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Exhibit 48: S&P 500 Price-to-Trend Earnings vs. Subsequent Calendar-Year Price Return Starting valuation multiples tell us little about equity returns over the following year. S&P 500 Returns 1 Year Forward (%) 50 - R?=5.2% 40 « ° oe 30 ° od 4 ° « 20 ¢ @,¢ o ; ® ° 10 wees © te ‘: ——+-_ 0 __ #4@ 6 = ia ¢ © + e o°¢ ry ry . 20 4 ¢ e 30 ¢ 40 r 50 J 0 5 10 15 20 25 30 35 40 Price-to-Trend Earnings Multiple Data as of December 31, 2016. Source: Investment Strategy Group, Bloomberg, Datastream, Robert Shiller. Exhibit 49: S&P 500 Valuation Multiples by Inflation Environment Periods of low and stable inflation have supported higher equity multiples. Multiple (x) 30 5 m Unconditional Average Over Entire Period m Average During Periods in Which Inflation Is 1-3% and Stable 22.6 22.5 Shiller CAPE: 1881-2016 Shiller CAPE: 1945-2016 Price-to-Trend: 1945-2016 Data as of December 31, 2016. Source: Investment Strategy Group, Bloomberg, Datastream, Robert Shiller. This bull market is already quite old by historical standards, second in length only to the almost 10- year period that preceded the technology bubble in 2000. Moreover, valuations now stand in their 10th decile, indicating they have been cheaper at least 90% of the time historically. In the past, starting from such a high base has led to muted equity returns over the subsequent five years, with only a third of those episodes generating a profit (see Exhibit 47). Even so, high valuations should not be confused with certainty of loss, especially over short periods. As seen in Exhibit 48, today’s equity multiples tell us very little about potential gains over the next year, explaining only 5% of their variation historically. Moreover, history teaches us that a strategy of selling equities based solely on expensive valuations has been a losing approach over time. As we noted in our 2014 Outlook, research conducted by three professors at the London Business School concluded that Investors have ridden this bull market for eight years, and while we don’t expect the ride to end in 2017, we must stay vigilant to avoid the horns. underweighting equities based exclusively on high valuations underperformed a strategy of remaining invested across every one of the 20 countries and three country aggregates they examined.'¢ In short, valuations alone are a poor tactical timing signal. Indeed, the S&P 500 has returned more than 36% since first entering its 9th valuation decile in November 2013, a time when many were already suggesting that US equities were in a bubble. Valuations must also be considered in the context of the prevailing macroeconomic environment. Consider that periods of low and stable inflation, such as we expect for the year ahead, have supported higher valuations in the past (see Exhibit 49). The same could be said for lower taxes and deregulation—were they to materialize later this year—as both would boost real returns on invested capital and justify higher equity values. Similarly, today’s structurally lower interest rates— reflecting slower population and productivity growth—reduce the rate at which all future cash flows are discounted, increasing their present value. Here, it’s helpful to remember that the S&P 500’s long-term average P/E ratio— which many investors use to gauge fair value—was forged over a period when risk-free rates averaged 4.5%. In contrast, the risk-free rate now is just 0.5-0.75% and the Federal Reserve Outlook | Investment Strategy Group 51 HOUSE_OVERSIGHT_014584