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Baird Market -2013 Economic _ Stock Market Outlook


America Endures: The Bridge to the Next Secular Bull Market

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									   Baird Market & Investment Strategy

   2013 Economic & Stock Market Outlook
   December 12, 2012

    Please refer to Appendix – Important Disclosures.

                 America Endures: The Bridge to the Next Secular Bull Market

                                               Outlook Summary
    Weight of the Evidence Mildly Bullish for Stocks Entering 2013; Intermediate Path Forward Dependent on Broad
                                                   Market Participation

             U.S. Economy in Slow Growth Mode; Europe in Recession; Emerging Markets Outlook Improving

    2013 Offers Potential for Pivot From Marking Time to Making Progress; Resolution of Major Fiscal Uncertainties
                    Could Provide Bridge to Next Secular Bull Market for U.S. Economy & Stocks

                                        Risk on S&P 500 To 1100; Reward to 1500

    •   Lack of Real Fiscal Progress Clouds Outlook
    •   Central Banks Activity Provides Cover On Fiscal Front
    •   Immigration Reform Could Provide Opportunity For Economy
    •   Business Spending Growth Cools Amid Uncertainty
    •   Labor Market Improvement Still Tepid; Wage Growth Lackluster
    •   Earnings Lose Momentum; Expectations Are Elevated
    •   Risks Remain Elevated With Fear Notably Absent
    •   Breadth Gains Needed For Rally To Persist

In mid-2013, the United States will mark the 150th anniversary of the Civil War Battle of Gettysburg. That battle,
fought over the course of three days in July 1863, was significant at the time because it represented the largest
number of casualties in a single battle in that war, but also, in retrospect, because it marked a turning point in
the war. It was not climactic and dark days were not past, but the Union victory in the Pennsylvania countryside
helped ensure that America would endure. President Abraham Lincoln captured this sentiment in his famous
Gettysburg Address delivered months after the battle but before the war had fully run its course. That battle, that
address, and the various monuments and memorials on either side of the National Mall in Washington, DC and
around the country attest to the fact that America endures.

And so we find ourselves entering a New Year compelled to recite the mantra: America endures? America
endures. America Endures! What does this mean for the economy and the stock market for 2013?

  Bruce Bittles                                    William Delwiche, CMT, CFA
  Chief Investment Strategist                      Investment Strategist                   
  941-906-2830                                     414-298-7802
         2013 Economic & Stock Market Outlook

    Consider the headwinds:                                      budget and tax reform. It has raised the long-
                                                                 term cost of this inaction as the monetary policy
        While not met on an actual battlefield (U.S.
                                                                 has become complicit with (rather than
         involvement in military operations around the
                                                                 independent of) fiscal policy – the Fed is doing
         world is at its lowest level in well over a
                                                                 the one thing it should not do (fuel potential
         decade), we face challenges nonetheless that
                                                                 asset price bubbles) and not doing the one thing
         could challenge the American economic ethos of
                                                                 it should do (being a staunch defender of the
         innovation and entrepreneurship. We can use
                                                                 dollar against the cravings for easy money).
         France as a case study of where we do not want
         to end up.
                                                                The debt overhangs persist and addressing the
                                                                 unfunded liability from entitlements gets harder
        We are emerging from a bitterly contested
                                                                 to address with each passing year. The
         election that was at once the most expensive
                                                                 demographics are such that we cannot grow our
         (nearly $6 billion is believed to have been spent
                                                                 way out of that problem and delaying does not
         on the Presidential and Congressional elections
                                                                 make the problem go away.
         of 2012) and perhaps most negative in history,
         but yet did not move the needle in terms of the
                                                                 We remember: America endures. While the
         balance of power. All the major actors (in the
                                                                 specific form is new, facing down adversity is
         White House and the U.S. Capitol Building) have
                                                                 not. We need to remember that even when it
         been returned to power with each side claiming
                                                                 appears that little progress is being made, and
         equal or increased support for its positions.
                                                                 the issues of the day border on absurd. The
                                                                 American economic experience has been
        A lack of leadership on fiscal policy issues has
                                                                 that adversity leads to opportunity and
         spurred repeated rounds of extraordinary action
                                                                 tomorrow always has a chance of being
         by monetary policymakers. This has reduced the
                                                                 better as long as we remain dynamic and
         short-term cost of inaction on the part of the
                                                                 flexible. If we are going to realize that better
         President and Congress in dealing with needed
                                                                 tomorrow, and cross the bridge to the next

    Robert W. Baird & Co.                                                                                       Page 2 of 20
     2013 Economic & Stock Market Outlook

 Source: Ned Davis Research

    secular bull market, for the economy as well as       this time with a focus on generals rather than
    stocks, we need policy certainty. This does not       battles. The Union cause was initially led by
    mean that policy will never change, but that it is    General George B. McClellan, a meticulous
    not constantly in flux. This would allow for          planner with an eye for detail and appearances
    economic adaptability even if the policy itself is    but who failed to take decisive action in the field
    viewed as sub-par.                                    and wasted precious time and resources by
                                                          endlessly delaying engagement. This ultimately
    With or without tough decisions being made, the
                                                          prolonged the war and added to its cost. On the
    road ahead for the economy is likely to be
                                                          other hand, Ulysses S. Grant, the general
    uneven. The key, from our perspective, is to
                                                          credited with guiding the Union to victory, and
    be marching away from the pivot point, not
                                                          Robert E. Lee, the gentleman general from
    still slipping towards it, even though we will
                                                          Virginia who was consistently outnumbered but
    not know for some time what that point was or
                                                          repeatedly thwarted superior forces, both
    will be. Getting the right policy for today and the
                                                          pressed their advantages and moved forward
    right policy for tomorrow will help unleash the
                                                          with creativity and daring. Not all their actions
    next secular bull market for the economy and for
                                                          proved to be correct in hindsight, but progress
    stocks. Policymakers need to focus their
                                                          was still being made. The current leadership
    attention on appropriate systems, not
                                                          coming from elected officials and entrenched
    prescribed outcomes, and then take
                                                          interests in Washington DC seem to be more in
    decisive action. Too many, in our view, fall into
                                                          the vein of McClellan, rather than Grant (or Lee).
    camp with Jean-Claude Juncker, Prime Minister
                                                          The American economy has been marking
    of Luxembourg and President of the Euro Group,
                                                          time for several years. Now is the time for
    who said “We all know what needs to be done,
                                                          making progress. If the policymakers cannot
    we just don’t know how to be re-elected after
                                                          lead, then at least they should get out of the
    we’ve done it.”

    Before moving forward with our outlook for
    2013, we return for a moment to the Civil War –

Robert W. Baird & Co.                                                                                     Page 3 of 20
        2013 Economic & Stock Market Outlook

Our outlook for 2013:                                               the downside as policy uncertainty is not likely to
       Absent real structural change in                            be significantly relieved in the U.S. and recession
        taxes/budgeting/entitlements the secular story is           in Europe is spreading towards the core (e.g.,
        unchanged and meaningful growth is unlikely to              Germany).
        emerge. Fiscal policy is likely to be a headwind           Stocks could consolidate 2012’s gains – broad
        for the economy for at least the first half of the          market strength and investor skepticism early in
        year as lower levels of government spending and             the year could help stocks push to marginally
        higher taxes take their toll. Regardless of how             higher highs, but the seasonal pattern we are
        the fiscal cliff negotiations play out, it is hard to       watching suggests lower-risk entry points could
        conceive of an outcome that does not include                emerge later in the year.
        both less spending and higher taxes in 2013 than
        in 2012.                                                                     *******

       Tailwinds include an improving trade balance,               We will spend some time considering the
        housing market stability, and still-high levels of          fundamental side of the weight of the evidence
        worker productivity.                                        (Monetary Policy, Economic Fundamentals,
       Headwinds include a less favorable regulatory               Valuations), but provide only a cursory look at
        environment, lack of household income growth,               the technical factors (Sentiment,
        and continued policy uncertainty from                       Seasonals/Trends, Breadth), as they change with
        Washington DC.                                              more frequency and are more fully considered in
       While stabilizing conditions in emerging markets            the course of our regular weekly and monthly
        could fuel higher commodity costs, overall                  correspondence. Finally, we discuss some
        inflation in the United States is unlikely to               expected investment implications of this outlook.
        meaningfully accelerate. Long-term interest rates
        are likely to remain low for now.                           Monetary Policy: The Federal Reserve remains
                                                                    explicitly committed to boosting asset prices as a
       Global growth will be restrained by U.S. and
                                                                    means of supporting economic growth. In the
        Euro-area policy uncertainty and a lack of
                                                                    short-to-intermediate-term, monetary
        developed market demand. Risks are skewed to

     Source: Ned Davis Research

    Robert W. Baird & Co.                                                                                           Page 4 of 20
     2013 Economic & Stock Market Outlook

 Source: Ned Davis Research

    policy remains a bullish influence on stocks.           extraordinary actions by the Fed) and each
    We are now in the third round of quantitative           successive round of quantitative easing has had
    easing (large-scale asset purchases in                  less of an impact than its predecessor. While
    Fedspeak), with a fourth round looking                  Ben Bernanke and company may feel the
    increasingly likely in 2013 (replacing the current      need to continue to take action because of
    Operation Twist which will be exhausted by year-        the lack of progress on the fiscal front, the
    end). From a longer-term perspective, however,          irony is that progress on the fiscal front is
    actions on the part of the Federal Reserve have         less likely with the Fed keeping interest
    been enabling for fiscal policy makers, reducing        rates near zero and providing a protective
    the near-term need for solutions to the secular         put for the stock market.
    issues that weigh on the economy. Central banks
    historically have existed to defend currencies          In our view, there are three primary longer-term
    against the cravings for easy money on the part         risks to the Fed’s current policy path:
    of elected officials. Current monetary policy        1. Rather than mitigating risk by providing
    endorses those cravings by subsidizing                  support (as is the case during a financial
    them.                                                   panic), current Fed policies add to risk by
                                                            distorting investment decisions. Federal
    Actions by the European Central Bank (ECB)              Reserve activism makes it difficult to gauge the
    show that there is a role for extraordinary             underlying health of the economy, and distorts
    monetary policy measures, but these should be           relative valuations between assets. This is most
    limited to periods of illiquidity and financial         specifically seen as investors search for yield in
    panics. As sovereign debt spreads spiked in             an environment where real Treasury yields are
    Europe in 2012, the ECB was able to pledge              negative. In this environment, the search for
    support for the Euro (and by extension, euro-           yield inevitably leads to risk. Moreover, while
    denominated debt) and this helped ease the              the Fed may feel confident that it can unwind its
    panic and led to contraction in spreads. The            balance sheet smoothly over time, individual
    United States has moved beyond financial panic          investors may not be in position to do the same.
    and illiquidity (thanks in large part to the            Unless Treasuries are held to maturity, their
Robert W. Baird & Co.                                                                                       Page 5 of 20
         2013 Economic & Stock Market Outlook

         being “risk-free” is a myth. A 10-year Treasury        wage growth (particularly at the lower end of the
         Note purchased in 2012 could see a significant         pay spectrum) at a time when stock market
         decline in principal value five years from now         investors have generally benefitted from the
         even if interest rates rise only modestly.             Fed’s focus on inflating financial assets. Extreme
2.       It increases the potential for a new bubble            levels of income inequality can have negative
         to form in financial markets. The Federal              social consequences (i.e., class warfare) and
         Reserve has a recent history of promoting              restrain economic growth. It is ironic that the
         (and/or not preventing) bubbles, with                  same policymakers that have overseen the
         Technology stocks and the housing market being         acceleration in inequality are also the most
         two obvious examples. If the economy is being          vocally upset by it.
         held back by secular fiscal issues (which we
         believe is the case), the Fed’s targeting of           Interest Rates: The Federal Reserve has
         financial assets could produce inflated asset          extended its low interest rate horizon from mid-
         prices without contributing to underlying inflation    2013 at this point last year to mid-2015 in its
         trends or economic growth. The ultimate effect         latest FOMC statement. Despite annual new
         could be the forming of a new asset bubble.            supply of around $1 trillion in treasury bonds,
         There is no evidence of this being the case            long-term yields remain low. Continued slack in
         presently, but the Fed could certainly be headed       the economy and continued purchases by the
         down that path.                                        Federal Reserve are likely to help keep Treasury
                                                                yields low in 2013, with the yield on the
3.       It adds to the wealth/income inequality in
                                                                benchmark 10-year Treasury likely to range
         the U.S. The Gini Index, a measure of income
                                                                between 1.40% and 2.40%. The risk for yields
         inequality, was steady from 2000 to 2008, but
                                                                appears to be to the downside, particularly if
         has climbed higher over the past four years and
                                                                economic headwinds contribute to slowing
         is at a new all-time high (indicating an increasing
                                                                growth in the first half of 2013.
         level of inequality). This reflects policy decisions
         over the past several years that have restrained

     Robert W. Baird & Co.                                                                                     Page 6 of 20
     2013 Economic & Stock Market Outlook

   In Focus: Why Not France?

   We have talked for some time about the risk to the American economy of becoming more like those seen on
   the European continent. Europe, though, is a diverse area, and not all the country-level economies operate in
   the same way. Despite a massive increase in debt in recent years, our economy is not on the verge of
   becoming the next Greece, and such comparisons do little but enflame passions.

   In our view, the most interesting comparison for the United States is France. At one point, in the not-too-
   distant past, France was the most vibrant country on the continent, and its capital, Paris, was a destination
   (for established businesses and entrepreneurs) without compare. For 200 years in the 19th and 20th
   centuries, Paris was the cultural capital of Europe.

   Fast forward to the present day and we see wealth, profits and high levels of income are demonized by
   elected officials and heavily taxed at confiscatory rates. According to The Economist, no entirely new
   company has entered the CAC-40 stock market index (the French equivalent of the Dow Industrials) since
   1987. Half of the current 30 stocks in Dow Industrials have been added to the index since 1987.

   The French economy does boast of some strengths (for example, its upper-echelon schools are among the
   elite in the world) but these are more legacies of the past than building blocks for the future. Excessive and
   burdensome regulation (the 35-hour work week is a popular example) makes businesses reluctant to hire
   new workers. Unemployment for the country overall is near 10%, with youth unemployment at 25%, and even
   higher among ethnic minorities.

   Overall, the economic culture is one of preservation, not innovation. Public debt in France is in excess of the
   90% threshold that has been cited in the academic literature as being a pivotal indicator of future growth. To
   add to the parallel with the United States, France has recently lost its AAA credit rating.

   For the United States, the lesson should be clear – retaining global economic leadership means encouraging
   and rewarding entrepreneurs and innovators and assimilating immigrants and minorities into the economy
   and cultural life. In other words, let’s not become France.

                                                                  windless, overcast days. The lack of progress
    Economic Fundamentals: The economic                           on these fronts has left the economic
    fundamentals can be considered from two                       recovery lacking internal momentum and
    vantage points – the secular and the cyclical. We             vulnerable to external shocks. Meaningful
    will consider them in turn.                                   progress on even half of these issues could be
                                                                  the bridge to the next secular bull market for the
    From a secular perspective, not much has                      economy and the stock market.
    changed over the past year, and that is a true
    disappointment. We continue to contend with                   We’ll add another secular economic issue to the
    unresolved fiscal policy headwinds that                       mix this year: immigration. A dynamic
    stem from a culture of spending and                           economy needs a supply of highly educated and
    consumption rather than savings and                           highly motivated workers. The labor market data
    investment. These are familiar topics for many                show that while we have excessive levels of un-
    – comprehensive tax reform rather than the                    trained (or poorly trained) workers, firms are
    current ad hoc approach, addressing unfunded                  having trouble filling slots in highly specialized
    entitlement liability, moving away from monetary              fields. We are not going to venture into the
    policy that provides cover rather than                        realm of policy specifics, but believe that the
    accountability for fiscal policy makers, and                  ability to attract and retain the best
    mobilizing the nation’s resources to take                     workers in the world will be critical to
    advantage of cheap and abundant domestic                      maintaining a dynamic and innovative
    energy (natural gas) that is available even on                economy in the years ahead. This requires
Robert W. Baird & Co.                                                                                                Page 7 of 20
    2013 Economic & Stock Market Outlook

    reforming how we bring new workers into the          forecasters. At this point last year, the Fed’s
    country and how we treat those who are already       consensus expectation of growth for 2012 was in
    here. The work being done on this issue by the       the range of 2.5% to 2.9%. The Survey of
    George W. Bush Institute and the Dallas Federal      Professional Forecasters published by the
    Reserve is encouraging.                              Philadelphia Fed saw GDP growth of 2.6% over
                                                         the course of 2012. Growth for the year appears
    One secular growth driver that has begun to          to be coming in closer to 2.0%, the pace of
    emerge is an improved trade balance. It has          growth seen in 2011. Any Q4 weakness related
    been more than 30 years since net exports were       the storm that hit the East Coast and/or concern
    a positive number. Over the past six years,          over the fiscal cliff could push growth for the
    however, real imports have been essentially flat     year lower. This would mean a sequential
    while real exports have risen by a cumulative        slowing in yearly GDP growth for the second year
    30%. This has cut the real trade balance nearly      in a row.
    in half. In large part, this improvement has been
    due to a decline in petroleum imports. If the        Expectations for 2013 show that many
    trend towards energy self-sufficiency continues,     forecasters think (again) this will be the year
    and we add the leverage of low domestic energy       that the cyclical recovery accelerates and we see
    costs (from natural gas) and productive              growth in line with historical trends. Many point
    advantages we have in high-tech manufacturing,       to improvement in the housing sector to support
    we could turn our trade deficit into a trade         this view. Housing market conditions have
    surplus. This would be a step towards an             improved, supported by record-low mortgage
    economy premised more on investment and              rates and somewhat easier loan standards, but
    production and less on consumption.                  the declining trends in homeownership and still-
                                                         subdued levels of household formation could
    Lack of progress on secular imbalances is            limit overall demand for housing. In other words,
    restraining the cyclical recovery, a fact that has   housing market activity has stabilized but
    been consistently overlooked by many                 continued strength there would require

Robert W. Baird & Co.                                                                                  Page 8 of 20
     2013 Economic & Stock Market Outlook

    improvements in the secular overhangs.                 pace. This is supported by a variety of leading
    Moreover, even if housing market activity              indicators, including the stock market. But if a
    continues to recover, it simply is not a large         recession does emerge (and remember, during
    enough part of the pie to drive overall economic       secular bear markets, the economic/market/
    growth. Even when the housing market was               macro surprises all tend to be on the downside),
    booming in the middle years of the last decade,        it may not be anticipated by spikes in the various
    residential investment at most contributed 50          financial stress indexes that were belatedly
    bps of growth to GDP.                                  identified as useful during the last downturn.

    The U.S. economy enters 2013 with                      The disruptions caused by Hurricane/SuperStorm
    business investment and spending cooling,              Sandy are distorting the incoming data, but
    inventories accumulating and a labor                   trends in business activity have nonetheless
    market that is adding jobs at a sub-par rate           cooled in recent months. This trend can be seen
    and without meaningful wage growth. While              across a host of data series and surveys. By way
    many market participants and economic                  of example, the 12-month change in new orders
    observers are on the look-out for another              and shipments in the core durable goods data
    financial panic-induced recession, the                 (non-defense capital goods excluding aircraft)
    improvement in corporate balance sheets and            has slowed dramatically over the course of 2012
    actions by the Fed in recent years make that an        and is approaching levels typically not seen
    unlikely scenario. More likely, in our view, is that   outside of recessions. Growth in real equipment
    the lack of aggregate demand in the economy            and software investments has slowed in each of
    (both at a consumer and business level) and            the last four quarters, posting an outright decline
    policy uncertainty (in the form of taxes and           in the third quarter of 2012 (data for the fourth
    regulation) lead to a cyclical retrenchment on par     quarter was not available as of this writing).
    with the recessions in 1990-91 or 2001, rather
    than the most recent recession. To be clear, our       On the other hand, inventories are beginning to
    base case is that the economy continues to             accumulate as production has outpaced demand.
    muddle through, expanding at a 1.5% to 2.0%            Inventory accumulation accounted for nearly

Robert W. Baird & Co.                                                                                      Page 9 of 20
    2013 Economic & Stock Market Outlook

    30% of real economic growth in the third quarter     market strength, as it combines the level of
    of 2012, and over past year (September 2011 to       payrolls and the average work week), however,
    September 2012) inventories grew at one-and-         was at 3.0% in February but slipped to 1.7% as
    one-half times the rate of sales. While it is        of November. Modest employment growth
    possible that storm dislocations and uncertainty     persists, but there is little evidence that it is
    surrounding fiscal policy (the “fiscal cliff”)       accelerating. Wage growth continues to
    heading into the end of 2012 have led to a           moderate, with average hourly earnings rising
    temporary stalling in demand, it is difficult to     only 1.7% over the past year, at the trough rate
    envision a marked expansion in demand after          that has emerged over the past 30 years. Real
    the first of the year. Higher tax rates and a less   wages continue to move lower.
    favorable regulatory environment will likely
    restrain corporate activity and business             For much of the year consumers delayed cutting
    spending.                                            back on spending and so the savings rate has
                                                         moved lower. Now, however, spending is cooling.
    The household sector is enjoying the                 Real spending has declined in three of the last
    confidence boost associated with seeing              five months. The three-month and six-month
    home prices recover some of their previous           trends in spending growth are just above zero
    losses, but the reality is that overall debt         and the yearly change in spending, at 1.3%, is
    levels remain high, employment                       its lowest in nearly three years.
    opportunities are uneven, and wages and
    incomes are hardly growing. The                      Inflation trends at this point are muted as the
    unemployment rate drifted lower over the course      weight of the unresolved debt overhang
    of 2012, dropping from 8.5% in December 2011         continues to serve as an anchor. While
    to 7.7% by November 2012. Underemployment            commodity prices will continue to fluctuate,
    remains above 14%. Payrolls have risen 1.4%          productivity enhancements across the economy
    over the past year, a rate that has held steady      reduce their impact domestically. Moreover,
    for much of 2012. The 12-month change in the         sustained price increases are unlikely to stick
    hours worked index (a broader measure of labor       without wage growth accelerating and that is not

Robert W. Baird & Co.                                                                                  Page 10 of 20
     2013 Economic & Stock Market Outlook

    being seen. In the short-to-intermediate term,      version that looks at both U.S. and European
    we continue to view deflation as a more likely      data. Recent history shows that stocks fare
    outcome (and more significant threat to the         better when economic surprises are expanding
    economy) than a spike in inflation.                 on the upside. This was the case for much of the
                                                        second half of 2012, but the trend is
    An acceleration in the cyclical recovery requires   deteriorating as we move towards year-end.
    moving beyond the fiscal cliff and resolving the    From the point of view of the stock market, a
    secular headwinds that have restrained this         retrenchment in economic expectations would be
    recovery since its genesis. A composite view of a   a welcome development.
    host of leading and coincident indexes suggests
    that the economy has lost significant upside        Valuations: We enter 2013 with a somewhat
    momentum and the growth trend is slowing.           diminished view of the usefulness of valuations
                                                        in the current environment. First of all, our
    One indicator to pay attention to over the course   preferred measures of the relationship
    of 2013 may be the National Activity Index          between prices and earnings are near or
    put out by the Chicago Fed. This indicator is a     just above their long-term averages. We are
    composite that indicates whether the economy is     not seeing the extreme readings of
    growing at, above, or below trend. The risk of      overvaluation or undervaluation that have
    recession rises when growth gets too far below      tended to mark significant turning points in
    trend. As we begin 2013, this indicator is on the   the stock market. We have not witnessed the
    cusp of signaling negative growth (not just         single-digit P/E’s for the market that would
    below-trend growth).                                suggest that a secular low has been reached.

    One other indicator to watch may be the             Earnings have rebounded, but growth has slowed
    economic surprise indexes. These, calculated by     significantly in recent quarters. Moreover, this
    Citigroup and published by Bloomberg, measure       recovery was driven more by productivity gains
    how incoming economic data compares to              that have led to record profit margins and
    expectations. We prefer to look at a weighted       interest cost savings than a rebound in revenue.

Robert W. Baird & Co.                                                                               Page 11 of 20
    2013 Economic & Stock Market Outlook

    There is little evidence that a sustainable trend in   spending overall represents a significant
    multiple expansion or contraction has emerged.         headwind for earnings in 2013.
    Given the lack of secular clarity on the economy
    and the cautious outlook of CEO’s, it is hard to       The best use of valuations, in our view,
    make a strong case of significant multiple             particularly at the macro-level, is as a
    expansion over the intermediate-term. On the           gauge of the longer-term sentiment and
    other hand, with the Fed offering zero percent         risk environment, and on this scale they are
    interest rates for the next several years (and         neutral to slightly elevated. Here we are
    perhaps further) it is difficult to argue that a       looking at P/E ratios that use normalized
    significant multiple contraction is likely.            earnings and price to sales ratios, both of which
                                                           are bordering on excessively high levels.
    With valuations not under significant pressure to
    expand or contract, it may make sense to focus         The technical influences on the market tend to
    on earnings in the current environment. As we          be more responsive to and reflective of
    said above, earnings growth is cooling after           developments that occur over the course of the
    companies have pulled the easy levers to boost         year. As such, our regular commentary on these
    the bottom line. The yearly growth in earnings         indicators may be more valuable than the
    for the S&P 500 is 19 points below where it was        forward-looking views expressed here.
    a year ago, indicating weak earnings momentum          Nonetheless, we will offer some views on the
    heading into 2013. While expectations for growth       technical indicators with an eye toward the
    have cooled and are no longer a headwind for           longer-term trends that are intact or may
    stocks, the bar is not yet set so low as to be         emerge.
    bullish. In fact, expectations are that earnings
    growth will begin to re-accelerate shortly and the     Sentiment: We’ll offer three comments on
    consensus for 2013 is for double-digit earnings        investor sentiment: two observations and one
    growth. Productivity proxies indicate that gains       speculation. First, we view the persistent
    there are slowing, and the recent cooling in           outflow over the past two years from equity
    industrial production growth and business              mutual funds as a demographic shift and

Source: Ned Davis Research

Robert W. Baird & Co.                                                                                   Page 12 of 20
     2013 Economic & Stock Market Outlook

 Source: Ned Davis Research

    not a reflection of bearish sentiment on             2012, and yet stocks managed to move higher. A
    stocks. The aging of the population and the          lack of fear does not provide for a lower-risk
    increased need for income/spending money is          entry point for stocks but does argue for
    leading to flows away from equities. When            pursuing investment strategies and asset
    looking at household asset allocations as            allocations that are tilted toward the
    reflected in the mutual fund/ETF/money market,       conservative side within an investor’s range of
    exposure to both equity and fixed income funds       exposure based on risk tolerance.
    is above long-term averages. Assets in money
    market funds, as a percentage of overall assets,     Third, and finally, as a matter of speculation, it
    are at historically low levels. This may be due to   appears that investor/advisory service
    these funds not offering any return in a zero        opinions as reflected in the various
    percent interest environment, but it also            sentiment surveys have become relative
    suggests that the outflows from equity funds are     sticky. There seems to be less fluid movement
    being used as current income and are being           from bullishness to bearishness, but rather the
    spent.                                               number that are permanently camped in either
                                                         bullish or bearish territory appears to have risen.
    Second, the VIX fear index is not at a level         The bears consistently overlook opportunities
    that has historically been associated with           and the bulls consistently discount concerns. If
    strong stock market returns. The Federal             sentiment has indeed become more bi-modal,
    Reserve’s pledge of support for financial assets     new approaches to gauge the relative intensity of
    has removed fear from the market and has             these camps may need to be developed. Existing
    provided a put that does not need to be              indicators of investor sentiment continue to
    purchased on an options exchange. This has           provide guidance, but may be missing useful
    prevented historically expected levels of fear       information at the margin.
    from entering the market even when stocks have
    sold off. Since 1996, all of the net gains in the
    stock market have come when the VIX has been
    above 28.5. That level was not seen at all during

Robert W. Baird & Co.                                                                                   Page 13 of 20
     2013 Economic & Stock Market Outlook

Source: Ned Davis Research

Source: Ned Davis Research

Robert W. Baird & Co.                       Page 14 of 20
     2013 Economic & Stock Market Outlook

    Seasonals/Trends: It has been our pattern to            stocks could weaken in the first half of 2013 and
    show the cycle composite chart for the year             then rally in the second half. This is consistent
    ahead at this point. That prospective path for          with the view with which we began this outlook,
    stocks, which is based on an equal weighting of         suggesting that 2013 could be an uneven year of
    the one-year seasonal cycle, four-year                  transition and, ultimately, progress. We could
    presidential cycle and the 10-year decennial            get an early indication of how the year is going
    cycle, suggests early- and late-year trading            to shape up based on the stock market’s reaction
    ranges wrapped around a second-quarter rally.           to further easing by the Fed (QE4) and/or
    That could well be what is seen next year. Given        resolution to the fiscal cliff. If these headline
    apparent weakening in the underlying growth             events are treated as opportunities to sell, the
    trend in the economy, uncertainty surrounding           post-1948 path may bear watching more closely.
    the fiscal cliff, and the historical relevance of the
    2012 presidential election, we think a different        Breadth: While seasonal strength in January
    prospective path bears considering.                     may provide clues about the direction of stocks
                                                            for 2013, any rally that does not include broad
    We’ve included a chart comparing the current            market support will need to be viewed
    example with what was seen around the 1948              skeptically. We will be watching several
    presidential election. In that election, President      indicators to gauge the strength of any moves in
    Harry Truman unexpectedly won re-election               equities. We would expect to see an
    (recall the notorious “Dewey Defeats Truman”            expansion in the number of issues making
    headline from the Chicago Tribune) over a               new highs on both the NYSE and the
    challenger that was perceived to be aloof and           NASDAQ and we should see trend
    distant, albeit more friendly to business. Truman       improvement at the industry group level.
    ran an aggressive campaign that included                The percentage of industry groups in up-trends
    attacks on do-nothing Republicans in Congress.          is finishing 2012 in a neutral mode, and any late-
    The 2012 presidential campaign may not                  2012/early-2013 strength that is likely to persist
    have been a repeat of 1948, but it certainly            should be accompanied by a rise above 65% in
    seems to rhyme with it. Under this scenario,            this indicator. If the cyclical expansion that ran

Robert W. Baird & Co.                                                                                     Page 15 of 20
    2013 Economic & Stock Market Outlook

      13 Goals For 2013

      Some of these are more likely than others – some are highly unlikely – but all are things that, in our view,
      would represent significant progress or would otherwise be welcome sights.

           1. Interest rate hike – The Federal Reserve should stop providing cover for elected lawmakers and raise
              interest rates.
           2. Immigration reform – Given our demographic issues, we may need to import labor – let’s do so in a
              reasonable fashion, encouraging full economic participation by highly motivated and highly trained
           3. End subsidies – Rather than ban soda (like New York City), a more constructive policy would be to
              end the subsidies that make sodas cheap. This could come within comprehensive tax reform.
           4. Tax code simplification – Our keys would be not raising marginal rates on individuals, reducing the
              corporate tax rates, simplifying the code by reducing subsidies and deductions that are favored by
              entrenched special interests of all stripes, and not including sunset provisions that are used as an
              accounting gimmick. A benefit to a special interest is a cost to the rest of us.
           5. Pass a Federal budget – The federal government should actually pass and sign into law a budget.
              The president continues to offer budgets that get no support, and the House passes budgets that die in
              the Senate. With President Obama entering his second four-year term, it is time that he be given the
              chance to sign a budget bill.
           6. Comprehensive, dynamic budgeting - On the subject of budgets, go to comprehensive budgeting
              that does not knowingly exclude costs that are likely to be paid (the annual Medicare doc fix is a prime
              example). The CBO should get rid of the practice of static budget scoring and scoring on a 10-year
           7. Address unfunded liabilities in entitlement programs – The entitlement programs (Medicare and
              Social Security) are in desperate need of reform, and delaying makes the decisions harder and the
              outcomes less favorable. The status quo here is not an option and should not be allowed to be thought
              of as one.
           8. Calm down the rhetoric – The proliferation of diffuse media sources means that people of opposing
              views are not getting their news from the same sources -- this makes conversations more difficult and
              generally means more talking but less communicating. Democrats should read the Wall Street Journal,
              and Republicans should read the NY Times just so that conversations can begin on the same page.
           9. Domestic energy policy – President Kennedy rallied the nation and we got a man on the moon in
              1969. Perhaps President Obama could energize the effort to take advantage of our natural gas (and
              other hydrocarbon) reserves.
           10. Get rid of ethanol mandates – At a time when food prices are moving sharply higher, we should not
               be dedicating nearly half of our corn crop to ethanol production. Alternatively, allow sugar cane-based
               ethanol imports from Brazil rather than require that ethanol be domestically derived from corn (which if
               not the law, is certainly the effect of the law).
           11. Cap government spending – Research shows it is excessive spending (mostly entitlements and
               transfers) that have led to persistent deficits since 1970. Neither part has proven responsible when it
               comes to the nation’s purse. Pick a percent of GDP as a cap, and let’s stick with it.
           12. Geo-political risks subside – Among the areas of potential: the civil war in Syria comes to an end as
               Assad is deposed or progress is made toward reining in North Korea, Iran, and Venezuela.
           13. A small-market renaissance for baseball – The Milwaukee Brewers win the MLB World Series (after
               defeating the Kansas City Royals four games to three).

Robert W. Baird & Co.                                                                                                Page 16 of 20
     2013 Economic & Stock Market Outlook

    from September 2011 to September 2012 is             With Central Banks around the world pursuing
    indeed still intact, the percentage of industry      ever-increasing amounts of quantitative easing,
    groups in up-trends may need to clearly break        the value of paper currencies is being
    out to a new high (stopping the pattern of lower     diminished. The full effect of this is not
    peaks that has been seen over the past several       reflected in the various exchange rates or the
    years). We will of course provide frequent           dollar index, but is well represented in the price
    updates throughout the year on the emerging          of gold – both in terms of dollars and against an
    breadth picture, so stay tuned.                      aggregate basket of currencies. Until we move
                                                         beyond the current monetary policies and
    Investment Implications: We do not have              actions or evidence emerges that a bubble
    evidence in hand that the secular bear market in     has formed, most investor portfolios should
    stocks has run its course. The historical pattern,   have a 5% to 10% allocation to gold as
    though, suggests it may be getting long in the       hedge against currency devaluation, not
    tooth and we are fully aware that it may not be      looming inflation.
    until after the fact that clear evidence emerges
    that we have transitioned from secular bear to       As the threat of a further financial panic recedes,
    secular bull. We have increasing confidence that     correlations across risk-assets should also
    a turn may be on the horizon, and 2013 could         decline. In recent years, declining correlations
    represent a significant step towards that shift.     (particularly among constituents in the S&P 500)
    For now, however, we argue for a relatively          has been associated with “risk-on” rallies. As we
    conservative investment allocation. For a typical    have moved through 2012, this relationship
    investor, this may mean modestly                     appears to be fading. It is also the case that the
    underweighting equities in favor of high-quality     idea of risk-on and risk-off has lost much of its
    corporate bond exposure. Investors should            usefulness. The trend in the ratio between risk-
    still focus on managing risks rather than            off and risk-on has been moving in favor of risk-
    chasing returns.                                     off even as stocks overall have rallied. The good
                                                         news for investors is that with the return of

Source: Ned Davis Research

Robert W. Baird & Co.                                                                                   Page 17 of 20
    2013 Economic & Stock Market Outlook

 Source: Ned Davis Research

    a less-correlated environment, in which             Investors looking for yield need to cast a
    degrees of risk again matter, diversification       wide net and remember that the search for
    can again play a positive role in portfolio         yield leads to risk. Many of the domestic yield
    construction.                                       plays appear crowded, and a more prudent
                                                        approach may be to build a globally
    In terms of allocations, we continue to have a      diversified (by region and asset class)
    cautious outlook for European equities, and         portfolio that generates income, but keeps
    believe that better investment opportunities        an eye on risk as well as yield. Importantly,
    can be found in Emerging Markets,                   among individual assets, there is usually a strong
    particularly in the Asia-Pacific region. We         positive correlation between yield and risk,
    continue to favor developed market exposure in      although at the portfolio level, diversification can
    dollar-issuing countries (Hong Kong, Australia,     help.
    Canada, and yes, the United States). The risk for
    emerging markets is that weakness in their          From a sector perspective, we finish 2012 with
    developed trading partners could reduce export      Industrials, Financials, Health Care and the
    demand. An investing climate less beset by fears    Consumer sectors showing leadership. Looking
    of financial panic and strong domestic balance      forward, we have a more constructive view on
    sheets are expected to help support emerging        areas that could benefit from resurgent business
    market equities even if growth headwinds weigh      spending than the areas tied to household
    on European and/or U.S. equities.                   spending. Industrials, Health Care, Materials,
                                                        and in the second half, Technology, could be
                                                        leaders in 2013. A less-favorable regulatory
                                                        environment in 2013 could weigh on Utilities and

Robert W. Baird & Co.                                                                                   Page 18 of 20
     2013 Economic & Stock Market Outlook

   Three things 2012 taught (or re-taught) us:

       1. 0% interest rates have an impact. It may not be on an economic scale (as hoped for by the
          Federal Reserve), but certainly from a financial perspective. It distorts investment decisions by
          pushing investors into stocks and other risk assets in search of yield, and it raises risks for
          those who invest in Treasuries of lengthier maturities.

       2. Monetary policy effectiveness is asymmetric. Aggressive action by Central Banks has a
          much stronger impact on forestalling liquidity crises than at promoting growth. Actions by the
          ECB in 2012 were geared toward the former and were generally successful. Actions by the
          Federal Reserve were geared more toward the latter and their impact is more dubious.

       3. Negative campaigning does win elections. Despite survey data that shows voters are
          turned off by negative ads, the 2012 election cycle showed that disparaging your
          opponent/predecessor (fairly or unfairly) can be a successful strategy.

  Three questions 2013 might answer for us:

      1. Whether or not we have turned the corner on growth – are we marking time or making
         progress? Forecasters again come into the New Year looking for an increasingly robust
         recovery. Will this be the year those hopes are realized, or will expectations again be revised
         lower over the course of the year. If this is a year of transition, we could see both downgraded
         expectations and a robust recovery in the second half.

      2. Can emerging market economies (and stock markets) decouple from developed
         markets (U.S. and Europe)? This will likely depend on the domestic demand, but an
         increasingly normalized environment and reduced correlations among risk assets suggest there
         is opportunity here.

      3. Does America endure? We finish our outlook where we began. The coming year offers a
         chance to prove that America’s innovative and entrepreneurial capacity is undiminished. While
         policy correctness would be great, even policy certainty could provide significant economic and
         investment opportunities. Even as the American economy has become more French-like,
         emerging economies have become more American. 2013 is poised to be a pivot year for the
         United States. We want to lead, not just participate, and so we’ll go out on a limb and answer
         this one right now. Yes!

Robert W. Baird & Co.                                                                                Page 19 of 20
      2013 Economic & Stock Market Outlook

Appendix – Important Disclosures


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.

Foreign and emerging market securities may be exposed to additional risks including currency fluctuation, political
instability, foreign taxes and regulations and the potential for illiquid markets. Historically, small and mid cap stocks have
carried greater risk and have been more volatile than stocks of larger, more established companies.


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 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 2012 Robert W. Baird & Co. Incorporated.

Other Disclosures

UK disclosure requirements for the purpose of distributing this research into the UK and other countries for
which 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 the
Financial Services and Markets Act 2000 (financial promotion) order 2001 being persons who are investment
professionals 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 the
Financial Services Authority. For the purposes of the Financial Services Authority requirements, this investment research
report is classified as objective.

Robert W Baird Limited ("RWBL") is exempt from the requirement to hold an Australian financial services license. RWBL
is 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.

  Robert W. Baird & Co.                                                                                              Page 20 of 20

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