August 16, 2013

Report prepared by: Ryan Lewenza, CFA, CMT

Q2/13 Earnings Recap and U.S. Sector Update Highlights

Overall, we give the Q2/13 earnings season a B rating, as results have generally beat lowered expectations. Of the 450 companies that have reported results, 324 (72%) reported earnings above analyst expectations. S&P 500 operating earnings are likely to come in around $26.50, which would mark a new quarterly high for the index and equate to Y/Y growth of 4.3%. Helping to drive the better-than-expected results were the financials and consumer discretionary sectors, which posted Y/Y growth of 28% and 11%, respectively. Top-line results were a challenge in the quarter, which should not be a surprise given slowing global growth seen for much of H1/13. Sales grew at 2.4% in the quarter, which was down from 8% in Q1/13. 56% of companies in the S&P 500 beat sales estimates, which is well below the long-term average beat rate of 62%. Corporate managers continue to be guarded in their outlooks, with 56 companies in the S&P 500 providing negative pre-announcements for Q3/13 quarterly results, versus 15 companies providing positive pre-announcements, according to Thomson Reuters. On February 14, 2013, we upgraded U.S. financials to marketweight, given improving fundamentals for the sector. With these supportive trends continuing, we are upgrading the sector to overweight. Our more constructive view of the sector is predicated on: 1) strong earnings, 2) improving fundamentals, 3) attractive valuations, and 4) strong technical trends. With interest rates on the rise we analyzed historical sector returns during previous periods of rising interest rates. As expected, the interest-sensitive sectors underperformed, with the utilities and telecommunications sectors posting weak relative returns. This supports are underweight position in these sectors. The strongest and most consistent outperformer was the information technology sector, which was the best performing sector in five of the six periods of rising interest rates. We remain overweight the sector. Consumer discretionary and materials at times outperform, however we remain underweight these sectors. Industrials generally outperformed the broader market, and we continue to recommend an overweight in the sector.

This Document is for distribution to Canadian clients only. Please refer to Appendix A of this report for important disclosure information.

U.S. Equity Strategy

August 16, 2013

Q2/13 Earnings Recap and U.S. Sector Update

With roughly 450 (90%) companies within the S&P 500 Index (S&P 500) having reported Q2/13 earnings results, we want to provide you with a recap of the quarterly results, and highlight the key trends that have emerged during the quarter. Overall, we give the Q2/13 earnings season a B rating, as results have generally beat lowered expectations. Of the 450 companies that have reported results, 324 (72%) reported earnings above analyst expectations (Exhibit 1). This level is in-line with Q1/13 quarterly results of 73%, but well above the long-term average of 62%. S&P 500 operating earnings are likely to come in around $26.50, which would mark a new quarterly high for the index and equate to Y/Y growth of 4.3% . Admittedly, expectations were greatly reduced heading into the quarter (analysts were forecasting earnings of $27.60 in the beginning of the quarter), but companies on aggregate delivered a 2.8% upside earnings surprise. Helping to drive the better-than-expected results were the financials and consumer discretionary sectors, which posted Y/Y growth of 28% and 11%, respectively. These sectors also posted strong results relative to analysts estimates, with the financials and consumer discretionary sectors posting upside earnings surprises of 8.8% and 3.4%, respectively. On the negative side were the resource-based sectors, with the materials and energy sectors posting negative Y/Y growth of 11.6% and 8.4%, respectively. As seen in Exhibit 1, the 4.3% Q2/13 growth rate is up from 3.6% in Q1/13, and is slowly trending higher following weakness seen in H2/12. For the second half of the year, analysts estimates are pointing to a significant improvement in earnings, with S&P 500 Q3/13 and Q4/13 earnings projected to be $27.12 and $29.15, which equates to growth of 7.4% and 16.4%, respectively. While we believe economic momentum is set to reaccelerate in H2/13, which should support higher earnings growth, we continue to believe that consensus expectations are too high, with Q4/13 estimates likely to be revised lower. As such, we maintain our full-year S&P 500 earnings forecast of $108, versus consensus at $110. Exhibit 1: Decent 72% EPS Beat Rate in Q2/13; S&P 500 Earnings Grew at 4.3% Y/Y
S&P 500 Quarterly EPS Beat Rate
25.0%
85% 82% 80% 80% 78% 76% 75% 72% 70% 73% 74% 72% 70% 68% 71% 73% 73% 72%
22.5% 22.4% Consensus forecasts 15.0% 15.2% 16.4%

S&P 500 Quarterly Earnings Growth Y/Y

20.0%

15.0%

10.0%

7.6% 3.6% 0.6% 1.7% 4.3%

7.4%

65%

5.0%

Long-term Average = 62%

60% Q1/10 Q2/10 Q3/10 Q4/10 Q1/11 Q2/11 Q3/11 Q4/11 Q1/12 Q2/12 Q3/12 Q4/12 Q1/13 Q2/13

0.0% Q1/11 Q2/11 Q3/11 Q4/11 Q1/12 Q2/12 Q3/12 Q4/12 Q1/13 Q2/13 Q3/13 Q4/13

Source: Bloomberg Finance L.P. As at August 13, 2013

Source: Bloomberg Finance L.P. As at August 13, 2013

Top-line results were a challenge in the quarter, which should not be a surprise given slowing global growth seen for much of H1/13. Sales grew at 2.4% in the quarter, which was down from 8% in Q1/13 (Exhibit 2). 56% of companies in the S&P 500 beat sales estimates, which is well below the long-term average beat rate of 62%. On the positive side, there was an increase in the companies that beat sales estimates from 49% in Q1/13 to 56% in Q2/13, driven by strong revenue beats in the information technology and utilities sectors. Exhibit 2: S&P 500 Sales Growth Slows to 2.4%; Sales Beat Rate Increases to 56% in Q2
20% 15% 10% 5% 0% -5% -10% -15% -20% -25% 99 00 01 02 03 04 05 06 07 08 09 10 11 12 S&P 500 sales growth slowed to 2% in the quarter.

S&P 500 Sales Y/Y Growth Rate

S&P 500 Quarterly Sales Beat Rate

90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Q1/10 Q2/10 Q3/10 Q4/10 Q1/11 Q2/11 Q3/11 Q4/11 Q1/12 Q2/12 Q3/12 Q4/12 Q1/13 Q2/13
67% 60% 68% 63% 69% 73% 66% 61% 56% 61% 56% 49% 42% 40%

Long-term Average = 62%

Source: Bloomberg Finance L.P. As at August 13, 2013

Source: Bloomberg Finance L.P. As at August 13, 2013

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U.S. Equity Strategy Other Observations from Q2/13

August 16, 2013

S&P 500 net profit margins increased 40 basis points (bps) Q/Q to 9.54% in Q2/13, which marks the second quarter of margin expansion following Q4/12s weak margin results. We find this interesting, given the recent surge in U.S. Treasury yields, with the 10-year yield increasing roughly 100 bps to 2.60% since early May (Exhibit 3). Based on analysis weve read, lower interest expense for S&P 500 companies, as a result of record low interest rates, has contributed roughly 70 bps to net margins in recent years. As interest rates reverse and move higher, we believe this tailwind for earnings, and therefore margins, could become a headwind in the coming quarters. Corporate managers continue to be guarded in their outlooks, with 56 companies in the S&P 500 providing negative pre-announcements for Q3/13 quarterly results, versus 15 companies providing positive preannouncements, according to Thomson Reuters. This results in a negative/positive ratio of 3.73, which is above the long-term average of 2.40, but well below last quarters 5.90 level.

Exhibit 3: Net Margins Expand Despite the Backup in Yields; Forward Guidance Remains Guarded
% 3.00

U.S. 10-Year Government Bond Yield

2.50

2.00

S&P 500 Pre announcements Positive In-Line Negative Total N/P Ratio
Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13

Q3/13 Total (#) Total (%) 15 20 4 5 56 75 75 3.73

Q2/13 Total (#) Total (%) 10 13 8 10 59 77 77 5.9

1.50

1.00 Jan-12

Source: Bloomberg Finance L.P. As at August 13, 2013

Source: Thompson Reuters. As at August 2, 2013.

Sector Update Upgrading U.S. Financials to Overweight On February 14, 2013, we upgraded U.S. financials to market weight, given improving fundamentals for the sector. With these supportive trends continuing, we are upgrading the sector to overweight. Our more constructive view of the sector is predicated on the following factors: The sector continues to deliver strong earnings growth with 25%+ EPS growth in three of the last four quarters. The financials sector is also seeing the strongest earnings revisions trends of any S&P 500 sector. The sectors strong earnings and improving fundamentals are in part being driven by an improvement in the U.S. housing and labour markets, lower loan loss provisions, improved stability in Europe, and more recently, a steepening yield curve, which should help drive higher net interest margins. Despite the rally in the sector, valuations remain attractive, with the sector trading at 1.28x P/B (a 14% discount to its 10-year average) and a 20% discount to where it typically trades relative to the S&P 500 (Exhibit 4). Finally, from a technical perspective, the sector continues to show strong relative strength, as it has outperformed the S&P 500 since early 2012.

Exhibit 4: Financials Sector is Trading at a 20% Discount to Average While Its Relative Strength Remains Strong
S&P 500 Financials P/B Relative to S&P 500
0.90 0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09 '11 '13
S5FINL Index Average

S&P 500 Financials Price Relative to S&P 500

0.18
S&P 500 FINANCIALS INDEX Relative to S&P 500

0.16

Financials trading at a significant P/B discount relative to the S&P 500.

0.14 Aug 10

Feb 11

Aug 11

Feb 12

Aug 12

Feb 13

Source: Bloomberg Finance L.P. As at August 13, 2013

Source: Bloomberg Finance L.P. As at August 13, 2013

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U.S. Equity Strategy

August 16, 2013

Sector Performance in a Rising Interest Rate Environment Finally, with the recent 100 bps rise in the 10-year Treasury yield and it breaking above an important technical resistance level, we wanted to contrast our current sector recommendations with historical sector returns during previous periods of rising interest rates. In Exhibit 5 we provide relative sector returns (versus the S&P 500) in six different periods of rising interest rates, along with rankings for each period. Some key highlights of this analysis include: As expected, the interest-sensitive sectors underperformed, with the utilities and telecommunications sectors posting weak relative returns, and consistently ranking at the bottom of the sector rankings. This data supports our underweight recommendation in these sectors. The strongest and most consistent outperformer was the information technology sector, which was the best performing sector in five of the six periods of rising interest rates. We are overweight this sector and note that the S&P 500 Information Technology sector recently broke above an important resistance level of 500, with improving relative strength. The consumer discretionary sector showed mixed but generally positive relative returns in periods of rising interest rates. We remain underweight in this sector, partly due to the high valuations for the sector. Industrials generally outperformed the broader market, with the sector outperforming the S&P 500 in four of the six periods. We continue to recommend an overweight position in the sector, and note that the ISM Manufacturing Index jumped to 55.4 in July, the highest reading since June 2011. The strength in the manufacturing sector should support industrial stocks in the H2/13. The materials sector has also outperformed the broader market, but given weak global growth trends, weak earnings outlook and technical trends, we maintain our underweight position in the sector.

Exhibit 5: Historical Sector Returns During Periods of Rising Interest Rates

Periods of Rising Rates Sector Performance S&P 500 ENERGY INDEX S&P 500 MATERIALS INDEX S&P 500 INFO TECH INDEX S&P 500 CONS DISCRET IDX S&P 500 INDUSTRIALS IDX S&P 500 HEALTH CARE IDX S&P 500 CONS STAPLES IDX S&P 500 UTILITIES INDEX S&P 500 TELECOM SERV IDX S&P 500 FINANCIALS INDEX 10/8/93-11/11/94 Rel. Ret. Rank -5.21 7 10.99 4 23.50 1 -4.02 6 0.06 5 20.59 2 12.64 3 -24.63 10 -11.22 8 -11.91 9 01/19/96-06/12/96 Rel. Ret. Rank -0.63 5 0.75 4 10.01 1 8.83 2 2.81 3 -1.46 8 -1.22 7 -15.82 10 -13.91 9 -1.15 6 10/05/98-01/20/00 Rel. Ret. Rank -31.65 7 -25.73 6 121.82 1 17.18 2 -3.38 3 -36.08 8 -48.80 9 -53.87 10 -8.42 4 -22.86 5 06/13/03-06/14/04 Rel. Ret. Rank 5.02 3 5.94 2 7.15 1 1.24 5 4.72 4 -8.80 8 -0.28 6 -9.78 10 -9.46 9 -1.81 7 06/01/05-06/28/06 Rel. Ret. Rank 20.61 1 5.91 2 -7.90 9 -5.07 8 3.06 5 -9.16 10 -2.04 7 1.48 6 3.75 4 4.37 3 12/30/08-06/16/09 Rel. Ret. Rank 0.22 4 14.03 2 20.74 1 5.02 3 -5.87 6 -8.27 9 -6.95 7 -7.21 8 -9.70 10 -4.92 5

Source: Bloomberg Finance L.P., Portfolio Advice & Investment Research. As at August 13, 2013 Note: Sector returns are relative to the S&P 500.

Conclusion With the improving fundamentals and confirming technical trends, we are increasing the U.S. financials sector to overweight. The financials sector joins our other overweight positions in the industrials, information technology and health care sectors. In a rising interest rate environment, information technology and industrials generally outperform the broader market, which provide support to our overweight recommendation. Conversely, we recommend an underweight position in the utilities and telecommunications sectors, which is supported by historical data, as these sectors typically underperform during periods of rising interest rates.

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U.S. Equity Strategy

August 16, 2013

Appendix A Important Disclosures

General Research Disclaimer The statements and statistics contained herein are based on material believed to be reliable, but are not guaranteed to be accurate or complete. This report is for informational purposes only and is not an offer or solicitation with respect to the purchase or sale of any investment fund, security or other product. Particular investment, trading, or tax strategies should be evaluated relative to each individuals objectives. Graphs and charts are used for illustrative purposes only and do not reflect future values or future performance. This document does not provide individual financial, legal, investment or tax advice. Please consult your own legal, investment and tax advisor. All opinions and other information in this document are subject to change without notice. The Toronto-Dominion Bank and its affiliates and related entities are not liable for any errors or omissions in the information or for any loss or damage suffered. TD Waterhouse Canada Inc. and/or its affiliated persons or companies may hold a position in the securities mentioned, including options, futures and other derivative instruments thereon, and may, as principal or agent, buy or sell such securities. Affiliated persons or companies may also make a market in and participate in an underwriting of such securities. Technical Research Disclaimer The opinions expressed herein reflect a technical perspective and may differ from fundamental research on these issuers. Fundamental research can be obtained through your TD Wealth advisor or on the Markets and Research site within WebBroker. The technical research opinions contained in this report are based on historical technical data and expectations of the most likely direction of a market or security. No guarantee of that outcome is ever implied. Research Report Dissemination Policy TD Waterhouse Canada Inc. makes its research products available in electronic format. These research products are posted to our proprietary websites for all eligible clients to access by password and we distribute the information to our sales personnel who then may distribute it to their retail clients under the appropriate circumstances either by email, fax or regular mail. No recipient may pass on to any other person, or reproduce by any means, the information contained in this report without our prior written consent. Analyst Certification The Portfolio Advice and Investment Research analyst(s) responsible for this report hereby certify that (i) the recommendations and technical opinions expressed in the research report accurately reflect the personal views of the analyst(s) about any and all of the securities or issuers discussed herein, and (ii) no part of the research analysts compensation was, is, or will be, directly or indirectly, related to the provision of specific recommendations or views expressed by the research analyst in the research report. Conflicts of Interest The Portfolio Advice & Investment Research analyst(s) responsible for this report may own securities of the issuer(s) discussed in this report. As with most other employees, the analyst(s) who prepared this report are compensated based upon (among other factors) the overall profitability of TD Waterhouse Canada Inc. and its affiliates, which includes the overall profitability of investment banking services, however TD Waterhouse Canada Inc. does not compensate its analysts based on specific investment banking transactions. Corporate Disclosure TD Wealth represents the products and services offered by TD Waterhouse Canada Inc. (Member Canadian Investor Protection Fund), TD Waterhouse Private Investment Counsel Inc., TD Wealth Private Banking (offered by The Toronto-Dominion Bank) and TD Wealth Private Trust (offered by The Canada Trust Company). The Portfolio Advice and Investment Research team is part of TD Waterhouse Canada Inc., a subsidiary of The Toronto-Dominion Bank. Trade-mark Disclosures Bloomberg and Bloomberg.com are trademarks and service marks of Bloomberg Finance L.P., a Delaware limited partnership, or its subsidiaries. All rights reserved. TD Securities is the trade name which TD Securities Inc. and TD Securities (USA) LLC. jointly use to market their institutional equity services. TD Securities is a trade-mark of The Toronto-Dominion Bank representing TD Securities Inc., TD Securities (USA) LLC, TD Securities Limited and certain corporate and investment banking activities of The Toronto-Dominion Bank. All trademarks are the property of their respective owners. /The TD logo and other trade-marks are the property of the Toronto-Dominion Bank or a wholly-owned subsidiary, in Canada and/or in other countries.

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