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Exhibit 53: US Equity Performance Relative to Fixed Income Stocks have outperformed bonds following periods of muted return differences. Total Return Difference Between S&P 500 and 10-Year Treasury (%) 10 8 718 0 2s Difference Over Last 20 Years (19th Percentile Since 1945) 3 Years 5 Years Median Return Difference Over Subsequent Time Period When Starting from Bottom 20th Percentile Data as of December 31, 2016. Source: Investment Strategy Group, Bloomberg, Leuthold Group. Exhibit 54: US Equity and Bond Fund Flows Equities could benefit from rebalancing out of bonds given lopsided flows since 2009. Cumulative Fund Flows ($ bn} 1,600 5 Bonds |, «== Equities 1,467 1,200 1,000 - 800 600 400 200 a4 200 “ TN e477 -400 ~ 2009 2010 2011 2012 2013 2014 2015 2016 Data through November 30, 2016. Note: Beginning in March 2009. Source: Investment Strategy Group, Bloomberg, ICI. expansion in the US economy (see Section II, United States). The state of the business cycle is a key driver of market performance, evident in the tight linkage between the S&P 500 and the ISM Manufacturing Index (see Exhibit 51). Notably, the S&P 500 has generated positive annual total returns 86% of the time during economic expansions in the post-WWII period, while suffering annual declines of greater than 10% just 4% of the time. During the same postwar period, nearly three-fourths of the bear markets—defined here as declines of 20% or more—occurred during US recessions. With few signs of an economic contraction on the horizon, the high odds of positive returns and low odds of large losses raise the hurdle for underweighting equities significantly. This is particularly true because the risks are not one- sided: markets often surprise to the upside, too, even at high valuations. Last year was a case in point: the S&P 500’s 12% return matched our good-case scenario, although at the start of 2016 we had attached only 20% odds to it occurring. As we consider the potential for similar upside surprises in 2017, earnings growth tops the list for three reasons. First, we expect the sizable profit drag from energy earnings to reverse in 2017, with scope for a greater than $4-5 contribution to S&P 500 EPS if recently announced global oil production cuts are realized. Keep in mind that this contribution was closer to $15 prior to the collapse in oil prices. Second, a shift to a 25% corporate tax rate could add $9-10 to S&P 500 EPS in 2017 if enacted retroactively (see Exhibit 52). Finally, a tax holiday for the estimated $1 trillion of cash held overseas could lead to an additional $1-2 of EPS upside from repatriation-driven buybacks. There are also other, less visible potential catalysts for equities. Over the last 20 years, the total return of stocks has exceeded that of 10-year Treasury bonds by only 2 percentage points, well below the historical average of 4.4 percentage points and a result that ranks in the bottom 20% of all post-WWII observations. But after similar periods of underperformance, stocks generated well above average relative returns over the next three and five years (see Exhibit 53). Said differently, history suggests stock returns will outpace those of bonds, even if expected equity returns are uninspiring. A related source of upside stems from the lopsided investor flows evident in Exhibit 54. Here, even moderate rebalancing out of bonds by retail investors—who represent 80% of mutual fund owners—would represent a sizable tailwind to equities. Historically, a shift in flows from bonds into equities has been motivated by three factors: confidence in the durability of the economic recovery, unattractive prospects for bond returns and higher equity prices (see Exhibit 55). Our central case features all three factors, suggesting the Outlook | Investment Strategy Group 53 HOUSE_OVERSIGHT_014586