Health Care

The S&P managed care index has steadily outperformed the S&P 500 over the past six months. Despite this outperformance, relative valuations have barely budged, underscoring that gains remain fundamentally-driven. After surging in late-2016, our managed care cost proxy has plunged in recent months (second panel). Premiums are set on a trailing cost basis, underscoring that there should be a window for upside margin surprises as revenue enjoys a pricing power bump from the previous rise in cost inflation, while current cost inflation melts. Importantly, consumer spending on health care is waning as a share of total spending, signaling fewer claims ahead, and an ongoing reduction in cost pressures. Further, an ACA overhaul, in whatever form it takes, is likely to be less restrictive in coverage for higher-risk, higher-cost members than its previous manifestation, implying ongoing earnings improvement. We reiterate our overweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC. Healthy Earnings Growth In Managed Care Healthy Earnings Growth In Managed Care

We are making room for the financials sector upgrade by trimming the health care sector to neutral. As discussed in recent weeks, a modest shift away from a defensive to a more balanced portfolio has been on our radar. At the beginning of the year we added the S&P health care equipment (HCE) index to our high-conviction overweight list for three main reasons: valuations had undershot owing to health care reform uncertainty, domestic sales were set to improve and leading indicators of foreign sourced revenue also painted a rosy picture. But some of these forces are losing their potency. The most troubling aspect has been a downturn in leading indicators of domestic demand growth. New health care facility construction has dropped sharply, warning that investment in medical equipment may soon follow suit (second panel). Consumer outlays at hospitals have nosedived on a growth rate basis. This suggests that the growth in patient visits has dried up, and may be a warning that medical equipment new order growth will also decelerate (third panel). Moreover, as outlined in recent Weekly Reports, the broad corporate sector has regained pricing power, but medical equipment suppliers have lagged (bottom panel). The implication is that our confidence in a further valuation re-rating has been dented. Take profits and downgrade to neutral, and please see yesterday's Weekly Report for more details. This brings our overall health care sector weighting to neutral. Take Profits In Health Care Equipment Take Profits In Health Care Equipment

Highlights Portfolio Strategy Upgrade the financials sector to overweight. This year's consolidation phase is drawing to a close as inflation expectations stabilize. Lift the S&P banks index to overweight. Leading indicators of credit creation are signaling a reacceleration as the year progresses. Trim the S&P health care sector to neutral via profit-taking in medical equipment stocks. Recent Changes S&P Financials - Upgrade to overweight from neutral. S&P Banks Index - Upgrade to overweight from underweight. S&P Health Care - Downgrade to neutral. S&P Health Care Equipment - Downgrade to neutral. Table 1 Girding For A Breakout? Girding For A Breakout? Feature Chart 1Yields Are Not Yet Restrictive Yields Are Not Yet Restrictive Yields Are Not Yet Restrictive The S&P 500 is challenging the top end of its range. A playable breakout looks increasingly probable, albeit the exact timing is difficult. First quarter profit results have been strong, corporate guidance has been solid and monetary conditions are unlikely to become tight enough in the short run to dent renewed profit optimism. The latest string of economic disappointments is seen as providing the Fed with ample leeway, and investors are willing to overlook ongoing sluggishness because earnings are outperforming the economy via margin expansion. As discussed in detail in recent weeks, earnings growth is supported by a broad-based recovery in sales and pricing power. Top-line growth is critical to sustaining the overall equity market overshoot given sky-high valuations. Indeed, the appeal of equities stems from their attractiveness relative to other asset classes rather than in absolute terms. History shows that an asset preference shift can take time to play out, and push valuations higher than seems justified on fundamentals alone as long as recession is not an imminent risk. The Treasury market can provide clues as to when vulnerabilities will intensify. According to BCA's Treasury Bond Valuation Model, yields usually need to be at least one standard deviation above normal before stocks, and the economy, are at risk of a major downturn (Chart 1). At those turning points, inflation concerns are typically running hot, forcing the Fed to tighten enough to slow growth and undermine economic activity. This simple rule of thumb warned of the most recent stock market peaks, as well as equity slumps in the early-1990s, 1987, and the early-1980s, and supported bond vs. equity outperformance. Recently, the 10-year Treasury yield has returned to fair value, and the U.S. dollar has come off the boil. The implication is that there is no monetary roadblock to halt the upward momentum in equities at the moment. There is ample room for yields to rise before becoming restrictive, especially if the primary driver is the real component. In this light, we will continue with our program of transitioning to a more balanced equity portfolio from its previous defensive tilt. This week we downgrade a defensive sector to neutral and redeploy capital into the financials sector. Upgrade The Financials Sector... The financials sector has given back roughly 50% of its post-election surge this year. The main culprits have been a calming in Fed interest rate hike expectations, a flattening yield curve and softening inflation expectations. Moribund credit creation has also created earnings uncertainty (Chart 2). Nevertheless, the corrective phase appears to be drawing to a close, because financials sector profits are increasingly likely to surpass those of the overall corporate sector going forward. Traditionally, the financials sector benefited from a strong U.S. dollar. A strong dollar exerted downward pressure on interest rates, which spurred domestic economic strength, loan demand and a steepening yield curve. However, since the GFC, the opposite has been true. Zero interest rates and intense deflationary risks were exacerbated by U.S. dollar appreciation, as the corporate sector and commodities suffered. In other words, with the economy operating on a knife's edge between deflation and inflation, a strong currency weighed heavily on financial shares. Thus, the hiatus in the U.S. dollar bull market is a significant positive catalyst, if it arrests the decline in inflation expectations. The yield curve is making an effort to stabilize, suggesting that the risks of falling back close to the deflationary precipice are low. There are already signs of a positive reversal in euro area financials, which had led the U.S. financial sector on the way down after peaking late last year (Chart 2). The euro area has been in a deleveraging phase with acute deflationary risks, underscoring that the signal from share price stabilization in this region is worth noting. The key to a sustained recovery in sector profits is economic reacceleration. Corporate sector profits are healing as a consequence of the pickup in global final demand and the peak in the U.S. dollar, which should ensure that labor market slack does not imminently build. That is necessary to sustain credit quality and generate faster credit demand, and can be illustrated through the positive correlation between the output gap and relative share price performance (Chart 3), at least until the gap grows too large to generate inflationary pressures and by extension, tight monetary policy. Chart 2Earnings Uncertainty... Earnings Uncertainty... Earnings Uncertainty... Chart 3...But A Narrowing Output Gap... ...But A Narrowing Output Gap... ...But A Narrowing Output Gap... Leading economic indicators are consistent with erring on the side of optimism (Chart 4). Our proxy for the supply/demand balance for C&I loans confirms a positive bias for future loan growth (Chart 4). The upturn in the financial sector sales/employment ratio is encouraging (Chart 4). Productivity improvement has begun prior to a reacceleration in loan creation, suggesting that additional upside looms as balance sheets expand. Any unlocking of the regulatory shackles would be a bonus. Strength in our Financials Cyclical Macro Indicator confirms that profits should best those of the overall corporate sector. The financial sector is contributing more to overall GDP growth than it did even during the credit binge/housing bubble (Chart 5), despite the headwind of ultralow interest rates. Chart 4...And Leading Indicators ##br##Are Positive Offsets ...And Leading Indicators Are Positive Offsets ...And Leading Indicators Are Positive Offsets Chart 5Market Cap ##br##Gains Loom Market Cap Gains Loom Market Cap Gains Loom Even though financials represent an ever increasing share of the broad economy, the sector still garners less than its historic median market cap weight (Chart 5). The upshot is that if the economy stays resilient, the correction in relative share price performance should fully reverse, and we recommend further upgrading allocations to overweight via the heavyweight bank group. ...And Bank On Faster Growth Bank profit growth is supported by three main pillars: the quantity, price and quality of credit. All three are set to improve. While seven out of eight lending categories are experiencing a negative credit impulse, forward looking indicators are sending a more positive message. Business and consumer confidence have skyrocketed (Chart 6). If the revival in animal spirits lifts real economic activity later this year, capital demands could finally break out of their slump and reinvigorate moribund loan growth (Chart 6). Importantly, our U.S. Capital Spending Indicator (CSI) snapped back into positive territory. This primarily reflects both the firming in the ISM manufacturing survey and tightness in the labor market. Credit growth has not yet troughed, but should recover in the second half of the year based on our CSI's reading (Chart 6, top panel). Other leading indicators are heralding a pickup in credit demand. A steepening yield curve and the soaring ISM new orders index have an excellent track record in leading the Fed's Senior Loan Officer Survey for overall credit demand (Chart 6). Solid house price inflation and a tight labor market should ensure that consumer credit growth also firms (Chart 7), pointing to the potential for a broad-based bank balance sheet expansion. Overall household leverage has fallen back to 2003 levels and the household debt-service ratio is at multi-decade lows. Chart 6A Turning Point For Loans... A Turning Point For Loans… A Turning Point For Loans… Chart 7...As Demand Recovers …As Demand Recovers …As Demand Recovers Bank deposits are still growing, outpacing nominal GDP by 200bps, and the sector is extremely well capitalized. The loan-to-deposit ratio remains low by historical standards (Chart 8). Bank holdings of risk free securities comprise about 15% of the sector's assets, well above the historic average (Chart 8). The upshot is that there is plenty of firepower to crank up credit creation. True, a rundown in Treasury holdings would result in mark-to-market losses, but banks are well positioned to navigate through rising interest rates. According to the FDIC, net interest income as a share of total revenue has climbed steadily at commercial banks with assets greater than $1bn (Chart 9). Thus, if a better economy and rising inflation materialize in the back half of the year, then higher interest rates will boost profitability (Chart 9). Chart 8Banks Have Dry Powder Banks Have Dry Powder Banks Have Dry Powder Chart 9A Durable NIM Expansion A Durable NIM Expansion A Durable NIM Expansion Table 2 shows a sample of the four largest U.S. banks' earnings sensitivity to interest rate changes. Banks profit from overall rising interest rates in two ways: reinvesting at higher yields and assets repricing at a faster pace than deposits. Table 2Top Four Banks' Interest Rate Sensitivities Girding For A Breakout? Girding For A Breakout? Thus, a steepening yield curve would signal that bank profit estimates should experience a re-rating, provided the yield lift at the long end of the curve was gradual and did not choke off growth via a sudden spike (Chart 9). In terms of credit quality, non-performing loans and charge-offs are sinking from already low levels. It would take a significant deterioration in the labor market to warn that credit quality was about to become a profit drag (Chart 10). Chart 10Credit Quality Is Not An Issue, For Now Credit Quality Is Not An Issue, For Now Credit Quality Is Not An Issue, For Now Importantly, the reserve coverage ratio has climbed to near 100%, as non-current loans have fallen faster than banks have released reserves. Historically, credit quality improvement has been positively correlated with rising valuations (Chart 10). This message is corroborated by return on equity (ROE). Bank ROE has recouped most of the losses since the GFC on the back of recovering productivity gains. However, valuations do not yet reflect the ROE improvement. History shows that after a financial crisis, it can take a prolonged period of improved ROE before investors reward the sector with a valuation expansion, as occurred in the early-1990s (Chart 7, bottom panel). Bottom Line: Boost the S&P financials sector to overweight from neutral. Lift the S&P banks index to overweight. The ticker symbols for the stocks in the S&P banks index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT. Take Health Care Equipment Down A Notch We are making room for the financials sector upgrade by trimming the health care sector to neutral. As discussed in recent weeks, a modest shift away from a defensive to a more balanced portfolio has been on our radar and the surge in equities over the past week suggests that the consolidation phase is now ending in a bullish fashion, as expected. At the beginning of the year we added the S&P health care equipment (HCE) index to our high-conviction overweight list for three main reasons: valuations had undershot owing to health care reform uncertainty, domestic sales were set to improve and leading indicators of foreign sourced revenue also painted a rosy picture. What has changed? Relative share prices have undergone a V-shaped snapback, all of which can be attributed to a valuation expansion. A flurry of recent M&A activity has also buoyed relative valuations, as takeover premiums have been significant. Relative performance is now at a natural spot to expect a breather. On the operating front, a number of positive profit drivers are still intact. The industry's shipments-to-inventories ratio remains at multi-decade highs and the backlog of medical equipment orders is robust (top and bottom panels, Chart 11). HCE exports are primed to accelerate in the coming months likely irrespective of the U.S. dollar's move. In particular, Europe matters most to S&P HCE constituents, as roughly half of international sales originate in the old continent. Forward-looking indicators of European demand are upbeat, especially with the surge in German medical equipment orders (Chart 11). However, domestic sales indicators have downshifted. New health care facility construction has dropped sharply, warning that investment in medical equipment may soon follow suit (Chart 12, second panel). Consumables demand growth may also take a breather. Consumer outlays at hospitals have nosedived on a growth rate basis. This suggests that the growth in patient visits has dried up, and may be a warning that medical equipment new order growth will also decelerate (Chart 12). Moreover, as outlined in recent Weekly Reports, the broad corporate sector has regained pricing power, but medical equipment suppliers have lagged. Chart 12 shows that relative selling prices are contracting at an accelerating pace. This is significant, as deflation concerns could undermine revenues, and halt the valuation expansion. If domestic medical equipment demand cools, then it will sustain downward pressure on industry activity (Chart 13). Already, medical equipment industrial production (IP) has collapsed, in marked contrast with the expansion in overall IP. Chart 11Export Prospects Are Positive... Export Prospects Are Positive... Export Prospects Are Positive... Chart 12...But Domestic Blues... ...But Domestic Blues... ...But Domestic Blues... Chart 13...Will Weigh On Activity ...Will Weigh On Activity ...Will Weigh On Activity Worrisomely, the HCE new orders-to-inventories ratio has also lost steam, warning that a recovery in future production growth may not be imminent. The implication is that productivity gains are petering out, denting our confidence in a further valuation re-rating. Bottom Line: Downgrade the S&P health care equipment index and remove it from the high-conviction overweight list for an 9% gain. This also pushes the broad health care index to neutral. The ticker symbols for the stocks in this index are: BLBG: S5HCEP: MDT, ABT, DHR, SYK, BDX, BSX, ISRG, BAX, ZBH, EW, BCR, IDXX, HOLX, VAR. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

The S&P managed care index is poised to break out to new, sustainable, all-time relative performance highs. The impetus behind upward momentum is fundamentally-driven. United Health raised its full year guidance, a trend that could spread through the industry if our indicators are a good guide. Many companies are exiting unprofitable business lines, most notably health care exchanges, while those remaining are experiencing a meaningful reduction in cost inflation. Indeed, our managed care cost proxy has plunged, reflecting a broad-based easing in both goods and services costs. This indicator suggests that the medical loss ratio will remain low. Importantly, consumers are gradually allocating fewer dollars to health care outlays, which signals that the payers of health care services (such as insurers) are at an earnings advantage compared to the providers of these services (such as hospitals). When relative spending accelerates, managed care lags, and decelerations/contractions tend to coincide with share price strength. Against this backdrop, a profit-led relative performance breakout is in the offing for the S&P managed care index. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC. Managed Care Is The Right Portfolio Tonic Managed Care Is The Right Portfolio Tonic

The S&P managed care index is testing new highs relative to the broad market, aided by optimism that an ACA overhaul will mean less pressure for insurers to cover high risk, high cost subscribers. Regardless of the proposed changes, the outlook for managed care stocks remains upbeat. They still command less than a market multiple, despite a solid growth outlook. The labor market remains strong, which is conducive to ongoing membership growth. Importantly, premiums are set on a trailing cost basis, and the previous surge in medical costs implies that a period of higher premiums looms just as costs are falling. Indeed, our proxy for medical costs has dropped sharply, heralding a steep decline in the medical loss ratio. There are high odds that this trend will be sustained, given that spending on overall health care is decelerating relative to total spending, an environment that has typically been associated with managed care outperformance. The less consumers are spending on procedures, the fewer claims that will be made, all else equal. That is particularly evident in the easing in pharmaceutical shipment growth and inflation rates. The bottom line is that the S&P managed care index remains a core portfolio overweight. The ticker symbols for the stocks in the S&P managed care index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC. Managed Care: A Cure For Any Portfolio Ills Managed Care: A Cure For Any Portfolio Ills

Highlights Portfolio Strategy Contrary to popular perception, non-cyclical sectors have led the market so far this year, while deep cyclical sectors are breaking down, in relative performance terms. Our models point to more of the same ahead. The oversold rebound in the pharmaceutical group may soon run into resistance so we recommend trimming positions to neutral. Put the proceeds into restaurants, a quasi-defensive group that enjoys a brightening sales outlook without pharma's political and regulatory risk. Recent Changes S&P Pharmaceuticals - Downgrade to neutral. S&P Restaurants - Upgrade to overweight. Table 1 Reading The Market's Messages Reading The Market's Messages Feature Equities are exhibiting signs of mild fatigue. Breadth has begun to narrow, and new highs have sagged compared with new lows (Chart 1). Both of these technical developments have warned of previous tactical pullbacks. The recent reset in oil prices may also test investor nerves. Oil prices have been a critical macro variable, because they influence inflation expectations and the corporate bond market (high yield bond spreads shown inverted, Chart 1). Crude oil price corrections have accurately timed equity retreats (Chart 1), and general risk aversion phases. To be sure, the global economy is no longer on a deflationary precipice, suggesting that weaker oil prices may not foreshadow a soft patch, but they may be a good enough excuse for profit taking in the equity market after a good run. Contrary to popular perception, cyclical sectors have not led the broad market so far in 2017. In fact, energy, materials and industrials have all broken down in relative performance terms (Chart 2), after peaking in mid-December. Only the technology sector has stayed resilient. Chart 1Short-Term Fatigue Short-Term Fatigue Short-Term Fatigue Chart 2Cyclicals Have Broken Down Cyclicals Have Broken Down Cyclicals Have Broken Down Chart 3Overshoot Renormalization Overshoot Renormalization Overshoot Renormalization Insipid cyclical sector performance has occurred within the context of a synchronized lift in global economic growth and recovering corporate sector pricing power. So why are cyclical sectors lagging? It may simply be a digestion phase. However, a different interpretation is that a number of key macro factors fail to confirm the durability of last year's outperformance, suggesting that defensive outperformance could last. Concerns that the current global inventory cycle may not morph into a broad-based upturn in global final demand continue to linger: the global credit impulse remains anemic, the Fed and China are tightening monetary policy and commodity markets are cracking (Chart 3). The lack of any meaningful improvement in Chinese loan demand signals that the economy may be quick to cool as the authorities tap the breaks on credit growth. It would take a decisive depreciation in the U.S. dollar to boost the relative profit fortunes of capital spending-dependent cyclical sectors on a sustainable basis. On a more positive note, the Fed's benign forward guidance last week bears close attention. If the U.S. dollar loses upside support, particularly with the ECB contemplating a retreat from full throttle easing, it could change the investment landscape. By reminding markets that their inflation target is symmetric, the Fed signaled it will be willing to tolerate a modest inflation overshoot, which is positive for risk assets in the short run. A softer U.S. dollar would take the pressure off of developing countries, support commodity prices, and bolster our cyclical sector sales models and Cyclical Macro Indicators. However, Chart 4 shows that the objective message from our models remains consistent with continued defensive sector outperformance. With a more protectionist U.S. Administration, we remain reluctant to position exclusively for a much weaker dollar. The ongoing underperformance of emerging market equities relative to U.S. and global benchmarks reinforces that foreign-sourced profit growth continues to lag (Chart 5). Positioning for cyclical sector earnings outperformance requires healthier profits abroad, to spur a new capital investment cycle. Chart 4Heeding The Message From Our Models... Heeding The Message From Our Models... Heeding The Message From Our Models... Chart 5... And The Markets ... And The Markets ... And The Markets We will look to selectively add cyclical exposure when the objective message from our Indicators provides confirmation that earnings-driven outperformance lies ahead. At the moment, there is no such confirmation. In fact, the elevated reading in the SKEW index continues to signal that a defensive posture will optimize portfolio performance (Chart 5). In sum, we continue to characterize the broad market's current momentum as an overshoot phase, with additional technical upside potential, but the rally is starting to fray around the edges. In this environment, holding a mostly defensive basket with selective beta exposure is still recommended. Importantly, within the defensive universe, there are tweaks to be made, especially if the U.S. dollar stops rising. Fade The Pharmaceuticals Rebound Health care has been the second strongest of the eleven broad sectors year-to-date, contrary to popular perception. That is in line with the flattening yield curve, cresting in inflation expectations and a modest correction in oil prices (Chart 6), all of which have revived the allure of non-cyclical sectors. Moreover, our Cyclical Macro Indicator (CMI) for the health care sector remains firm, supported by the ongoing large pricing power advantage. Relative value is the most attractive it has been in five years. While the latter provides little timing help, it indicates low risk, especially with technical conditions still deeply oversold (Chart 7). Chart 6Health Care Is Storming Back Health Care Is Storming Back Health Care Is Storming Back Chart 7Still Cheap And Oversold Still Cheap And Oversold Still Cheap And Oversold The heavyweight pharmaceutical group has led the sector's tactical charge, recouping the ground lost, in relative performance terms, leading up to the U.S. election. While we were caught off guard by the severity of the pullback last September/October, we refrained from selling into an oversold market and noted our intention to lighten positions whenever the inevitable relief rally occurred. The time has come to execute on this thesis. Pharmaceutical stocks are very cheap and have discounted a hostile regulatory environment. The relative forward P/E is well below its historic mean, even though both 12-month and 5-year relative forward earnings growth expectations are depressed (Chart 8). Typically, the latter would serve to artificially inflate valuations. These conditions exist even though free cash flow growth remains strong; merger activity has been solid, albeit ebbing in recent months; and companies have used excess capital to reduce total shares outstanding (Chart 8). In other words, relative forward earnings would have to decline substantially to validate these expectations. Is this plausible? Much depends on the regulatory environment. While details of the U.S. Administration's proposal to replace the Affordable Care Act have started to leak out, final details are still elusive and legislative action is not imminent. So far, it appears as if a worst case scenario would see an increase in the number of uninsured Americans, with a rising cost of insurance (to the benefit of managed care companies). According to the Department of Health & Human Services, the uninsured rate of the U.S. population nearly halved from 16% in 2010 to 9% in 2015. That led to a lift in the number of procedures performed and bolstered hospital bottom lines. Hospitals are a major pharmaceutical buying group. Higher utilization rates fed increased pharmaceutical demand for a number of years. However, drug spending growth has dropped off, and if the legion of uninsured patients rises anew in the coming years, then hospital utilization rates will decline, taking drug consumption growth down with it. Moreover, Trump wants to streamline the FDA's approval process, which would ultimately boost the number of high margin new drugs coming to market. Drug stocks boomed back in the mid-1990s, the last time FDA approval rates accelerated meaningfully (Chart 9). Chart 8Full Capitulation Full Capitulation Full Capitulation Chart 9Full Capitulation Full Capitulation Full Capitulation But at the same time, if government is given leeway to negotiate drug prices directly with drug companies, then pricing power will continue to converge down toward overall corporate sector pricing power, especially if drug consumption rates ease (Chart 9). At the moment, drug consumption growth remains above the rate of overall consumption growth, but that is much slower than during the boom following the introduction of the Affordable Care Act. Retail sales at pharmacies are growing robustly, and hospitals are still adding staff, signaling that they continue to position for expansion, i.e. rising procedure volumes (Chart 10). On the downside, the strong U.S. dollar is a big drag on top-line growth. Drug imports exceed exports by a wide margin, resulting in a negative trade balance and a drag on U.S. drug company profits, all else equal. The combination of a sales growth deceleration and adequate channel inventories has capped drug output growth (Chart 10). That is a productivity and profit margin headwind. Against this background, the industry will need an external assist to deliver profit outperformance. Relative profit estimates rise when disinflationary forces reign supreme, as measured by the NFIB planned price hikes series (shown inverted, Chart 11). This measure of future corporate pricing power intentions has rolled over, but broader measures of inflation are creeping higher. Ergo, drug earnings forecasts may be challenged to keep pace with the overall corporate sector. Chart 10... But Growth Rates Are Slowing ... But Growth Rates Are Slowing ... But Growth Rates Are Slowing Chart 11Mixed Signals Mixed Signals Mixed Signals The good news is that even though U.S. dollar strength is an export drag, the negative drug trade balance suggests that it will hurt other industries more. Indeed, a rising currency often coincides with profit outperformance (Chart 11). There is not enough evidence that exogenous factors will offset slowing domestic drug consumption growth. In all, the case for a further and sustained relative performance recovery has weakened, and we are taking advantage of this year's oversold bounce to move to the sidelines. Bottom Line: Trim the S&P pharmaceuticals index to neutral. This position was deep in the money initially, but last year's downdraft pushed it into a loss position of 10%. BLBG: S5PHARX-JNJ, PFE, MRK, BMY, LLY, AGN, ZTS, MYL, PRGO, MNK. Restaurants: Increasing Appetite The broad consumer discretionary sector has been treading water, largely owing to fears that a border adjustment tax (BAT) will undermine the retailing sub-component. This consolidation has restored value and created an attractive technical entry point (Chart 12, bottom panel). Importantly, industry earnings fundamentals are on the upswing. Our consumer discretionary sector Cyclical Macro Indicator has perked up (Chart 12), supported by an increase in wages, and more recently, the decline in oil prices. The latter is freeing up disposable income, which consumers have an incentive to spend given that household net worth (HNW) has climbed to all-time highs as a percent of disposable income (Chart 13). Chart 12A Good Place To Shop A Good Place To Shop A Good Place To Shop Chart 13Piggyback The Wealth Effect Piggyback The Wealth Effect Piggyback The Wealth Effect While we remain overweight housing related equities (homebuilders and home improvement retailers) in addition to our upbeat view on the media and advertising complex, a buying opportunity has surfaced in the neglected S&P restaurants index. We booked gains on an underweight position and lifted exposure to neutral back in late-October. Since then, value has improved further, while leading sales indicators continue to firm. Stronger consumer finances should flow into the casual dining industry. Sales have already started to reaccelerate, and should climb further based on the leading message from HNW (Chart 14). The lower income, $15K-$35K, cohort is also feeling increasingly confident, according to the latest Conference Board survey data (Chart 14). Meanwhile, the National Association of Restaurants Performance Index has regained momentum (Chart 15), signaling increased activity and rising confidence among restaurateurs. While the gap between the cost of dining out and dining in remains wide, it has begun to narrow, which is a plus for store traffic, all else equal. Chart 14Buy Into Weakness Buy Into Weakness Buy Into Weakness Chart 15At A Turning Point Domestically... At A Turning Point Domestically... At A Turning Point Domestically... Chart 16... And Globally? ... And Globally? ... And Globally? Our restaurants profit margin proxy (comprising restaurants CPI versus a blend of the industry's wage bill and food commodity costs) is trending higher. That is notable because it has a good track record in leading relative earnings growth estimates (Chart 15). Nevertheless, it is not all good news. International exposure remains a headache. Typically, soft EM currencies warn of translation drags on foreign sourced revenue (Chart 16). This cycle, there is an offset, as EM interest rates have come down, which is a plus for domestic demand (Chart 16). Thus, the headwind from outside the U.S. should abate as the year progresses. Adding it all up, factors are falling into place for a playable rally in the under-owned and unloved S&P restaurants index. This group offers attractive quasi-cyclical defensive exposure to replace the S&P pharmaceuticals index, without the political and regulatory risks. Bottom Line: Redeploy funds from the pharma downgrade and boost the S&P restaurants index to overweight. BLBG: S5REST-MCD, YUM, CMG, SBUX, DRI. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

We bought the S&P health care facilities index last December after a steep post-election sell-off created a valuation and technical undershoot relative to the fundamental outlook. The doomsday concern was that President Trump would tear up the Affordable Care Act (ACA), potentially leaving millions without insurance: treating the uninsured is the bane of any hospital's existence. The index has outperformed by 12% since then, encouraged by a jump in analyst net profit revisions following upbeat profit results and guidance from industry heavyweights such as HCA Holdings, and a realization that any ACA action is likely to be more of a rework than a total rebuild. Our conviction level has decreased a notch. Our concern is primarily revenue based, rather than fear that provisions for doubtful accounts will suddenly deteriorate as a consequence of treating uninsured patients. Instead, the main push from the surge in the insured population and increase in procedures on the back of rising consumer confidence/job security is likely to peter out. Consumer spending on hospitals has already rolled over decisively on a growth rate basis, and is contracting compared with total consumer spending. The same is true of spending on physician visits. Fewer doctor visits mean a reduction in procedures performed at hospitals. Health care is a labor-intensive industry. Health care facilities staff up when they get busy and prune when capacity utilization slips. As such, slowing growth in hospital employment reinforces that patient volume growth is likely to ebb. In fact, the contraction in hospital hours worked signals the same ahead for hospital sales. Bottom Line: Downgrade the S&P 1500 health care facilities index to neutral, locking in a 12% profit since inception in December 2016. Please see yesterday's Weekly Report for additional details. Book Profits In Health Care Facilities Book Profits In Health Care Facilities

Highlights Portfolio Strategy A relapse in the global financials sector threatens to spill into U.S. financials as credit growth sinks. Bank equities are the most vulnerable to such a phase, given their reliance on rising interest rate expectations rather than increased lending. Take profits in the S&P health care facilities index and downgrade to neutral. Recent Changes S&P Health Care Facilities - Take profits of 12% and downgrade to neutral. Table 1Sector Performance Returns (%) As Good As It Gets? As Good As It Gets? Feature Momentum continues to trump all else, with the equity market surging to new all-time highs last week. However, in the background, the Fed is becoming steadily more hawkish, and the odds of a March rate hike have risen substantially. This should be cause for some trepidation. Chart 1Multiples Are Headed##br## Lower As The Fed Hikes Multiples Are Headed Lower As The Fed Hikes Multiples Are Headed Lower As The Fed Hikes The market advance since November has been supported primarily by valuation expansion, along with some improvement in corporate profits. The forward P/E has climbed to 18, its highest level in well over a decade. The scope for further expansion is limited. Importantly, if a transition to an earnings-led rally is in the offing, Fed funds expectations likely need to be ratcheted higher. Chart 1 shows that valuation multiples contract during Fed tightening cycles, using cycle-on-cycle analysis. Thus, the valuation expansion is inconsistent with a significant upgrade in the economic and profit outlook, particularly with return on equity so weak (Chart 1). In other words, the economy has good momentum, but that is not translating one for one to the corporate sector. Keep in mind that even a small two P/E multiple point decline requires 11% earnings growth for the market just to hold its ground. That is a tall order given the squeeze on profit margins from labor cost inflation and a strong U.S. dollar. Ironically, high multiples would be more durable if economic data softened enough for the Fed to hold its fire. Against this background, it is not surprising that a stealthy flight to safety has developed, although it is not uniform across asset classes. For instance, gold has outperformed most major currencies (note we recently upgraded the gold shares group as a portfolio hedge); global government yields have eased back while sovereign bond spreads have widened (Chart 2). In the U.S., the economically-sensitive transport group has rolled over in line with the yield curve narrowing (Chart 2), the equity SKEW index remains historically elevated, and a defensive vs. cyclical portfolio bias has outperformed handily since early December (Chart 2, bottom panel), on broad-based non-cyclical sector participation. These shifts, on the margin, signal that some investors are bracing for a bout of volatility. On the flipside, U.S. junk bond spreads have narrowed back to 2014 lows, and emerging market corporate bond spreads are testing similarly tight levels. The global purchasing manager survey recorded yet another monthly gain (Chart 3). Chart 2Contrarian##br##Alert... Contrarian Alert... Contrarian Alert... Chart 3... Defensives Can Outperform##br## When Growth Is Good ... Defensives Can Outperform When Growth Is Good ... Defensives Can Outperform When Growth Is Good Ergo, a systemic economic threat is not the main obstacle to further asset price appreciation. Rather, it is that expectations in some assets and sectors have become divorced from reality. Indeed, we have noted for the last two months the disturbing downtrend in bank credit growth and the unprecedented gap between strong 'soft' and pedestrian 'hard' economic data. Mixed economic and financial market messages suggest that any equity turbulence may be marked by a mostly rotational correction rather than a savage drawdown in the broad averages. Still, the latter cannot be ruled out given the high degree of complacency and buoyant profit and economic expectations. It is notable that defensive equities embarked on a massive outperformance phase when both U.S. and EM bond spreads were just as low as they are currently, i.e. they hit 'as good as it gets' levels (Chart 3). Any widening in corporate bond spreads would tighten financial conditions, spurring a slowdown in growth down the road. In sum, the odds of an equity market sweet spot extension beyond the very near run have diminished as a consequence of ongoing strong economic data, which reflects the easing in financial conditions a year ago. In terms of positioning portfolios, there is still a mismatch between developed and developing markets, as measured by the relative ISM indexes (Chart 3, fourth panel). The upshot is that defensives will continue to generate much more cash than their cyclical counterparts (Chart 3, bottom panel), supporting the nascent relative share price recovery. The financial sector could also be due for a correction. Financials And Banks: Where To Next? The global financials sector has cheered the firming in leading economic indicators and back up in bond yields since last autumn, but that celebration is likely drawing to a close. Euro area financials have rolled over, in line with renewed weakness in German government bond yields (Chart 4). Continued slippage in global yields could cap U.S. yields, thereby flattening the yield curve (Chart 5). U.S. financials are much more expensive than their euro area counterparts (Chart 5, bottom panel), suggesting heightened vulnerability. Chart 4Are EMU Financials ##br##Sending A Warning Signal? Are EMU Financials Sending A Warning Signal? Are EMU Financials Sending A Warning Signal? Chart 5Watch The##br## Yield Curve Watch The Yield Curve Watch The Yield Curve In our view, the S&P bank index contains the most downside vulnerability, in relative performance terms, of all the financial sector sub-components, especially if regulatory reform disappoints and/or is slow to evolve. True, as outlined in a Special Report published on October 3, 2016, interest rate expectations have a checkered history of predicting bank stock relative performance. When they do drive bank stocks, it is typically because most other profit drivers are lacking, as is currently the case (Chart 5, top panel). This cycle, interest rate spreads have been unduly suppressed by the zero lower bound. Under normal circumstances, when short-term interest rates are well above zero lower bound, banks can target a spread between rates on assets and liabilities. But when the fed funds rate is at zero, the spread is compressed, because banks generally cannot charge customers a penalty implied by negative interest rates on deposits (at least in the U.S.). As the Fed pushes interest rates back upward, banks may be able to return their spreads to their target levels, by raising deposit rates more slowly than loan rates. However, this dynamic has been fully priced in over the last few months and the risk is that higher net interest margins will not offset the lack of credit creation and/or that Fed funds rate expectations will level off if economic data start to disappoint. After all, Chart 6 shows that net interest margins can both widen and narrow when the Fed is hiking interest rates. Moreover, the yield curve is narrowing, after peaking two months ago. If rising fed interest rate expectations are the primary factor driving bank stock performance, then it follows that market expectations must continue to price in a much more hawkish rate environment in order to extend any rally in bank share prices. However, the global credit impulse is still negative, albeit less so, reflecting capital constraints and deleveraging. The Bank of International Settlements global credit impulse indicator has been an excellent leading indicator of relative bank profitability, and it is premature to expect earnings outperformance (Chart 7). U.S. credit data are also inconsistent with a major upshift in Fed funds interest rate expectations. Total loan growth is contracting, led by commercial & industrial loans (Chart 8). Commercial real estate loan growth has also turned lower. Chart 6Net Interest Margins And The Fed Net Interest Margins And The Fed Net Interest Margins And The Fed Chart 7Don't Chase Without Profit Support Don't Chase Without Profit Support Don't Chase Without Profit Support Chart 8Shrinking Balance Sheets Shrinking Balance Sheets Shrinking Balance Sheets The most recent Fed Senior Loan Officer Survey showed that banks are tightening lending standards in most categories, with the exception of mortgages (Chart 9). The number of banks reporting increased loan demand has also softened. Since the credit crisis, banks have shifted their balance sheet exposure toward businesses and away from consumers and residential mortgages, underscoring that a decent housing market is unlikely to provide an offset to lackluster corporate credit demand. Only mortgages have experienced an uptick in loan demand and availability of funds (Chart 9). This credit backdrop is not conducive to a much more aggressive Fed, reinforcing that it would be dangerous to discount a sustained and meaningful uptrend in net interest margins. To further confound the bank stock reward/risk profile, bank employment continues to rise steadily (Chart 10), even though balance sheet expansion is no longer a sure thing. We have shown in past Reports that bank stocks have almost always underperformed when bank employment is rising. Chart 9Credit Standars Are Tightening Credit Standars Are Tightening Credit Standars Are Tightening Chart 10Sagging Productivity Sagging Productivity Sagging Productivity The current combination of fading credit creation and rising employment has done a number on our bank productivity proxy. The latter is now contracting on a rate of change basis, warning that the expansion in bank stock valuations is due for a squeeze (Chart 10). Bottom Line: The run in bank stocks over the past few months is on the cusp of a reversal, based on the leading message from the euro area, sinking productivity and punk credit demand. Our financial sector preference remains skewed toward areas not dependent on credit creation, such as asset managers. Book Profits In Health Care Facilities We bought the S&P health care facilities index last December after a steep post-election sell-off created a valuation and technical undershoot relative to the fundamental outlook. The doomsday concern was that President Trump would tear up the Affordable Care Act (ACA), potentially leaving millions without insurance: treating the uninsured is the bane of any hospital's existence. At the time of purchase, the 52-week rate of change was diverging positively from the share price ratio after hitting deeply oversold levels, often a harbinger of a playable rally (Chart 11). That was particularly true given an historically high short position. The index has outperformed by 12% since then, encouraged by a jump in analyst net profit revisions following upbeat profit results and guidance from industry heavyweights such as HCA Holdings (Chart 11), and a realization that any ACA action is likely to be more of a rework than a total rebuild. Valuations remain appealing, but a technical breakout above key resistance levels requires increased confidence in the durability of profit outperformance. Is such a phase forthcoming? Our conviction level has decreased a notch. Our concern is primarily revenue based, rather than fear that provisions for doubtful accounts will suddenly deteriorate as a consequence of treating uninsured patients. Instead, the main push from the surge in the insured population and increase in procedures on the back of rising consumer confidence/job security is likely to peter out. Consumer spending on hospitals has already rolled over decisively on a growth rate basis (Chart 12, third panel), and is contracting compared with total consumer spending. The same is true of spending on physician visits. Fewer doctor visits mean a reduction in procedures performed at hospitals. Chart 11Hitting Resistance Hitting Resistance Hitting Resistance Chart 12Top-Line Trouble Ahead? Top-Line Trouble Ahead? Top-Line Trouble Ahead? Health care is a labor-intensive industry. Health care facilities staff up when they get busy and prune when capacity utilization slips. As such, slowing growth in hospital employment reinforces that patient volume growth is likely to ebb (Chart 12). In fact, the contraction in hospital hours worked signals the same ahead for hospital sales (Chart 12, bottom panel). The good news is that labor costs remain in check, as measured by the employment cost index for hospitals (Chart 13). Other input costs, such as the cost of medical equipment and supplies, have perked up (Chart 13), which may require increased pricing power in order to sustain profit margins. However, the revenue trends noted above suggest that hospitals may not experience a sufficient rise in patient volumes to the extent that restores pricing power to a more solid footing. Chart 14 shows that the consumer price index for hospitals is losing momentum relative to overall inflation. Durable outperformance phases require accelerating relative pricing power, in addition to a cooling in overall economic growth, as proxied by the ISM manufacturing index (see shading, Chart 14). Those conditions provide a durable competitive profit advantage. Chart 13A Mixed Picture For Costs A Mixed Picture For Costs A Mixed Picture For Costs Chart 14Shaky Long-Term Support Shaky Long-Term Support Shaky Long-Term Support Chart 15Macro Headwinds Macro Headwinds Macro Headwinds In addition, the ideal macro conditions for hospital stocks exist when consumer spending on overall health care services is accelerating relative to total spending. That implies that the providers of health care services have an advantage over those that pay for them, such as insurers. Total medical care spending is steadily decelerating (Chart 15), underscoring that investors are better off targeting investments in other parts of the sector. In sum, the forces required to sustain the oversold rally in the S&P 1500 health care facilities index are losing clout, so we recommend booking profits. Bottom Line: Downgrade the S&P 1500 health care facilities index to neutral, locking in a 12% profit since inception in December 2016. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Highlights Key Portfolio Highlights Improved world economic growth and rising inflation expectations have buoyed global equities (Chart 1). The downside is that financial conditions are tightening and U.S. dollar-based liquidity is contracting, which is growth restrictive (Chart 2). The massive outperformance of the financials and industrials sectors since the U.S. election implies that U.S. markets have been largely politically-motivated. Positive economic surprises remain mostly sentiment/confidence driven, rather than from upside in hard economic data (Chart 3). That unusually large gap implies that a big jump in 'hard data' surprises is already discounted and represents a latent risk, as it did in the spring of 2011 just before the summertime equity market swoon. Federal income tax receipts are contracting, suggesting that an economic boom is not forthcoming (Chart 4). In fact, there has never been a contraction in tax receipts without a corresponding slump in employment growth. Corporate sector pricing power gains have not been evenly distributed. Deep cyclicals gains came off a low base and may already be experiencing a relapse. Conversely, defensive and interest rate-sensitive sectors are demonstrating the most strength (Chart 5). Our macro models are not signaling that investors should position as if robust and self-reinforcing economic growth lies ahead. Our Deep Cyclical indicators are the weakest, while defensive and interest rate-sensitive models are grinding higher (Chart 6). Deep cyclical sectors are very overvalued and overbought, while defensives are deeply undervalued and oversold (Charts 7 and 8). Mean reversion is an apt theme for the next few months. The most attractive combination of macro, valuation and technical readings are in the consumer staples, health care sectors. The financials sector is a close second, but it is overbought. The least attractive combinations are in energy, materials and industrials. Prospects for elevated market volatility, stronger economic growth in developed vs developing economies, a tighter Fed and expensive U.S. dollar are consistent with maintaining a largely defensive portfolio structure (Charts 9-12). Chart 1Pricing Power Revival... Pricing Power Revival... Pricing Power Revival... Chart 2... But A Liquidity Drain ... But A Liquidity Drain ... But A Liquidity Drain Chart 3Show Me The Money Show Me The Money Show Me The Money Chart 4Yellow Flag Yellow Flag Yellow Flag Chart 5Pricing Recovery Is Not Broad Based Pricing Recovery Is Not Broad Based Pricing Recovery Is Not Broad Based Chart 6Indicator Snapshot Indicator Snapshot Indicator Snapshot Chart 7Focus On Value Focus On Value Focus On Value Chart 8Mean Reversion Ahead Mean Reversion Ahead Mean Reversion Ahead Chart 9Fundamentals Favor Defensives... Fundamentals Favor Defensives... Fundamentals Favor Defensives... Chart 10... As Do Market Signals ... As Do Market Signals ... As Do Market Signals Chart 1112-Month Performance After Fed Hikes Cyclical Indicator Update Cyclical Indicator Update Chart 1224-Month Performance After Fed Hikes Cyclical Indicator Update Cyclical Indicator Update Chart 13Staples Will Cushion A Volatility Resurgence Staples Will Cushion A Volatility Resurgence Staples Will Cushion A Volatility Resurgence Chart 14Media Stocks Like A Strong Currency Media Stocks Like A Strong Currency Media Stocks Like A Strong Currency Chart 15Unduly Punished Unduly Punished Unduly Punished Chart 16Strong Fundamental Support Strong Fundamental Support Strong Fundamental Support Chart 17Less Production... Less Production... Less Production... Chart 18... Means More Rigs ... Means More Rigs ... Means More Rigs Chart 19End Of Sugar High End Of Sugar High End Of Sugar High Chart 20A Toxic Mix A Toxic Mix A Toxic Mix Chart 21Tech Stocks Don't Like Inflation Tech Stocks Don't Like Inflation Tech Stocks Don't Like Inflation Chart 22Time To Disconnect Time To Disconnect Time To Disconnect Feature S&P Consumer Staples (Overweight - High Conviction) The Cyclical Macro Indicator (CMI) has been grinding higher for several months, even climbing through last year's share price shellacking. The CMI has been supported by the uptrend in relative consumer spending on essential items and consumer preference for saving vs. spending. More recently, a pricing power recovery in a number of groups has provided an assist as has a rebound in staples export growth. Booming consumer confidence and business confidence have held the CMI in check. The strong U.S. currency, particularly bilaterally against China, also implies a reduction in the cost of imported goods sold, and has also been an indication of relative valuation expansion because it often signals increased financial market volatility (Chart 13 on page 6). The attractive valuation starting point this cycle, and historic outperformance when the Fed raises interest rates (Chart 13 on page 6), were key factors behind our upgrade to high conviction status in January. Technical conditions are completely washed out. Sector breadth and momentum have reached oversold extremes. That signals widespread bearishness, which is positive from a contrary perspective. Chart 23 S&P Consumer Staples S&P Consumer Staples S&P Consumer Discretionary (Overweight) Our CMI is forming a tentative trough, supported by rebounding relative outlays on media services, low prices at the pump, a budding recovery in mortgage equity withdrawal and firming wage growth. The biggest drags over the past few months have come from higher Treasury yields and consumers increased propensity to save. However, rising job certainty and a vibrant residential real estate market suggest that consumers should loosen their purse strings. The VI has deflated toward the neutral zone, although remains moderately expensive from a long-term perspective. Our TI started to rebound from oversold levels. History shows that a recovery in the TI from one standard deviation below the mean has heralded a playable relative performance rally. Overweight positions should remain concentrated in housing-related equities and the media space, both of which benefit from U.S. dollar appreciation (Chart 14 on page 6). Chart 24 S&P Consumer Discretionary S&P Consumer Discretionary S&P REITs (Overweight - High Conviction) Our new REIT CMI has ticked lower, but the share price ratio has over-exaggerated this small move down. REITs have traded as if the back up in global bond yields will persist indefinitely, and that they are the only factor that drives relative performance. Improving cash flows and cheap valuations suggest that REITs can decouple from bond yields. Banks have tightened standards on commercial real estate loans, but this appears more likely to limit supply growth than create a slowdown. Commercial property prices are hitting new highs and our REIT Demand Indicator (RDI) has climbed into positive territory, signaling higher rental inflation. The latter is already outpacing overall CPI by a wide margin (Chart 15 on page 7). While REITs are back to fair value from a long-term perspective, on a shorter term basis the sector is very undervalued (Chart 15 on page 7), particularly with Treasury yields now in undervalued territory. Our REIT TI is extremely oversold, at a point which forward relative returns typically shine on a 12 and 24 month basis, even excluding the dividend yield kicker. Chart 25 S&P Real Estate S&P Real Estate S&P Health Care (Overweight) Our CMI continues to grind higher, opening a massive divergence with relative performance. This gap can be explained by the political attack on the pharmaceutical industry, the sector's heavyweight, rather than by a downturn in relative earnings drivers. Pharmaceutical shipments are hitting new highs and pricing power continues to grow at a robust mid-single digit rate. Future pricing gains may slow if government gets more heavily involved in setting prices, but this is already discounted. Pricing power in the rest of the sector remains strong, while wage inflation is tame. Health care spending is still growing as a share of total spending, but the pace is decelerating. Typically, this backdrop signals outperformance for health care insurers, who may also receive a risk premium reduction from a potential revamp of the Affordable Care Act, albeit the timing will likely be drawn out. Relative valuations are very attractive. The sector has been used as a source of capital to fund purchases in areas expected to benefit from increased fiscal stimulus. That is an overreaction, and flows should be restored to reflect the sector's appealing investment profile, particularly given the sector's track record during Fed tightening cycles (Chart 16 on page 7). The TI is deeply oversold. Breadth measures are beginning to recover from completely washed out levels. These conditions reinforce that an exploitable undershoot has occurred. Chart 26 S&P Health Care S&P Health Care S&P Financials (Neutral) Our Financial CMI has surged, underscoring that the advance in relative performance reflects more than just a reaction to anticipated sector deregulation by the Trump Administration. Leading indicators of capital formation, such as the stock-to-bond ratio, have jumped sharply. Moreover, the yield curve has steepened in recent months, bolstering the CMI. An improvement in overall profit growth and the tight labor market suggest that the credit cycle may not become a profit drag until the economy begins to cool. While not yet evident, the restrictive move in oil, the dollar and bond yields warn that disappoint may emerge in the coming months. It is notable that bank loan growth has dropped to nil over the last 3 months. C&I loan growth is contracting over that time period. Banks are hiring more aggressively, yet are tightening lending standards, suggesting productivity disappointment ahead. Despite the share price jump, value remains attractive after 8 years of financial repression. Our TI is overbought and breadth is beginning to recede, which is often a precursor to a consolidation phase. We are not willing to move beyond a market weight allocation at this juncture. Chart 27 S&P Financials S&P Financials S&P Energy (Neutral) Our CMI has plunged, probing all-time lows. Rising oil inventories and spiking wage inflation are exerting severe gravitational pull on the CMI, more than offsetting the budding recovery in domestic production. Refining margins are probing six year lows as the Brent/WTI spread has evaporated. Nevertheless, OPEC is finally curtailing production, joining non-OPEC producers (Chart 17 on page 8), which should ultimately help eat into excess global oil supply. History shows that once supply growth peaks, the rig count typically firms. That is a plus for energy services (Chart 18 on page 8), even though rising oil production will prove self-limiting for oil prices. High yield spreads have narrowed significantly from nosebleed levels, but industry balance sheets remain bruised. Net debt is historically elevated, EBITDA has yet to return to its glory days, and interest coverage remains anemic and vulnerable to any downside energy price surprises. The surge in our VI reflects depressed cash flow, and is overstating the degree of overvaluation. The TI has returned to the neutral zone, and will need to hold at current levels otherwise a relapse in the share price ratio toward previous lows is probable. Selectivity is still warranted in the energy complex. We remain underweight refiners and overweight the energy services index. Chart 28 S&P Energy S&P Energy S&P Utilities (Neutral) Our utilities sector CMI is stabilizing. That is a surprise, given the rebound in inflation expectations and firming global leading economic indicators, which are typically bearish for this defensive, fixed-income proxy. The latter negative exogenous factors are being offset by falling wage inflation, better pricing power and rising electricity output growth. Power demand is linked with manufacturing activity, underscoring that there is an element of cyclicality to sector profits. The share price ratio has held up better than most other defensive sectors since the U.S. election, perhaps on the hope that an overhaul of the tax code will benefit this domestic sector. Regardless, valuations have retreated from the extremely expensive zone where we took profits and downgraded to neutral last summer, but are not yet at a level that warrants re-establishing overweight positions. An upgrade could occur once our TI becomes fully washed out, provided that occurs within the context of additional CMI strength and a peak in global growth and inflation momentum. Chart 29 S&P Utilities S&P Utilities S&P Industrials (Underweight - High Conviction) The CMI has edged lower after a modest recovery in recent months. The strong U.S. dollar, relapse in short-term pricing power measures and sector productivity contraction are offsetting improvement in global PMI surveys. The lack of confirmation of an industrial sector revival from emerging markets is also holding back the CMI. There continues to be a deflationary undercurrent in the form of more rapid capacity than industrial sector output growth, suggesting that durable pricing power gains may remain elusive (Chart 19 on page 9). The post-election surge in share prices is slowly being unwound, as the sector was quick to discount expectations for massive domestic fiscal stimulus. Our valuation gauge is not at an extreme, although a number of individual groups are trading at historically rich multiples, such as machinery and railroads. Participation is beginning to fray around the edges, as our relative advance/decline line has rolled over, as has breadth. Our TI is pulling back from overbought levels, warning that a further correction in the share price ratio looms. It would be nearly unprecedented for the share price ratio to trough before our TI hits oversold levels. Industrials fare poorly when the Fed tightens. Chart 30 S&P Industrials S&P Industrials S&P Materials (Underweight) The CMI has nosedived, reflecting China's diminishing fiscal thrust and the recent tightening in monetary policy. Commodity price inflation peaked in mid-December concurrent with the Fed raising rates, signaling that emerging markets end-demand, in general and Chinese in particular, is likely past its prime. The nascent rebound in EM currencies represents a positive offset, but not by enough to turn around the CMI. Select heavyweight EM manufacturing PMIs are still below the boom/bust line. Relative valuations are becoming extended according to our VI, and stretched technical conditions are waving a red flag. Keep in mind the materials sector has an abysmal performance history after the Fed starts tightening (Chart 20 on page 9). The heavyweight chemical index (75% of the sector) bears the brunt of the downside risks owing to excess capacity (Chart 20 on page 9). On the flipside, overweight exposure in gold mining (via the GDX:US ETF) and the niche containers & packaging sub-indexes is recommended. Chart 31 S&P Materials S&P Materials S&P Technology (Underweight) The CMI has rolled over, driven lower by contracting relative pricing power, decelerating new orders-to-inventories growth, lack of capital expenditure traction and the appreciating greenback. Tech stocks thrive in a disinflationary/deflationary environment and suffer during inflationary periods (Chart 21 on page 10). Inflation is making a comeback, so it will be an uphill battle for tech companies to successfully raise selling prices at a fast enough pace to keep profits on a par with the broad corporate sector. While a capital spending cycle would be a welcome development, the narrowing gap between the return on and cost of capital warns against extrapolating improvement in business sentiment just yet. Our S&P technology operating profit model warns that tech profits are likely to trail the broad market as the year progresses, a far cry from what is embedded in analysts' forecasts. The good news is that valuations are not demanding nor are technical conditions overbought, which should cushion the magnitude and sharpness of downside risks. Chart 32 S&P Technology S&P Technology S&P Telecom Services (Underweight) Our CMI for telecom services has gained ground of late, primarily on the back of a sharp decline in wage inflation. However, we recently downgraded exposure to underweight, because of a frail spending backdrop. Our telecom services sales model is extremely weak (Chart 22 on page 10). Softening outlays on telecom services have reinvigorated the industry price war, and our pricing power gauge is sinking like a stone (Chart 22 on page 10). Telecom carrier capital expenditures have been running at a healthy clip, which could further pressure profit margins. Undervaluation exists, but this has been a chronic feature for the sector over the past decade, and does not foretell of cyclical upside or downside risks. Our TI has plunged into the sell zone, but remains above levels that would signal that a countertrend rally is imminent. Chart 33 S&P Telecommunication Services S&P Telecommunication Services Size Indicator (Overweight Small Vs. Large Caps) The small/large cap ratio is correcting short-term overbought conditions. The dip in the U.S. dollar has provided a fundamental reason for corrective action in this domestically-oriented asset class. However, we doubt a trend change is at hand. Our style CMI is climbing steadily. Small company business optimism has soared, partly because of an increase in planned price hikes, but also from an anticipated reduction in the regulatory burden. If small company price hikes persist, then rising labor costs will be more easily absorbed. That is critical to narrowing the profit margin gap between small and large firms. A stronger domestic vs. global economy and the potential for trade barriers is also unambiguously positive for small firms that do the bulk of their business at home. Despite the surge in the share price ratio post-U.S. election, our valuation gauge is not yet at an overvalued extreme. The lack of extreme overvaluation suggests that positive momentum will persist, perhaps similar to the 2004-2006 period, when the share price ratio stayed in overbought territory for years. Chart 34 Size Indicator (Small Vs. Large Caps) Size Indicator (Small Vs. Large Caps)

The downside of a transitioning to a self-reinforcing economic dynamic is tighter financial conditions. This backdrop poses a challenge for the high-beta biotech group. The top panel of the chart shows that more restrictive monetary settings tend to coincide with biotech underperformance (the shadow Fed funds rate is shown inverted). Higher interest rates boost the discount rate, undermining valuations in the highest multiple market sectors. Similarly, U.S. dollar liquidity drainage - which represents a tightening in global monetary conditions - has historically been an excellent indicator of biotech stock momentum: the current message is also bearish (second panel). On the back of Gilead's recent revenue warning, we expect the biotech bubble to continue to deflate. Bottom Line: We reiterate our high-conviction underweight status on the Nasdaq biotech index (ETF ticker: IBB:US). Biotech Stocks Don't Like Diminishing Liquidity Biotech Stocks Don't Like Diminishing Liquidity