)
quarter bounce in earnings driven by
remarkably easy year-ago comparisons.
Continued strong earnings growth in the
second half of the year, when
comparison become less favorable,
could support the view that we may be
able to relieve some of the valuation
pressure through better earnings
(reduce the P/E ratio by increasing the E
rather than just decreasing the P).

Source: Ned Davis Research

We have gotten used to the trend in

recent years of high initial estimates for
growth and earnings that come down
over time. From an earnings
perspective, 2017 seems to be
generally following that well-trod path.
While expectations for this year have
not been reined in to the same degree
as was seen in 2015 and 2016, they
have drifted lower. Breaking this
pattern, and seeing expectations hold
steady or even rise over the course of
the second half would speak to
underlying economic strength and an
improving fundamental backdrop.

Source: Ned Davis Research

Robert W. Baird & Co. Page 9 of 16

Investment Strategy Outlook

Investor sentiment can be measured in

real time in two ways: listening to what
investors say, and tracking what they do
and how they are positioned. Listening
to what investors say, sentiment
suggests complacency and some
underlying bullishness. The exuberant
optimism that typically signals higher
risk environments for stocks,
however, is not apparent in the
sentiment surveys. Bullishness among
advisory services and individual
investors has waned over the course of
the first half, although the 55% bulls
among advisory services is still a
historically elevated reading. The NAAIM
exposure index shows that active
managers continue to hold elevated
exposure to equities. This index can
remain elevated for extended periods of
time.

In terms of tracking what investors are

doing and how they are positioned, we
can look at fund flows and aggregate
exposure. Equity funds have seen
inflows over the course of the first half
2017, which is a marked difference
between this year and last year (when
equity funds saw persistent outflows
until after the presidential election).
From a positioning perspective,
investors have historically elevated,
although not extreme, levels of equity
exposure. History suggests a strong
inverse relationship between equity
exposure and forward equity
returns. While not a short-term timing
mechanism, it does suggest that
equities overall are a crowded trade.
The historically under-owned asset
class is cash.

Source: Ned Davis Research

Robert W. Baird & Co. Page 10 of 16

Investment Strategy Outlook

Seasonal patterns offer a mixed

message for the second half of 2017.
When looking at the cycle composite for
the S&P 500 (which aggregates the 1-
year, 4-year, and 10-year cycles), the
path of least resistance could push
higher into the summer months but then
get more challenging heading into year-
end. While this describes what has
happened in the past, this time (as is
every time) is necessarily different. No
two experiences are the same, so we
would not want to rely on this roadmap
without confirmation from the breadth
and trend indicators.

Source: Ned Davis Research

Not only do we not see confirmation

from the current breadth and trend
indicators, but the seasonal patterns
are not in full agreement for the second
half of the year. As we mentioned
before, the lack of significant weakness
in the first half of 2017 argues for
above-average strength in the second
half. From a global perspective, the
four-year trend remains a tailwind
for stocks until the second quarter
of 2018 (when domestic attention
will likely turn to mid-term
elections). For now we are keeping
seasonals rated neutral, but fully
expect the second half of 2017 to
feature more volatility than was seen in
the first half (it could hardly experience
less, it would seem).

Source: Ned Davis Research

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Investment Strategy Outlook

While narrow rally participation became

a popular opinion, the narrative that only
a handful of stocks were supporting the
first-half rally was never really based in
reality. Breadth has stayed generally
strong over the course of the first half of
2017. While the percentage of industry
groups in up-trends waned, it never
broke down to a troubling level. More
recently, while the mega-cap
Technology names that dominate the
narrative of narrow leadership have
stalled, breadth has been improving
and the percentage of industry
groups in up-trends has expanded. It
should be noted that one area where we
have yet to see additional breadth
confirmation is a new high list that has
yet to meaningfully expand.

Broad participation is not just a

domestic theme. Most markets around
the globe have been in rally mode in
2017. This is the mark of a strong bull
market. Currently better than 85% of
the markets that make up the All
Country World Index (ACWI) are above
their 200-day averages. The bottom
line here is that strength in the S&P
500 has been and continues to be
supported by broad support within
the index and around the world.

Source: Ned Davis Research

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Investment Strategy Outlook

Normalization is not just a monetary

policy phenomenon in 2017. Following
an extended period in which asset
allocation through diversification has not
provided expected benefits, 2017 has
started to see a return to a more normal
trade-off between risk and return and
the benefits to a globally diversified
portfolio. For U.S. investors the past
few years have been a case where
staying at home in terms of
investments provided the best
risk/return trade-off and diversifying
overseas reduced returns and
increase portfolio volatility. The
emergence of more normal asset
allocation environment in 2017 is a
healthy development that is expected to
continue.

Source: Ned Davis Research

We have also seen a continued decline

in correlations between S&P 500
stocks and the index itself. The
correlation peaked in the wake of the
financial crisis as stocks were in a risk-
on/risk-off mode. Correlations briefly
rose again in 2015 as the S&P 500
went through a cyclical bear market. In
2017 the correlation between stocks
and the index has dropped below its
long-term average for the first time
since prior to the 2008-2009 bear
market. The takeaway from this is that
more so than in recent years, investors
are able to consider a market of stocks
(and sectors) rather than just a stock
market. This means relative
opportunities within the market may be
more pronounced in recent years. At a
time when the focus is increasingly
on passive investing, it may be
beneficial to consider some actively
tactical tilts toward leading sectors.
Source: Ned Davis Research

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Investment Strategy Outlook

Sector leadership trends are captured

by our relative strength rankings. Not
only does this help identify leading
sectors to tilt toward, but it also helps
identify relative laggards that should be
avoided (or underweighted). At mid-
year, leadership rests with
Information Technology, Health Care,
Industrials, and Financials. Within this
group, Information Technology looks the
most extended and may be set to see a
decline in ranking over the course of the
second half. Industrials have been solid
for some time, while Financials and
Health Care have begun to strengthen
more recently. The most pronounced
weakness is coming from Energy and
Telecom Services.
Source: Baird. Ranking of 1 indicates best relative strength; ranking of 10 indicates worst relative
strength.

Consistent with, and contributing to,

weakness in the Energy sector has
been the collapse in the price of oil,
particularly when considered on a
dollar-adjusted basis. Importantly,
weakness in oil does not appear to be
a signal to expect broader weakness.
In fact, crude oil falling is bullish for
stocks overall. So while the second
half of 2017 may see an increase in
the muted volatility experienced in the
first half, the decline in the price of oil
is not likely to be the culprit.

Source: Ned Davis Research

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Investment Strategy Outlook

BAIRD STRATEGIC ASSET ALLOCATION MODEL PORTFOLIOS

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

Mix: Stocks /
Model Portfolio Risk Tolerance Strategic Asset Allocation Model Summary
(Bonds + Cash)
Emphasis on providing aggressive growth of capital with high
All Growth 100 / 0 Well above average fluctuations in the annual returns and overall market value of the
portfolio.
Emphasis on providing growth of capital with moderately high
Capital Growth 80 / 20 Above average fluctuations in the annual returns and overall market value of the
portfolio.
Emphasis on providing moderate growth of capital and some
Growth with
60 / 40 Average current income with moderate fluctuations in annual returns and
Income
overall market value of the portfolio.
Emphasis on providing high current income and some growth of
Income with
40 / 60 Below average capital with moderate fluctuations in the annual returns and
Growth
overall market value of the portfolio.
Emphasis on providing high current income with relatively small
Conservative
20 / 80 Well below average fluctuations in the annual returns and overall market value of the
Income
portfolio.
Emphasis on preserving capital while generating current income
Capital
0 / 100 Well below average with relatively small fluctuations in the annual returns and
Preservation
overall market value of the portfolio.
Bairds Investment Policy Committee offers a view of potential tactical allocations among equity, fixed income and cash, based upon a
consideration of U.S. Federal Reserve policy, underlying U.S. economic fundamentals, investor sentiment, valuations, seasonal trends,
and broad market trends. As conditions change, the Investment Policy Committee adjusts the weightings. The table below shows both
the normal range and current recommended allocation to stocks, bonds and cash. Please consult a Baird Financial Advisor in
determining if an adjustment to your strategic asset allocation is appropriate in your situation.

Asset Class / Growth with Income with Conservative Capital

All Growth Capital Growth
Model Portfolio Income Growth Income Preservation
Equities:
Suggested allocation 95% 75% 55% 35% 15% 0%
Normal range 90 100% 70 - 90% 50 - 70% 30 - 50% 10 - 30% 0%
Fixed Income:
Suggested allocation 0% 15% 35% 45% 50% 60%
Normal range 0 - 0% 10 - 30% 30 - 50% 40 - 60% 45 - 65% 55 85%
Cash:
Suggested allocation 5% 10% 10% 20% 35% 40%
Normal range 0 - 10% 0 - 20% 0 - 20% 10 - 30% 25 - 45% 15 - 45%

ROBERT W. BAIRDS INVESTMENT POLICY COMMITTEE

Bruce A. Bittles B. Craig Elder Jay E. Schwister, CFA
Managing Director Director Managing Director
Chief Investment Strategist PWM Fixed Income Analyst Baird Advisors, Sr. PM

Kathy Blake Carey, CFA Jon A. Langenfeld, CFA Timothy M. Steffen, CPA, CFP
Director Managing Director Director
Associate Director of Asset Mgr Research Head of Global Equities Director of Financial Planning
Patrick J. Cronin, CFA, CAIA Warren D. Pierson, CFA Laura K. Thurow, CFA
Director Managing Director Managing Director
Institutional Consulting Baird Advisors, Sr. PM Director of PWM Research, Prod & Svcs
William A. Delwiche, CMT, CFA
Managing Director
Investment Strategist

Robert W. Baird & Co. Page 15 of 16

 Investment Strategy Outlook

Appendix Important Disclosures and Analyst Certification

This is not a complete analysis of every material fact regarding any company, industry or security. The opinions expressed
here reflect our judgment at this date and are subject to change. The information has been obtained from sources we
consider to be reliable, but we cannot guarantee the accuracy.

ADDITIONAL INFORMATION ON COMPANIES MENTIONED HEREIN IS AVAILABLE UPON REQUEST

The Dow Jones Industrial Average, S&P 500, S&P 400 and Russell 2000 are unmanaged common stock indices used to
measure and report performance of various sectors of the stock market; direct investment in indices is not available.
Baird is exempt from the requirement to hold an Australian financial services license. Baird is regulated by the United States
Securities and Exchange Commission, FINRA, and various other self-regulatory organizations and those laws and
regulations may differ from Australian laws. This report has been prepared in accordance with the laws and regulations
governing United States broker-dealers and not Australian laws.

Copyright 2017 Robert W. Baird & Co. Incorporated

Other Disclosures

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For the purposes of the FCA requirements, this investment research report is classified as investment research and is
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Baird Limited or any other entity within the Baird Group, in particular Robert W. Baird & Co. Incorporated, and (ii) may differ
from the views of another individual of Robert W. Baird Limited.
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RWBL is exempt from the requirement to hold an Australian financial services license. RWBL is regulated by the FCA under
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