Stuart T. Freeman, CFA, Chief Equity Strategist Scott L. Wren, Senior Equity Strategist Equity Strategy Weekly analysis and outlook for the equity market November 11, 2014 Outperformance of Early Phase Group Suggests More Upside for Equities From time to time, we monitor the relative performance of those sectors that tend to be early outperformers in a cycle, versus late. We divide key S&P 500 Index sectors into four groups: Early Cycle outperformers (Phase 1), Early-Mid (Phase 2), Late-Mid (Phase 3) and Late Cycle (Phase 4) outperformers. Phase 1 stocks tend to outperform very early in an economic cycle, but sometimes during mid-cycle when U.S. growth is relatively strong, the dollar is rising and inflation expectations are soft. In this cycle, we experienced a period of such mid-cycle Phase 1 outperformance in 12-month periods that ended 2012 and 2013. At that time, investors were concerned about slow international growth and worried over the potential for a double-dip domestic recession. Today, weak growth concerns are focused primarily upon the international economies. During the last three months, the year-to-year performance of the Phase 1 group has been stronger than that of the other three phase groups. In today’s case, all four phase groups are higher than a year ago. However, softening performance from some Consumer Discretionary subgroups in the Phase 2 segment, and weakening support from the Energy and Materials sectors (impacting the Phase 3 and late cycle Phase 4 groups) has resulted in better relative performance for the Phase 1 basket. Consumer Staples, Financials, and Health Care stocks tend to drive performance there. However, we continue to see favorable forwardlooking signs for the domestic economy. The shift in internal market performance appears largely due to international weakness, the strong dollar, weaker oil and basic materials prices, and softer inflation expectations. We believe 2015 GDP growth will be stronger than experienced in 2014. In the accompanying graph, we have plotted the tendency of a market cycle to move from early cycle to late cycle Phase Group outperformance back to mid-1989 (in blue). This cycle and the prior two are noted by the arrows, and recessionary periods are encircled and also depicted by the red lines. Note that recessions are most frequently preceded by outperformance of the Phase 4 basket of stocks, not Phase 1 stocks. We looked back to the late 1980s for the history of forward 12-month performance of the S&P 500 Index when the last twelve months have been dominated by early cycle stocks. This cycle and the prior two are noted by the arrows, early Phase 1 periods are encircled, and recessions are depicted by the red lines. The performance range was between -16.8% and 48.8%. The S&P 500 Index increased in value (over the next twelve months) in 90% of the cases with an average increase of 20.4%. The broad index decreased in value only 10% of the time (and the average decline was 10.9%). Overall, these statistics would be aligned with our expectation for continuing domestic growth. Please see page 5 of this report for Disclaimers Page 1 of 5 Equity Strategy As one can see in the graph, the mid-1990s represented a mid-cycle period during which internal market performance was dominated by Phase 1 stocks. Like today, we were not moving through a recessionary period in the mid-1990s. However, we were moving through a strong-dollar period during which energy and materials prices softened. During the mid-1990s, large capitalization domestic stocks outperformed Eurozone stocks, and the S&P 500 Index outperformed the price performance of many commodities, including gold. Overall, the softer oil and commodity prices are likely to add some boost to corporate margins for many segments of the economy. Recently, lower oil November 11, 2014 and gas prices have acted as “tax cuts”, putting more money in the pockets of U.S. consumers. Consumer discretionary income should increase as a result of this cost reduction; consumer confidence and spending should also benefit from the continuation of moderate job growth. We continue to recommend investors lean toward the more cyclically sensitive Industrials, Information Technology, and Consumer Discretionary sectors of the S&P 500 Index. We carry a 2015 operating earnings estimate of $128, and continue to use a 2150-2250 S&P 500 Index target range for year-end 2015. Page 2 of 5 Equity Strategy November 11, 2014 Weekly wrap and look ahead All three major indices recorded modest gains in last week’s trading. Index S&P 500 DJIA NASDAQ Last week’s performance* +0.7% +0.04% +1.1% *for the week of November 3 – Novermber 7 2014 YTD performance +9.9% +6.0% +10.9% Looking at S&P sector performance, four of ten outperformed while eight of ten managed to finish higher on the week. Best Performing Sectors Consumer Staples Industrials Utilities Last week’s performance* +2.1% +1.6% +1.6% *for the week of November 3 – Novermber 7 Worst Performing Sectors Health Care Consumer Discretionary Telecom Services Last week, in terms of economic data, investors were largely focused on the employment report covering October. While the Federal Reserve recently stated that job gains have been “solid”, we would categorize the last handful of labor reports as good but not great. The October data fit that description in our opinion. The net number of non-farm payroll jobs added last month came in at 214,000, just slightly below the expected 235,000 gain. We consider any reading near 200,000 as good. Over the last 9 months or so these gains have been steady and the labor market is making the slow progress we have been expecting. We look for that to continue in 2015 as the unemployment rate falls from the current 5.8% level down to 5.4% by the end of next year. Wage gains, or lack thereof, were a focal point for us in this report. Wages have been stagnant for years relative to inflation. Average hourly earnings, an indicator closely watched by the Fed, is up only 2% over the last 12 months. The Fed would like to see wage increases in the 3% to 4% range. Remember, consumer inflation is at 2% or less so the buying power of the average consumer has not been going up. This is something the Fed mentions frequently and one of the main reasons why we do not see interest rates going up any time soon. Last week’s performance* -0.5% -0.2% +0.2% The Fed is also watching the labor force participation rate. It improved to 62.8% from 62.7% in September. The September reading reflected the lowest percentage of working age people that are actually in the work force since the late 1970s. There are still millions of workers with part-time jobs that want full time positions. In addition, a large percentage of the unemployed have been out of work for six months or longer (about 35%). All of these factors should improve over time, but not quickly. The Institute for Supply Management (ISM) also released their surveys covering the manufacturing and services segments of the economy. Both came in above 55. Recall that any reading above 50 for these indicators reflects expansion. The manufacturing survey came in at 59, well above the 56.1 expected. The services survey fell slightly short of expectations coming in at 57.1 versus the expected 58. However, these are good readings and mesh well with our outlook for economic growth of 2.8%. We would consider any readings above 60 for these indicators as robust. Recessions normally do not occur until the manufacturing survey consistently falls to the low 40s. As is typical in the week following the release of the labor market data, there are a limited number of reports on the schedule. A modest number of Page 3 of 5 Equity Strategy November 11, 2014 earnings reports will cross the tape, but the overall numbers are not likely to change much from the summary we provided in our Equity Strategy report last week. Investors will see measures of both business and consumer confidence/sentiment. The National Federation of Independent Business (NFIB) will release its Small Business Optimism Survey early in the week. Business sentiment has been on the increase and now stands at a level normally associated with a modestly growing economy. Businesses have been slow to make capital expenditures in this recovery and have only hired when absolutely necessary. We see business confidence rising higher over the next 12 months. Consumer sentiment/confidence has been improving as well. The last reading on consumer confidence from the Conference Board was quite a Sector S&P Weighting * bit higher than we expected but we look for some retrenchment later this month when they update the report. In any case, with gasoline prices falling, the stock market hitting new highs and the labor market improving, one would expect consumer confidence to be moving higher. As with business sentiment, we look for further improvement in consumer confidence in the coming year. Retail sales for October will also be reported this week. Expectations call for a 0.2% rise in the headline number. Looking at “core” retail sales which strip out the effects of autos, gasoline and building supplies, the consensus is calling for a 0.4% gain. Core retails sales are a better reflection of pure consumer discretionary spending. As the labor market improves and more people are working, we see retail sales moving ahead at a modest rate. Wage stagnation will continue to be a headwind for retail sales and overall consumer spending. Wells Fargo Advisors Guidance Consumer Discretionary 11.6% Overweight 12.5% Consumer Staples 9.8% Underweight 8.2% Energy 9.1% Evenweight 9.9% Financials 16.5% Evenweight 16.3% Health Care 14.1% Evenweight 13.8% Industrials 10.5% Overweight 12.0% Information Technology 19.5% Overweight 21.4% Materials 3.3% Evenweight 3.5% Telecommunications Services 2.4% Evenweight 2.4% Utilities 3.2% Underweight 0.0% S&P 500 Earnings Estimate for 2014: $120.00 S&P 500 Year-End 2014 target range: 2,050-2,100 S&P 500 Earnings Estimate for 2015: $128.00 S&P 500 Year-End 2015 target range: 2,150-2,250 Source: Wells Fargo Advisors Sector Weightings May Not Add To 100% Due To Rounding Weightings as of 11/07/14 close Page 4 of 5 Equity Strategy November 11, 2014 Disclaimers There is no assurance that any of the target prices or other forward-looking statements mentioned will be attained. Any market prices are only indications of market values and are subject to change. Technology and internet-related stocks, especially of smaller, less-seasoned companies, tend to be more volatile than the overall market. An index is unmanaged and unavailable for direct investment. The Advisory Services Group (“ASG”) of Wells Fargo Advisors works with information received from various resources including, but not limited to, research from affiliated and unaffiliated research correspondents as well as other sources. ASG Strategists provide investment advice based on their own observations and analysis (both fundamental and quantitative) for the clients of Wells Fargo Advisors and its affiliates. The Advisory Services Group does not assign ratings to or project target prices for any of the securities mentioned in this report. Wells Fargo Advisors is a trade name of certain broker/dealer affiliates of Wells Fargo & Company; other broker/dealer affiliates of Wells Fargo & Company may have differing opinions than those expressed in this report. Contact your financial advisor if you would like copies of additional reports. Effective November 1, 2014, certain research functions which impact WFA’s advisory Programs were delegated to our affiliate, Wells Fargo Investment Institute, formerly known as Alternative Strategies Group, Inc. (SEC File #801-64191). These functions include due diligence on Program-eligible money managers and mutual funds. After the delegation to Wells Fargo Investment Institute, Wells Fargo Advisors, however, retains authority to select the managers that will be made available to clients from the approved list of managers provided by Wells Fargo Investment Institute. Additional functions such as creating capital markets assumptions and creating asset allocation research will transition to Wells Fargo Investment Institute in early 2015. Prior to transitioning, these functions were performed by Wells Fargo Advisors, LLC. Additional information available upon request. Past performance is not a guide to future performance. The material contained herein has been prepared from sources and data we believe to be reliable but we make no guarantee as to its accuracy or completeness. This material is published solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or investment product. Opinions and estimates are as of a certain date and subject to change without notice. Investment and Insurance Products: NOT FDIC Insured NO Bank Guarantee MAY Lose Value Wells Fargo Advisors is the trade name under which W Fargo & Company provides brokerage services through two registered broker-dealers: Wells Fargo Advisors, LLC, Member SIPC, and Wells Fargo Advisors Financial Network, LLC, Member SIPC. Each broker-dealer is a separate non-bank affiliate of Wells Fargo & Company. ©2014 Wells Fargo Advisors, LLC. All rights reserved. CAR # 1114-01846 Page 5 of 5