1. Through the Looking-Glass,Heading Toward a Better Tomorrow2012 Economic and Stock Market OutlookBruce Bittles William Delwiche, CMT, CFAChief Investment Strategist Investment Strategistbbittles@rwbaird.comwdelwiche@rwbaird.com941-906-2830414-298-7802

2. A message from Bairds CEO, Paul PurcellExtreme market volatility turned 2011 into a wild ride for many investors. And, with the Presidentialelection on tap for 2012, we may not begin to see clarity around many of the domestic unknownsfueling that volatility until November. Then, of course, theres the eurozone to consider.This is not to say investors might be better off spending the year on the sidelines. As weve seen,market volatility swings both ways, and an informed strategy built on sound principles and with theflexibility to capitalize on opportunities as they arise will be critical to successful wealth management.The insights on the following pages are designed to help you understand Bairds perspective onthe market environment, and where we see both opportunities and challenges ahead. These ideascome from our leading minds on the economy and investing and they are consistent with thedisciplined, risk-managed approach weve taken to keep Baird strong and stable for clients like youthrough unquestionably trying times.If you have any questions about the implications for your specific situation and portfolio, please donot hesitate to contact your Baird Financial Advisor.We thank you for the trust and confidence you have placed in us. Please know that we strive to earnthem every day.Paul E. PurcellBaird Chairman, President & Chief Executive Officer 2 3. Through the Looking-Glass, HeadingToward a Better TomorrowIn the Lewis Carroll classic, Alice, fresh off her adventures in Wonderland, finds herselfone snowy evening wondering about life on the other side of the mirror that hangsover the fireplace. She climbs atop the mantelpiece and discovers that she can step 2012 Outlook Summarythrough into a looking-glass world. Once there, Alice encounters a reality that isRisk on S&P 500 to 1000,anything but normal. Left is right, forward is backward and a new set of rules applies. Reward to 1400.We too find ourselves pulled into a new environment, one that if not so real wouldseem to be a farce. Consider these situations, that we have seen in 2011: Election and European DebtUncertainties Are DominantRisks in First-Half. Headwinds A country gets its sovereign debt downgraded, but yet yields on that debtCould Abate Later In The Year. fall sharply.GDP Outlook Lack of Income The parliament in the second-poorest (based on per capita output) country in theGains Could Cap U.S. Growth At EU (Slovakia) casts the final and decisive vote for a European stability fund that at2%. Europe In Recession. the time seemed crucial to the ongoing viability of the EU and the euro. After first rejecting the measure, the Slovakian parliament in the end approved it.Secular Base-Building MeansVolatility Unlikely To Ebb; The United States, which has funded operations of late more by continuingManage Portfolios For Risk As resolutions than a comprehensive budgeting process, and has had to borrow 38Well As Return. cents on every dollar spent over the past three years (in the process accumulating $4 trillion in new debt), is now lecturing the EU and its member countries on the need for fiscal reform and getting debt and deficits under control.10-Year T-Note Yield and Trend S&P Downgrades U.S. Debt Rating 3 4. This is our looking-glass world ofmust be addressed. Marginal rateson protecting the value of the dollar.today. It is not normal in a new senseneed not be flat, but they should be Raising short-term interest ratesor old but is real. It is not permanent as low as possible. High marginal rateswould reward domestic savers andbut it persists, and we must operate make the U.S. dollar more attractive,within it. Just as Alice had to learn howrather than just a haven in periods ofto negotiate her way across the chessstress. Federal Reserve policy in recentboard and toward her destination, soIt is not as thoughyears has gone from counter-cyclicallytoo must we navigate the financialthe U.S. economy has providing the punch bowl in badmarkets. Even as we look forward andnothing going for it.times and removing it in good times,move toward a better tomorrow, we There have been areasto seemingly augmenting the boom/of improvement in theconfront our current reality.bust cycle. Later, we will look moreeconomy in 2011 thatAs we consider that better tomorrow, closely at what the Federal Reservecould bode wellwe see changes just over the horizon and other central banks are doing, andfor 2012.that could reflect a secular shift what we expect them to do. In termsfor the economy and the financialof what they should do, protecting themarkets. Right now, the need for value of the dollar and having a lesschange is being recognized primarilyare a disincentive to production. More active role in the economy are desired.at the grass-roots level, so figuring effective, and fairer, simplification Government spending/entitlementout the exact scope and timing of would come from reform in the reformthat change will take more time, as calculation of taxable income andtax credits. It is here that favors to In the wake of the inability by thewill convincing the powers that bespecial interests create complications,Congressional super committeeof the need for change. The majordistortions and a deep sense ofto make even token budget cutsgrass-roots efforts that have emergedunfairness. A similar story is seen in and with seemingly little impetusacross the country over the pastthe corporate tax code rates in thetoward extending the payroll taxcouple of years (principally, the TeaU.S. are among the highest in thecuts that expire at the end of thisParty movement and, more recently,world, and the code is full of loopholes year and next, the federal budgetOccupy Wall Street) are, in our view,for favored industries. We are pastdeficit is, on paper, poised to improvedifferent manifestations of a similarthe point where solutions are founddramatically. This outlook is based,sentiment. Underlying both is thein slogans or temporary measures.though, on the budgeting assumptionsense that the current political/Comprehensive reform is needed, andthat tax increases and budget cutseconomic/corporate structure needsthe proposals by the Simpson-Bowleswill have no impact on economicmassive reform, beginning with aor Domenici-Rivlin commissions are activity. This is almost certainly not thedisentangling of special interests andgood starting points. We also need case. Rather than back-dooring ourentrenched politicians.to move beyond the point where the way to an improved fiscal situationAspects of this change include:on paper, we need comprehensiveremoval of special breaks counts as aTax reformtax increase.reform of government spending and entitlements. A Federal Reserve officialThere is little doubt that the U.S. tax Monetary policyrecently pegged the unfunded liabilitycode needs reform. It is hopelesslyDysfunctional fiscal policy has put thefrom Medicare alone at $70 trillion complex, doles out favors to specialonus of action on the Federal Reserve. vastly higher than the current totalinterests, and has a distortionaryIf Fed Chairman Ben Bernanke is to government debt outstanding. This iseffect on production and investment.be taken at his word, there is a stronga structural deficit issue that a cyclicalCurrent complications in the taxdesire on the part of the Fed to cedeeconomic recovery is not going to solve.code make simple ideas appealing,the mantle of economic/financialIn some ways, the lack of a superbut reform must not be premised onmarket savior. One way to do this iscommittee deal may actually be asimple alone. Issues of fairness alsoto focus more of the Feds energieslong-term positive. It has been our4 5. 12-Month Total Federal Receipts and Outlaysview that the worst-case outcomeand the mandates associated withabove can help build a base for thewould be a perceived solution thatit are a legacy of Iowas historicaleconomy from which a robust, self-actually did nothing, or that the role as an early participant in the sustaining recovery can emerge. Thatsequestration rule (the mandatedpresidential candidate nomination is the better tomorrow that we see. Webudget cuts starting in 2013) would process. Modern corn-farming, will get there, but patience along thejust be reversed. At this point neither ironically enough, is petroleum-way is required. Admittedly, the electionof these outcomes has been realized,intensive, and corn is ill-suited to theof 2012 may delay near-term progress,so there is still an awareness of the production of ethanol. When it is all but it may also help crystallize, in theneed for actual reform. Hindering said and done, corn-based ethanol electorate and politicians, long-termthe process has been the breakdownmay actually consume more energygoals. With the Democrats looking backin the level of trust in Washington,than it produces. Ethanol is much at 2008 as their mandate for changeD.C., and because of this, no one more effectively derived from sugar and the Republicans seeing 2010 asappears willing to take the first step. cane, but Brazilian-produced sugartheir call to action, the 2012 electionsThe solution must be comprehensivecane-based ethanol faces tariffs, and set up as a tie-breaker of sorts. Well talkand likely lies somewhere toward thein some cases, corn-based ethanol ismore about the expected effect of themiddle (between the loosely outlinedlegislatively required. While alternative election on the financial markets whenproposals on either side). Importantly, forms of energy may eventually be we consider the seasonal patterns in thean honest solution needs to tackleviable, they are not now, particularlyweight of the evidence section below.sacred cows for both parties. at the scale needed. Natural gas, For now, particularly as we considerhowever, is a proven fuel source, and isthe financial markets, we remainEnergy policyreadily available in the United States. on the other side of the mirror.The United States lacks a cohesiveAn energy policy focused on the Like Alice, we are trying to makeenergy policy, relying on andomestic production and distributionsense of our own Tweedledum andamalgamation of reactive regulations, of natural gas would help secure aTweedledee. At this point, gettingunsupported mandates, political cheap and reliable source of energy our hands on a vorpal sword withfavors/subsidies, and ideals that for the country.which to slay the Jabberwocky wouldare unmet in reality. Take ethanolChanges along the lines discussed be particularly useful. We are facedfor example: corn-based ethanol 5 6. NYSE Daily Breadth Ratioswith the question of whether, in theto the market. They are now relativelynearly 30% in that time period. Hascurrent environment, the usefulness common, and little is gained from the rally seen since the early Octoberof long-used indicators has changed.their observation.low been a bear market rally or hasAs long as macro uncertainties remain Our basic premise remains this: the it represented a new cyclical bullelevated and liquidity continuessecular bear market that has been market? For now the jury is still out,to ebb and flow in an exaggerated in place for over a decade is intact. but absent conclusive broad marketmanner, volatility in the market is likelyCyclical trends emerge and fade.evidence that points to a change into remain elevated. In part, we riskThe cyclical bull market that emerged the primary trend, we assume thatover-reading changes in the indicatorsoff of the March 2009 lows ended in the previous trend is intact. For 2012,(i.e., they still work, but not necessarily 2011. The pertinent question now is our working assumption is that thein the way we have expected), and inwhether the cyclical bear market that cyclical bear may re-emerge in the firstpart, certain indicators are less useful. was in place in the middle part ofhalf, with market conditions growingTrading days on which up volume 2011 has run its course. From its April more favorable in the second halfoutpaced down volume by more than peak at 1364 to its October troughof the year. These ongoing cyclical10 to 1 (and vice-versa) used to be at 1099, the S&P 500 fell more than swings accompanied by unrelentingrarities, and offered important signals 19%. The small-cap Russell 2000 fellvolatility represent a period of secularS&P 500 Indexx10 6Source: MetaStock 7. base building. As we make progress Indicator Reviewon the secular issues outlined above,the probability of a meaningful secular Fundamental Factorslow emerging increases. Federal Reserve PolicyBullish+1While we have expectations of what Underlying Economic FundamentalsBearish -1might happen, we need to balance ValuationsNeutral0this with our observable reality. Werely on our weight-of-the-evidence Technical Factorsapproach to do so. Heading into Trends/Seasonal TendenciesBullish+12012, the weight of the evidence is Investor SentimentBullish+1mildly bullish. Federal Reserve policy, Tape/BreadthBearish -1sentiment, and seasonal trendssupport higher stock prices, while Weight of the EvidenceMildly Bullish +1poor economic fundamentals andbroad market divergences couldweigh on stocks. Valuations are neutral2011 has seen a coordinated effort byincreasingly dependent on Fed-from a cyclical perspective. Puttingthe Federal Reserve and other global supplied liquidity. The Fed continuesthis into context for our 2012 outlook,central banks to ease the liquidityto discuss exit strategies, the firststocks could work higher into January,strains that have emerged in Europe. of which would be to allow naturalbut the path forward from there willThis effort, while ensuring sufficient contraction of its balance sheet asrely on the evolution of the sentimentdollar-funding as the European banks its fixed income holdings come toand breadth data. A surge in optimismcome under pressure, is a short- maturity. For now, however, this is acould reduce the opportunity for rally,term liquidity mechanism that is theoretical discussion, and the nextwhile improvements in the broaddesigned to prevent a seizing up ofstep is likely to be more interventionmarket could help fuel further gainsthe financial markets. Indicators of rather than less.and signal confirmation of a cyclicalfinancial stress improved followingbull market.this joint intervention. The reaction inFederal Reserve policy is bullish the commodity markets to this news The Feds strategysuggests that this may be the first of appears to be an effortWhile we have already reviewed ourseveral coordinated efforts that, we to buy the economy asperspective on what the Fed shouldexpect, will culminate in a third roundmuch time as possiblebe doing, we need to consider whatof quantitative easing domesticallyto right itself and beginit is doing and what we expectand more active intervention byto move back towardit will do. The acronym-intensivethe ECB. Even before the Novembertrend growth.intervention in the markets that theannouncement on swap rates, theFederal Reserve pursued in 2008/2009Federal Reserve was floating trialhas been replaced by more directballoons for QE3, with the most overtWhile the Fed has its hands on theintervention, the buying of Treasurysbeing the dissenting vote at the money supply levers, its crystal ball isand mortgage securities.The secondNovember FOMC meeting calling forfar from omniscient. The Fed (and mostround of quantitative easing (QE2)more easing by the Fed.economic forecasters) has consistentlywas wrapped up by mid-2011, butwas soon followed by a programThe Feds strategy appears to be overestimated the strength of the U.S.to lengthen the maturity of the an effort to buy the economy aseconomy in recent quarters. The FedsFeds Treasury holdings (Operationmuch time as possible to right itselfJanuary 2011 estimates for growthTWIST), with the Fed also declaring its and begin to move back towardwere for better than 3.5% growthexpectation that short-term interesttrend growth. The problem is thatin 2011 and nearly 4% growth inrates will remain low into 2013. Late-the economy and the markets are2012. By November, those estimates7 8. Federal Reserve Bank Credithad been revised down to 1.7%commodity and/or stock bubble to market (to say nothing of the lackgrowth for 2011and 2.7% growth inbuild rather than the emergence of of fiscal clarity/leadership out of2012 (expectations for 2013 growth sustainable growth. Ultimately, theWashington, D.C.).were revised down from 4.2% to world economies will have to stand The ongoing source of consternation3.2%). The Feds expectation for the on their own, unsupported by central is elevated debt and deficit levels.unemployment rate in 2012 rose frombanks. Getting to that point willWhile we are hopeful that increaseda January 2011 estimate of 7.8% to a require time, but getting there will beawareness will bring about realNovember estimate of 8.6%. The point important. For now, though, we see change (the first step to solving ahere is not to bash the Feds ability to little evidence that the Federal Reserve problem is admitting that you haveforecast economic variables. Precise will be able to back away from its one), the path forward is not easy.forecasting tends to be a futile exercise, active role. Further easing is likely, and Academic studies have shown thatand one in which we do not engage. this is bullish (at least near-term) for historically there are four mainRather, the Fed has consistently stocks and gold. avenues for governments to reduceoverestimated its ability to back awayhigh debt/GDP ratios: robust nominal Economic fundamentalsfrom active intervention in the marketgrowth, higher taxes, default, and/or remain poorand support of the economy. inflation. The key, in our view, is robust Growth in Europe has stalled, andWe do not believe that anothernominal growth, and from a policy a continent-wide recession may beround of bond-buying by the Fed (or perspective that should be the focus emerging. Emerging economiesECB) represents a long-term path to in both the United States and Europe. remain vulnerable to the cumulativeprosperity, but it may be necessary Absent an expanding economy, higher effects of interest rate hikes and(particularly in Europe) to prevent taxes and/or budget cuts (the austerity weakness in their end markets. Thefurther destabilizing. It is much measures that are being pursued United States economy is beset bymore likely that flooding the systemaggressively throughout Europe and weak aggregate demand, persistentwith dollars and euros will allow a more hesitantly in the United States) unemployment and a weak housing 8 9. Total Credit Market DebtAs a percentage of GDPare unlikely to achieve success. Theyoutside of Germany, and probablyin Europe remains in doubt. Whatare contractionary in nature, and it even when Germany is included). is clear, though, is that the time hasis much more difficult to reduce the This has brought to the surface come to address the actual issues, notoverall debt to GDP ratio when the design flaws within the structure just hold summits and release vaguedenominator (GDP) is declining. Better of the EU. While monetary policy is communiqus. More work needs towould be an effort to limit the growth coordinated, fiscal policy remainsbe done on determining a path toin the numerator (particularly over thediscrete. With both strong and weak solvency, which likely means a morelonger term) while stimulating growthalike using the same currency, thereconcerted effort to recapitalize thein the denominator (particularly inis cajoling and resurgent nationalism.banking system and shore up liquidity.the near term). Importantly, growth in Investors in the U.S. have learnedAbsent confidence that there is anGDP must outpace growth in debt if more about the local politics ofultimate backstop not to preventthe overall ratio is to decline. This is a Slovakia, Greece, and Italy (to namelosses from occurring but to ensureprocess, not an event, and takes timea few) than many would have cared orderly operations rumors and fearsto evolve. The policy improvements to. While no system of government will lead to ongoing turmoil, whichthat we described at the outset wouldis perfect, the strains in Europe havecan be seen in the recent spikes inbe important steps in the process of exposed one of the weaknesses of asovereign debt yields across Europe.supporting nominal growth in the parliamentary government. The lackData in the United States show aeconomy and limiting the growth of of an independent executive makes moderate firming in activity in thedebt. For now, the growth outlookpolitically unpopular decisions harderfourth quarter of 2011. Much ink hasremains uneven, with risks skewed to to sustain. While the first half of 2011been spilled discussing whether thethe downside.was marked by the Arab Spring thatUnited States is just lagging EuropesWhile the European Commissionssaw the collapse of governments decline into recession, or whetherforecast for growth in the euro area on the southern shore of thethere has actually been a decoupling.is for +0.5% in 2012 (down fromMediterranean Sea, the latter half of the As a history professor once remindeda previous estimate of 1.8%), theyear saw the collapse of governmentsus (in the context of the Frenchdata being seen at the end of 2011 on the northern shore (there must berevolution), events throughout historyincreasingly suggest that the area issomething in the water).happen in real-time as decisions areslipping into recession (almost certainlyAs we move into 2012, the outcome made, and the course that we can look9 10. European Sovereign Debt YieldsSource: FactSetback on now was not preordained financial market disruptions could well for 2012. Liquidity is returningor necessarily inevitable. Likewise,weigh on the United States, as could and credit market conditions havethe outcome for the United States the expiration of the payroll tax cut at improved considerably. Further,economy in 2012 is largely contingent the end of 2011 and continued lack ofthe housing market may finally beon events that have not yet occurred, fiscal policy leadership.hitting bottom. Inventories of newalthough its weakened state leavesIt is not as though the U.S. economy and existing homes for sale remainit vulnerable to shocks. Spilloverhas nothing going for it. There have elevated, and this could continueeffects from Europe not so much been areas of improvement in the to weigh on construction activity.poor economic growth, but rathereconomy in 2011 that could bodeHowever, the ratio of the medianMedian Existing Home Price vs. Median Income 10 11. home sale price to median income the extra hours of each day gained2011. While households would like tohas dropped to a historically lowby not working (i.e., time that would pay down debts, they are not willinglevel, and the Obama administrationbe spent at work if employed), only to do so at the expense of eating orhas unveiled new efforts to support1% goes towards looking for a job,purchasing necessities (a vague termthe housing market through the while 30% goes toward extra sleep which changes with every generation).reworking of current mortgages.and watching T.V. This goes beyondThis has put downward pressurePrograms of this nature have beenjust inter-generational resentments.on the savings rate and delayedannounced in the past, but haveUnemployed workers, of all ages, face improvements in the householdproduced little in terms of results. skill degradation, which acceleratesbalance sheet. Renewed efforts atWhile hopeful that this latest program over time and hampers the underlyinghousehold austerity will re-emerge aswill find broader implementation dynamism of our economy (not only the income picture improves.(as is its design), we are cautiousare current skills lost, but new ones aregiven the lack of follow through seennot learned on the job). Rather thanon this front. The Federal Reserves having the government acting as aefforts to keep mortgage rates low venture capitalist and investing in From a seasonalare also supportive. Concerted unproven (and perhaps ultimatelyperspective, the popularprogress in easing the debt burdensuntenable) technologies, an aggressive averages could well be dominated by next yearsof homeowners would be good news investment in job-training and presidential election.for the economy and probably moreeducation may be more worthwhile.stimulative than short-term tax cuts.Just as debt is an issue at the nationalThe household sector in the United level, so too is it a problem at theStates faces a looming structuralhousehold level. While more work hasBusiness activity re-accelerated inissue nearly one in five workers been achieved by households thanlate 2011, spurred by a relieving ofunder the age of 25 is unemployed. the government in terms of reducing mid-year supply constraints and asThis becomes a generational issuedebt loads, this process has fallen preybusinesses moved ahead of the year-as the older workers begin to view to the unevenness of the economic end expiration of related tax credits.the younger generation as lazy, andrecovery and overall disappointing jobMuch has been made of the strengththe younger generation becomes growth. Poor job growth has translatedof corporate balance sheets and thediscouraged. Recent research from theinto a stalling in income growth. Realamount of cash they have on hand.NBER (National Bureau of Economicdisposable personal income fell inWhile this in part reflects a newfoundResearch) supports these views. Of both the second and third quarters of conservatism in corporate finance,Unemployment RateMonthly and 12-Month Average11 12. Real Disposable Personal Incomeit may also reflect a lack of global Further, capital spending is a function weigh on growth in 2012 as federalgrowth opportunities. Moreover, theof corporate sentiment. Companies and local governments cut back onimprovement in the corporate balance that are optimistic about the futurespending. This can best be seen insheet may not be as significant as will tend to invest. CEO confidence has the employment data. Gone are themany believe. Corporations are awash declined sharply in recent quarters,days in which government payrollsin cash, but non-financial corporate and this may weigh on businessconsistently expanded and when adebt levels remain high. Short-termspending in 2012. government job lasted a lifetime. Overdebt has declined relative to cash,Even aside from policy actions (orthe past twelve months (Decemberbut also relative to longer-term debt. inactions), government will likely2010 November 2011), private sectorEquipment and Software Expenditures vs. CEO Confidence12 13. payroll gains averaged 150,000 per1.8% in November 2010 to 5.1% inbuying Treasurys and debt continuingmonth, while government at all levels May 2011 (near the culmination of to act as an anchor, there is unlikely totrimmed payrolls by 25,000 jobs per QE2), before falling back to 2.1% be much sustainable upward pressuremonth. While having more resourcesin October 2011 (the most recentin yields. Beyond the Fed, though, pastdevoted to the private sector isdata available). This can also be buyers of U.S. government debt seemultimately a good thing for the seen in inflation expectations. The less inclined to add to their positions.economy, the transition exacerbates University of Michigans five-yearThe Feds efforts to spur growth bythe over-supply in the labor market inflation expectation figure has hardly keeping interest rates low have beenand could weigh on growth in 2012.budged over the past couple years,devastating to savers, who must nowInflation The ending of the debtremaining well-anchored even as move into riskier assets to find yield.super-cycle and trends in globalization the Fed has dramatically expandedValuations are neutralare both strongly deflationary (toits balance sheet. Given the view bysome at the Federal Reserve (includingOverall economic growth remainsclarify, the inter-connectedness of theChairman Bernanke) that for the uneven, but corporate earnings haveglobal economy is deflationary forconduct of monetary policy, economicremained strong, generally meetingdeveloped countries; it is inflationaryexpectations matter more than recentor exceeding elevated expectations.for emerging economies). Moreover,observations, it is possible that the Over the long run, earnings growthweakness in aggregate demandFed would tolerate (if not welcome) is going to match overall economicand excess supply in the domestichigher inflation in the short term if growth, although in the short termlabor market are also helpingexpectations do not rise. This woulddivergences can emerge and persist forcontain inflation. One area in whichhelp support nominal growth. Whilea time. This strength in the E of the P/Ewe have largely agreed with theanother round of quantitative easingratio has allowed our most preferredFederal Reserve is that the threatin 2012 would likely lead to a greatervaluations to remain near or slightlyof deflation has been greater thanswing in recorded inflation, we do notbelow their long-term medians. Whilewidely appreciated, and that theview it as a sustainable threat to thenot arguing that a secular low hasaforementioned counterweightseconomy at this point.been made, valuations do not currentlykeep near-term upswings in inflationpresent a headwind to stocks. In afrom being persistent. That was Bond yields Short-term interest ratescontinuing positive, expectations forseen in 2011. The six-month changeremain near zero, while the 10-yearfuture earnings growth are moderating.(annualized) in the CPI rose from T-Note yield is near 2.0%. With the FedMichigan 5-year Inflation Expectations13 14. S&P 500 Index vs. Median Expected Earnings GrowthStocks tend to fare best when not ability to surprise on the upside. top line. With profit margins now atsaddled with high expectationsThe divergence between overall record levels, it seems unlikely thatfor earnings growth. This is not agrowth and corporate earnings canthis engine of growth will remain asreflection on analysts abilities tobe explained by expanding profit robust as in recent years. This wouldforecast earnings growth, but rather amargins. That is, earnings growthincrease the need to expand therecognition that elevated expectationsat the bottom line has not beenrevenue line to fuel earnings growth.leave little margin for error and lessdriven by gains in revenue at theWe believe that it is in the corporateS&P Industrial Average & Profit Margin14 15. sector that the seeming disconnectputting it to work. We will be watching confidence about whether we arebetween higher commodity prices for an expansion in the net issuance of experiencing a typical rally within aand moderate inflation gets resolved. corporate equities, as this could cause cyclical bear market (those tend to beLackluster final demand and weakexcessive supply, which would be asharp moves that fail in key resistanceincome growth could make it difficult headwind for stocks. Not only would levels), or are indeed in the earlyto pass higher costs on to consumers, it reveal renewed (perhaps excessive) stages of a cyclical bull market thatleaving corporations to absorb theoptimism in the corporate sector, but could enjoy further upside. A breakhigher commodity costs that havewould put more pressure on earnings by most indexes below their 50-daybeen seen and could continue to beand valuations. averages would suggest the former;seen as central banks ease monetary Right now, our preferred valuationa decisive break above their 200-daypolicy. Therefore, not only doesmeasure, which looks at trailingaverages would point to the latter.continued expansion in profit margins earnings, shows that stocks are nearOur long-term regression-based trendseem unlikely, but they could actuallyfair value. Longer-term measures that indicators are also mixed at present.contract somewhat moving forward. look at normalized earnings offer a From a seasonal perspective, theCorporations have been buying backmore cautious outlook.popular averages could generally betheir stock in recent quarters, pushing dominated by next years presidentialthe net issuance of corporate equitiesSeasonals/trendselection. The cycle composite that wein to negative territory. Even withoutSeasonals/trends are bullish into like to review as a potential roadmapany improvement in its aggregateyear-end 2011, before becoming more suggests stocks could fare well intofinancial situation, reducing the mixed in 2012. The trend indicators January, face growing headwindsnumber of shares of a company willare mixed. While the popular averages as we move from primary electionsimprove per share metrics, includingare generally trading above their toward the general election, andearnings per share and price. This50-day averages, which are generallythen rally as the uncertainty overtrend reflects general cautiousness now rising, they are below theirthe outcome of the election fades.on the part of companies choosing 200-day averages, which are falling.Historically, the market has faredto return cash to investors rather than By mid-January, we may have morebetter in election years when theS&P 500 Index vs. NDR Cycle Composite15 16. incumbent is re-elected (+12%similar juncture), and incumbents campaign against a do-nothingon average) versus when he ishave been defeated when the Republican party that does notunseated by a challenger (-3%). This unemployment rate has been well deserve the presidency, as well as thetendency, though, is likely not abelow current levels. While muchpersonal failings of the actual nominee.market preference for incumbents,can change between now and theThis provides a disincentive to theas much as a reflection on the election, if voters are going to reward President and Democrats in Congresseconomic circumstance that led to an an improving economy, those gains to getting anything accomplished (i.e.,incumbents re-election/defeat.would likely need to be seen in the the do-nothing label cannot stick ifPresidential elections in which therenear future after the first quarter things are indeed being done). Thisis an incumbent and a challenger of 2012 it may be too late to changescenario means that we could be incan generally be boiled down to twoeconomic perceptions. for an especially negative presidentialbasic questions: 1. Do voters approveThe strategy for the Republican campaign that could exacerbate theof the incumbents handling of the challenger, whoever it ends up being, normal seasonal tendencies.economy? and 2. Can voters see the will likely be to hammer on President Investor sentimentchallenger as presidential? If the Obamas handling of the economy. Investor sentiment, as we moveanswer to the first is yes, the second Not only could this depress sentiment into 2012, is mildly bullish. Investordoes not matter and the incumbent(recall the mid-2011 malaise that optimism tends to swell as we moveis likely to win. If, on the other hand, accompanied the debt-ceiling debate), from one year to the next, so thethe answer to the first is no, the but it provides Republicans in Congress sentiment surveys that we watch on asecond question becomes the key awith a disincentive to try to accomplish weekly basis could move higher intoyes answer gives the presidency to anything between now and the election January without offering much of athe challenger and a no allows the lest it provide the president with a headwind for stocks (as of this writing,incumbent to keep his job despitetailwind for his re-election campaign. they show a mostly even mix betweenpoor marks.Unable to campaign on the strengthbulls and bears). The key over theNow, a year ahead of the election, of the economy, President Obamas near term will be the reaction of thePresident Obama gets generally re-election hopes may hinge onsentiment indicators to movementspoor marks on his handling of theportraying the challenger as insufficient in prices price declines that areeconomy (recent polls show him to the office of president. Here, the met with a surge in pessimism arewith a favorability rating in the lowhope will likely be to tie the challenger unlikely to persist, while rallies that40s, below even Jimmy Carter at a to the Republicans in Congress andattract elevated levels of optimism areStock Market and Investor Sentiment16 17. vulnerable to reversal. Well continue to this desire to move away frombreadth confirmation of a cyclicalto watch sentiment on a weekly basis stocks. On an anecdotal level, we bull market. Also, the number ofas we read the various sentiment hear of an increasing reluctance to issues making new highs versus newsurveys as well as the options data. maintain exposure to a stock market lows has been trending lower and isTwo longer-term sentiment indicators that appears to be schizophrenic at inconsistent with a cyclical bull marketdeserve mention here. First, mutualbest and may just simply be chaotic.at this point.funds are fully invested (accordingPrudent regulation (such as something The risk-on/risk-off nature of theto data from ICI, the mutual fundthat puts high-frequency trading firmsstock market and the tendency forcash/asset ratio near the end of 2011more in the camp of market makers)(nearly) everything to move in thewas just above its all-time low near may help restore investor confidencesame direction has an impact on our3.1%), which could limit the ability and encourage increased, long-termbreadth measures. As we mentionedof institutional buyers to step into involvement in the stock market.previously, 10-to-1 days are soweak markets to support prices. This isBreadth indicatorscommon now as to be practicallyfurther exacerbated by a demand formeaningless. In recent months, it Breadth indicators are bearishredemptions by mutual fund investors has been the rule, rather than the entering 2012. An expansion in rally(again according to ICI, equity mutual exception, that 80% to 90% of the S&P participation at an issue, industry-funds have seen net outflows in every500 is moving in the same direction on group or world market level wouldmonth since May). Second, we are in aany given day. It appears that this may support the view that the 2011 cyclicalperiod of secular shift away from thereduce some of the leading tendencies bear market has indeed run its course.stock market on the part of individual in the breadth indicators, but does not That has not yet been seen. In fact,investors. Eventually this will be bullish cancel the need to see confirmation thus far the breadth indicators havefor stocks (once the final investor hasfrom the breadth indicators to gain been much more consistent withfinally washed his hands of stocks and confidence that movements in the the continuation of the cyclical bearvows never to buy one again), but in indexes are significant. into the first half of 2012. We arethe meanwhile it weighs on equities. Aside from the indicators mentioned particularly watching our measure ofInvestors continue to realize that theyabove, we are watching three the percentage of industry groups inwere overinvested in stocks, bearing areas of the market in particular for up-trends, which historically needsmore risk than was appropriate. Theconfirmation of what we see in the to get decisively above 65% to signalvolatility in the market has addedS&P 500 and Industry Group Breadth17 18. S&P 500: the Financials sector, small- dynamic approaches to assetmarket re-emerges, tilt toward morecap stocks and China. If two of theseallocation that recognize that riskcyclical areas and those that wouldareas get (decisively) back in gear, weand risk tolerances are not static.benefit from a near-term ebbing inwould have increased confidence that Allocations to all asset classes volatility (high-yield corporate debt,rallies seen in the S&P 500 can persist. (including cash) should be activelyfor one).Absent that, and without an expansiondecided upon, and they will fluctuate Emerging markets have better growthin the percentage of industry groups (within bounds) as market conditions prospects and better balance sheetsin up-trends, we remain cautious.change. One of the byproducts of (generally) than their developed the current environment is the risk- counterparts, yet remain vulnerablePortfolio implications and on/risk-off tendency of the market.to market forces in the developedexpectations The risk-on/risk-off dynamic and world. We believe investors shouldWhile hopeful about tomorrow and the high correlations it engenders increase exposure there once a cyclicalthe prospect for secular change, for are a primary reason to focus on upswing is evident.now we remain in a basing period thatportfolio risk in the first place. Inis inherently high-risk as the market For investors looking to diversify periods of stress, correlations acrossswings between cyclical bull and bear.equity exposure away from the U.S., risky asset classes converge and theThe emergence of elevated levels of we generally would look towards other expected benefits of diversificationvolatility adds to the risk. Investors, countries that use dollars (Canada, fade. Effectively identifying shiftsprofessional or amateur, cannot Hong Kong, Singapore, and Australia). between these regimes can allow(and should not attempt to) manageEconomic and financial conditions in investors to more successfully manageportfolios for the three- to four-weekthese countries are among the best risk. From a trading perspective,rallies and declines that have in the in the world. The caveat is that all this is done by looking at the co-past taken months or quarters toare influenced by movements in the movements of various indexes andemerge. Much of the market action commodity markets, which could add asset classes. From an investingon a day-to-day basis is just noise thatto their volatility. perspective, this means watching forneeds to be filtered out. The remainingbreadth confirmations/divergences In the end, investors must rememberinformation, if there is any, can be and identifying periods of excessive that return (either price appreciationreacted to. In this secular environment, optimism and pessimism.or dividend yields) and risk areinvestors should focus on managingdirectly correlated. Managing for riskrisk, not chasing returns. The comingSo, then, what is an investor to domeans not chasing returns.secular upswing will be the time toin 2012?focus on returns. We continue to view gold as animportant component within a Since the individual goals of eachThis is not to say that investors shoulddiversified portfolio. The secular up- investor vary, we encourage youhide their money under their mattresstrend appears to be intact, and we to contact your Baird Financialand do nothing for the duration of thebelieve gold is likely to be a primary Advisor in early 2012 to discuss thesecular bear market that emerged abeneficiary from a more active implications of this market outlookdozen years ago. In fact the contraryEuropean Central Bank and U.S. on your own portfolio and wealthmay be true. First of all no oneFederal Reserve. management plans.knows when the next bull marketwill emerge. Second, managing for We believe you should use the firstrisk rather than return addresses half of the year (assuming the 2011motivation, not action. Finally, even cyclical bear market is intact) to focuswithin the long-term trading rangeon defensive allocations, includingthat we find ourselves in, cyclical lower-beta, higher-quality sectors ofopportunities emerge. the market and high-grade corporateWe continue to view favorably debt. If and when a cyclical bull18 19. Important DisclosuresDisclaimersThis is not a complete analysis of every material fact regarding any company, industry or security. The opinions expressed here reflect our judgment atthis 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 andregulations and the potential for illiquid markets. Historically, small and mid cap stocks have carried greater risk and have been more volatile than stocksof larger, more established companies.ADDITIONAL INFORMATION ON COMPANIES MENTIONED HEREIN IS AVAILABLE UPON REQUEST.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 thestock 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 ExchangeCommission, FINRA, and various other self-regulatory organizations and those laws and regulations may differ from Australian laws. This report has beenprepared in accordance with the laws and regulations governing United States broker-dealers and not Australian laws.Copyright 2011 Robert W. Baird & Co. Incorporated.Other DisclosuresUK disclosure requirements for the purpose of distributing this research into the UK and other countries for which Robert W Baird Limited holdsan 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 MarketsAct 2000 (financial promotion) order 2001 being persons who are investment professionals and may not be distributed to private clients. Issued inthe United Kingdom by Robert W Baird Limited, which has offices at Mint House 77 Mansell Street, London, E1 8AF, and is a company authorized andregulated by the Financial Services Authority. For the purposes of the Financial Services Authority requirements, this investment research report isclassified as objective.Robert W Baird Limited (RWBL) is exempt from the requirement to hold an Australian financial services license. RWBL is regulated by the FinancialServices Authority (FSA) under UK laws and those laws may differ from Australian laws. This document has been prepared in accordance with FSArequirements and not Australian laws.2011 Robert W. Baird & Co. Incorported. Member SIPC. MC-34114. #1444