Investment Strategy - Raymond James

Investment Strategy Ryan Lewenza, CFA, CMT, Private Client Strategist

January 5, 2015

2015 Market Outlook

Table of Contents Economic Outlook………………2-3 Fundamental Outlook……………4 Technical Considerations……….5 Risks to Outlook………………….…6 Positioning…………………………….7

Highlights 

We see the North American (NA) and global economy gradually improving in 2015, with the US economy leading the way. The US economy is forecasted to grow at 3% in 2015, up from 2.3% in 2014.



The Canadian economy stands to benefit from an accelerating US economy. We see the potential for higher exports on the back of a stronger US economy and a weaker Canadian dollar. However, the Canadian economy should trail the US given weak commodity prices and high consumer debt.



Our 2015 S&P/TSX Composite Index (S&P/TSX) price target is 15,300, which is based on a 17x P/E multiple and our $900/share earnings forecast. Adding in a 2.8% dividend yield, we see the potential for a total return of 7.5%. We expect the S&P 500 Index (S&P 500) to outperform the S&P/TSX for the fifth consecutive year.



While we see further upside next year it will likely come with higher volatility as the US Federal Reserve (Fed) normalizes monetary policy by hiking interest rates in mid-2015. We see a decent first half followed by potential weakness in H2/15 as the Fed begins to hike rates.



The technicals remain bullish and supportive of our fundamental call for additional upside. Key positive technical trends include: 1) the S&P 500 remains in a long-term uptrend and is above its rising 40-week moving average (MA); 2) market breadth remains supportive; and 3) numerous market cycles point to additional gains.



Key risks to our outlook include: 1) growth deceleration from key regions such as Europe, Japan and China; 2) a stronger US dollar and its impact on the emerging markets; 3) significantly lower oil prices; and 4) the age of the current expansion cycle.



Preferred Canadian sectors include: Financials, Consumer Discretionary, Industrials and Information Technology. Underweight sectors include: Materials, Utilities and Health Care.

Please read domestic and foreign disclosure/risk information beginning on page 8 Raymond James Ltd. 5300-40 King St W. | Toronto ON Canada M5H 3Y2. 2200-925 West Georgia Street | Vancouver BC Canada V6C 3L2.

2015 Market Outlook

January 5, 2015 | Page 2 of 8

Economic Outlook Our investment strategy framework begins with our expectations for economic growth. We see the North American and global economy gradually improving in 2015, with the US economy leading the way. The US economy, which represents 22% of global GDP, is forecasted to grow at 3% in 2015, up from 2.3% in 2014. Our US economist is forecasting a more modest 2.75% next year (mid-point of 2.5% to 3% forecast range), but nonetheless, we see the US economy improving, helping to drive stronger global growth. Key supports for a stronger US economy include:



US labour market conditions continue to improve with the US economy adding on average 240,000 jobs per month in 2014, up from the 194,000 average monthly job gains in 2013. In fact, last year’s job gains were the strongest since 1999. As a result of the strong monthly gains (and a decline in the participation rate) the US unemployment rate has declined from 10% at the peak of the crisis to 5.8% currently. We see continued healthy job gains driving the unemployment rate below 5.5% by year-end 2015.



The Composite PMI Is Consistent With US GDP Growth Of 3%

The manufacturing sector continues to deliver solid gains, with the ISM Manufacturing Index sitting at 58.7, well above the key 50 level. New orders are incredibly robust at present, which bodes well for future production.



We see continued progress in the US housing sector driven by a stronger labour market, improved consumer balance sheets and low interest rates.



While we expect capital spending in the energy sector to take a hit in 2015, this should be offset by an increase in capital spending in other areas. With US companies flush with cash and the average age of plant and equipment at 22 years – the oldest since the 1950s – we see overall capital spending ramping up next year, offsetting weakness from the energy sector.

6

60

4

55

The composite PMI index, which includes ISM Manufacturing and Services, currently sits at 59.1 and is consistent with US GDP growth of 3% (sidebar).



65

2

50 0 45 -2

40



-4

ISM Composite (LHS)

35

US GDP Y/Y (RHS) 30

-6 '00

'02

'05

'08

'11

Source: Bloomberg

Finally, lower oil prices are likely to have a positive impact on economic growth next year. Consumer spending accounts for roughly 70% of US GDP while oil and gas capital spending represents 1% of GDP. Given this calculus, lower energy prices should provide a net benefit to the US economy.

Putting it all together we see the US economy delivering stronger economic growth next year, helping to push global growth higher in 2015. US Job Gains Highest Since 1999

US GDP Growth To Increase To 2.75% In 2015

500

11

300

10

100

9

-100

8

-300

7

1.0

-500

6

0.0

6.0 4.6

5.0

US Nonfarm Payrolls Mthly Chg (LHS)

2.9

3.0

4 '07

'08

'09

'10

Source: Bloomberg, Raymond James Ltd.

'11

'12

'13

'14

2.7

2.5

2.3

RJ Forecast

2.2

1.8

1.6

2.7 2.7 2.6 2.6

0.8 0.1

-1.0

5

US Unemployment Rate % (RHS) -900

3.9

3.5

2.0

-700

4.6

4.5

4.0

-2.0 -3.0

-1.5

US GDP Growth Q/Q Annualized

-2.1

Q1/11 Q3/11 Q1/12 Q3/12 Q1/13 Q3/13 Q1/14 Q3/14 Q1/15F Q3/15F

'13

2015 Market Outlook


Canadian Outlook With the important economic and financial linkages to the US economy, where it goes, so does the Canadian economy. This is captured in the high (0.90) correlation between the two economies. Given this relationship, the Canadian economy stands to benefit from an accelerating US economy. In particular, we see the potential for higher exports next year, on the back of a stronger US economy and a weaker Canadian dollar. We expect energy-related exports to come under pressure next year, but see other areas, such as machinery and autos offsetting the weakness in energy. Exports rose 6.8% annualized in Q3/14, following a 17.8% increase in Q2/14. We see this trend continuing in 2015, helping to propel the Canadian economy higher. While we see stronger activity for the Canadian economy, we believe it will continue to trail the US given two significant headwinds:





Canadians have taken on a significant amount of debt in recent years, as a result of low interest rates and rising home values. Household debt relative to disposable income has increased from 120% in 2004 to 165% today. Putting this into context, US debt to income peaked at 163% prior to the credit crisis and stands at 135% today. We expect Canadians to “tighten their belts” as they look to address their high debt loads. If correct, this could weigh on consumer spending and economic growth.

Heavily Indebted Canadians Provides A Headwind To Growth 180 160 140 120

The second major headwind for Canadian growth is the weak outlook for commodities. With the emerging markets slowing, this is resulting in lower demand for commodities. For example, oil has declined precipitously from US$105/bbl last summer to US$56/bbl today. While we expect oil prices to firm up in H2/15, as global growth picks up, we still see oil trading in a new lower range which should negatively weigh on the energy sector and Canadian corporate profits.

100 80 Canadian Household Debt to Disposoable Income (%)

60 '90

'93

'96

'99

'02

'05

'08

'11

Source: Bloomberg

In sum, we believe the Canadian economy will benefit from stronger US growth; however, key headwinds such as high debt loads and weaker commodities will result in slower growth from Canada. We see economic growth closer to 2.5% versus 2.75% for the US in 2015. Canadian Economy Should Benefit From US Growth

With Exports Getting A Boost

8

r = .90

20%

6

15%

4

10% 5%

2

0% -5%

0

-10%

-2

-15% Canada GDP Y/Y

-4

-20%

US GDP Y/Y '98

'00

'02

Canadian Domestic Exports Y/Y

-25%

-6 '04

'06


'08

'10

'12

'14

'98

'00

'02

'04

'06

'08

'10

'12

'14

'14

2015 Market Outlook


Fundamental Outlook Incorporating our GDP growth expectations into our earnings model we come up with an S&P/TSX earnings estimate of $900/share which equates to growth of 6% Y/Y. Our earnings forecast is 5% below the current bottom up consensus estimate of $950/share, as we see the potential for further negative earnings revisions from the resource sectors. This also helps explain why the earnings trajectories for the S&P/TSX and S&P 500 have diverged in recent quarters, with S&P 500 earnings continuing to power higher, while S&P/TSX earnings have weakened. Our more constructive outlook for US earnings is one factor in our call for the S&P 500 to outperform the S&P/TSX once again in 2015. With the large equity gains since the financial crisis, valuations have expanded markedly with the S&P/TSX currently trading at 18.4x trailing earnings and 1.8x price to book value (P/B). For perspective, at the March 2009 low, the S&P/TSX traded at 10x earnings and 1.2x P/B. Clearly stocks are no longer “cheap” but nor are they extremely “expensive”, in our view. While history suggests the potential for further multiple expansion, this is not our base case for next year. We see upside next year being driven by corporate earnings growth. Our official S&P/TSX price target is 15,300, which is based on a 17x P/E multiple and our $900/share earnings forecast. Adding in a current 2.8% dividend yield, we see the potential for a total return of 7.5% in 2015 from current levels. While we see further upside next year it will likely come with higher volatility as the Fed normalizes monetary policy by hiking interest rates in mid-2015. Typically, equities decline in the first few months after the first interest rate hike, but then rebound on average 5%, 12 months following the first Fed hike. This is largely due to the fact that the economy is doing better, which translates into stronger corporate earnings. It is generally not until the third or fourth rate hike that the stock market tends to peak, as investors fully realize that the Fed is intent on slowing down the economy and tackling inflation. Therefore, we see a decent first half followed by potential weakness in H2/15 as the Fed begins to hike rates. The expected first rate hike is in mid-2015 which would coincide with the typically weak summer months. Stocks could come under pressure in the summer/fall period, but by end of year, we believe NA equities will be higher, in line roughly with corporate earnings growth.

$900

$100

$700

$80

$600

$60 $40

$400

0.0%

$0

$0 '98

'00

'02

'04


'06

'08

'10

'12

-2.0% -4.0%

$100

S&P/TSX Trailing Earnings (RHS) '14

Equities initially decline than gain 5% on average

4.0% 2.0%

$200

S&P 500 Trailing Earnings (LHS)

6.0%

$500

$300

'96

Source: Bloomberg. As of December 22, 2014

8.0%

$800

'94

S&P/TSX S&P 500 Current Vs LT Av'g Current Vs LT Av'g 18.4 -3.2% 18.3 11.1% 15.6 0.0% 17.2 4.2% 1.9 -6.0% 2.8 -2.2% 5.4 -3.2% 5.5 -8.4% 2.9 45.2% 1.9 -20.5%

Equities Initially Decline Following Fed Hike Then Rally

$120

$20

Metric Trail P/E Fwd P/E P/B Earnings Yield Dividend Yield

-6.0%

S&P 500 Average Performance After First Fed Hike (periods include '80, '83, '88, '94 '99, '04)

1 12 23 34 45 56 67 78 89 100 111 122 133 144 155 166 177 188 199 210 221 232 243 254

S&P 500 And S&P/TSX Trailing Earnings

North American Equity Valuations Are Above Average But Not At Extremes

Days

2015 Market Outlook


Technical Considerations Our strategic framework incorporates both fundamentals and our technical readings of the markets. When the technicals “confirm” our fundamental conclusions it increases our confidence in our forecasts and helps provide a more complete picture. Currently, the technicals remain bullish and supportive of our fundamental call for additional upside in 2015. Key positive technical trends include:









The S&P 500 remains in a long-term uptrend and is trading above its rising 40-week MA, which we use to define the long-term uptrend. On a shortterm basis the S&P 500 is trading at resistance which could leave it vulnerable to a pullback early in the year, similar to 2014. The S&P/TSX is also in a long-term uptrend; however, it is currently below its 40-week MA. Additionally, the S&P/TSX remains in a relative downtrend versus the S&P 500, which is one factor in our call for the S&P 500 to outperform the S&P/TSX in 2015 for the fifth consecutive year (sidebar).

The S&P 500 Has Outperformed The S&P/TSX Since 2011 0.21 0.19

S&P/TSX outperforming

0.17

Market breadth remains decent with the NYSE Advance/Decline (A/D) line consistently making new highs. Often at major market tops the NYSE A/D diverges with price action, providing an early warning signal. This is currently not present.

0.15

A number of market cycles that we track are bullish for 2015. They include:

0.07

S&P 500 outperforming

0.13 0.11

0.09 S&P 500 Relative to the S&P/TSX



The Presidential Cycle, which posits that stock returns track the US President’s term, with years 3 being the best for stock returns. Since 1945, the S&P 500 has returned an average 16% in year 3 of the President’s term, versus 6% for all other years.



US midterm elections have been very positive for subsequent S&P 500 12-month returns. Since 1945, the S&P 500 has posted a positive return in every subsequent 12-month period following a mid-term election, with an average price return of 17.5%.

'94

'96

'98

'00

'02

'04

'06

'08

'10

'12

Source: Bloomberg

 The Decennial Cycle states that equities tend to trade in a 10-year market cycle, with years ending in 5, 8 and 9 being bullish for stock returns. Year 5 in particular has been the strongest. Since 1833, there have been 18 years ending in 5, with 15 (83%) of those years posting a positive return for the Dow Jones Industrial Average. Both technicals and market cycles point to additional upside for the NA equity markets in 2015, supporting our call for single-digit returns next year. S&P 500 Remains In A Long-Term Uptrend

Presidential Cycle Points To Strong Returns In 2015

2,100

40%

1,900

35%

1,700

30%

1,500

25%

1,300

20%

Year 1

Year 2

Year 3

Year 4

We're here

15%

1,100

10%

900

5%

S&P 500 40-Week MA

700

0%

500 '05

'06

'07

'08

'09


'10

'11

'12

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'14

-5%

S&P 500 Performance Over the FourYear Presidential Cycle (1945-2012) Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct

'14

2015 Market Outlook


Risks to Outlook Let’s be clear, it’s not all roses. There are a number of headwinds that should they intensify could put the global economy at risk. We believe on balance that the positives outweigh the negatives, but they require close monitoring. They include:



Key regions such as Europe, Japan and China have weakened with their growth decelerating or going negative in recent quarters. We see these key areas stabilizing and posting stronger economic growth in 2015 due in part to the lagged impact of monetary stimulus. However, should these areas decelerate further, possibly due to an exogenous shock, this could impact the global economy. Some believe the US economy could “decouple” from weakness abroad, however, we are not in this camp. Continued weakness abroad could put the US economy at risk.



We remain US dollar bulls on the back of tighter monetary policy from the Fed. Historically, a stronger US dollar has been a headwind for the emerging markets (EM) as it impacts trade, capital flows and monetary policy. As we saw in 2013 when emerging market currencies and equity markets declined on US dollar strength, should this occur again in 2015, it could be destabilizing to the global economy.



Low oil prices are good, until they are not. We believe the weakness in oil prices has been mainly supply-driven rather than demand-driven. As such, weak oil prices are not signalling a global slowdown or looming recession, in our view. We see oil prices firming up in H2/15 as global growth improves. However, if this does not play out, and oil prices continue to weaken, they could signal that something is amiss with the global economy.



Finally, the current expansion phase is getting older with the US economy nd entering its 22 quarter of expansion, which is in line with the long-term average expansion cycle. We believe this cycle will last longer than “normal” given the depth of the last recession and the unprecedented liquidity injected into the financial markets. But the fact remains that this expansion cycle is getting older and therefore requires close monitoring.

As always in the case of forecasting and investing, there are a number of risks that could retard economic growth and put our projections at risk. However, our base case view is that these risks are manageable and that the global economy should be able to withstand any flare ups that might occur in 2015.

Number of Quarters of Expansion

Current Phase Is Getting Older At 21 Quarters

Oil Prices Reflect Excess Supply Rather Than Demand 150%

45

40

40

US Recession

WTI 6-Month % Chg

35

35

100%

31

30 25

24

Average

21

20

50%

20 15

14

13

0%

12 8

10

-50%

5 0 1950

1954

1958

1961

1971

1975

1983

1991

Starting Year of Expansion Cycle


2002

2009

-100% '83 '85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09 '11 '13

2015 Market Outlook


Positioning We continue to recommend a cyclical bias in portfolios with respect to sectors and equity holdings. Cyclicals tend to outperform later in the business cycle, when economic momentum is improving. With the Fed likely to hike interest rates in mid2015, as a result of stronger economic activity, we see the potential for bond yields to rise which would likely be a headwind to interest-sensitive sectors such as utilities. In the accompanying table we outline the rationales behind our sector recommendations. S&P/TSX Sector Recommendations For 2015 Sector Financials

Consumer Discretionary

Canada (S&P/TSX) Stance Overweight

Overweight (↑ Market weight)

Rationale • Sector delivers steady earnings growth which could lead to higher dividends in 2015 • Valuations are reasonable at 12.5x forward earnings and 1.8x P/B • Positive technical trends • Sector stands to benefit from lower oil and energy prices • Sector is expected to deliver strong EPS growth of 16% next year • Positive technical trends

Industrials

Overweight

• Industrials stand to benefit from stronger US growth and capital spending • Sector is expected to deliver strong EPS growth of 24% next year • Positive technical trends

Information Technology

Overweight

• Information technology sector is a good play on stronger capital spending • Sector typically outperforms when interest rates rise • Positive technical trends

Energy

Market weight (↓ Overweight)

• Stronger US dollar and weak emerging market growth is a headwind for sector • OPEC decision not to cut production was a game changer for oil prices • Decent valuations and weak 2014 performance should limit downside

Consumer Staples

Market weight

• Sector stands to benefit from lower oil and energy prices • Positive technical trends • High valuations at 21x forward earnings should limit upside

Telecom Services

Market weight (↑ Underweight)

Materials

Underweight (↓ Market weight)

Utilities

Underweight

Health care

Underweight

• Earnings growth has begun to improve following weak 2012 - 2013 period • Technical trends have improved • Valuations are reasonable with sector trading at 16.9x forward earnings • Higher US dollar and slower emerging market growth are headwinds to commodities • Commodity indices and gold prices have broken below long-term uptrends • Negative technical trends • Sector is likely to be negatively impacted by rising interest rates • Sector is trading at 12-year high valuations at 25x forward earnings • Negative technical trends • Canadian health sector lacks breadth and depth - prefer US healthcare sector

Source: Raymond James Ltd.

Conclusion We view the current economic conditions of “not too hot, not too cold” as being ideal for equities and see continued gains next year. Improved economic growth should result in stronger corporate earnings, while inflation trends remain benign, allowing the Fed to be slow and gradual in raising interest rates. While we believe 2015 will come with higher volatility for equity investors, particularly through the summer/fall months, we see North American equities posting another year of positive returns in 2015, with the cyclical sectors leading the way.

2015 Market Outlook


Important Investor Disclosures Complete disclosures for companies covered by Raymond James can be viewed at: www.raymondjames.ca/researchdisclosures. This newsletter is prepared by the Private Client Services team (PCS) of Raymond James Ltd. (RJL) for distribution to RJL’s retail clients. It is not a product of the Research Department of RJL. All opinions and recommendations reflect the judgement of the author at this date and are subject to change. The author’s recommendations may be based on technical analysis and may or may not take into account information contained in fundamental research reports published by RJL or its affiliates. Information is from sources believed to be reliable but accuracy cannot be guaranteed. It is for informational purposes only. It is not meant to provide legal or tax advice; as each situation is different, individuals should seek advice based on their circumstances. Nor is it an offer to sell or the solicitation of an offer to buy any securities. It is intended for distribution only in those jurisdictions where RJL is registered. RJL, its officers, directors, agents, employees and families may from time to time hold long or short positions in the securities mentioned herein and may engage in transactions contrary to the conclusions in this newsletter. RJL may perform investment banking or other services for, or solicit investment banking business from, any company mentioned in this newsletter. Securities offered through Raymond James Ltd., Member-Canadian Investor Protection Fund. Financial planning and insurance offered through Raymond James Financial Planning Ltd., not a Member-Canadian Investor Protection Fund. Commissions, trailing commissions, management fees and expenses all may be associated with mutual funds. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. The results presented should not and cannot be viewed as an indicator of future performance. Individual results will vary and transaction costs relating to investing in these stocks will affect overall performance. Information regarding High, Medium, and Low risk securities is available from your Financial Advisor. RJL is a member of Canadian Investor Protection Fund. ©2014 Raymond James Ltd.