. Capital Market Projections

Our Capital Market Approach Purpose

Methodology

Expected returns for the capital markets are important inputs for both portfolio construction and for building retirement income projections. Although estimating future returns is difficult and the future is likely to be different from any projection, successful planning requires assumptions about the future. Our goal is to make reasonable, well-reasoned assumptions future returns that can be adapted to changes in the markets and allow for meaningful planning.

We recognize that historical returns play an important role, but the data is complex and should be adjusted based on current knowledge. Asset class returns are broken into components to construct reasonable expected returns for equity, fixed-income and other asset classes. We attempt to separate longer-term trends from shorter term "noise." Our projected returns for planning puposes assumes index-based returns for the broad U.S. and foreign stock and U.S. bond markets. Actual portfolio returns may include other asset classes and/or active management that could increase or decrease future returns.

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Our Capital Market Approach Assumptions

Risk and return are closely related over time, i.e., achieving higher returns requires accepting higher risk. For the longer-term, stocks and other equity oriented investments will provide higher returns than bonds or other forms of debt, after inflation and taxes. Returns expected from a given level of risk shift over time, i.e. risk premiums for stocks vs. bonds are not stable but change based on market conditions. Correlations between assets are not stable; therefore, the effectiveness of portfolio diversification changes over time. Full-bore market timing is an unproductive exercise that rarely produces good long-term results. Administrative and transaction costs should be minimized to produce the highest net return after all costs.

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Basic Components of Capital Market Returns

The returns for both stocks (equities) and bonds (fixed-income) are generally viewed over long periods of time as a product of changing "risk premiums," or the amount of return each earns over and above a less risky alternative investment.

Since 1926, for example, large company U.S. equities have earned an average risk premium of 4.1% over long-term U.S. government bonds. (Ibbotson)

In developing future returns and related risk premiums for stocks and bonds, it is helpful to breakdown the determinants, or components of return for each asset class.

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Equity Return Components Equity Return Dividend Yield

For equities, dividend yield is dividend payment divided by stock price. Dividend payments ultimately depend on earnings and amount of earnings paid as dividends (payout ratio).

+/Real Earnings Growth

In addition to cash dividends, equity shareholders also receive a return from real (inflation-adjusted) growth in earnings, which can be positive or negative.

+/Valuation Change

Equities are valued at varying multiples of earnings depending on changing economic conditions economic conditions, investor risk preferences, and other factors.

+/Size Premium

Small company and/or country stocks have historically earned a risk premium over stock of larger, more established companies.

+/Inflation

Equities share some characteristics with real assets and are impacted overtime by changes in the rate of inflation.

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Fixed Income Return Components Fixed Income Return U.S. Treasury Real Yield

Bond yields represent the return that equates the present value of all payment streams to the current price.

+/Inflation

Long-term interest rates are closely related to inflation expectations; higher expected inflation results in higher interest rates and lower bond prices.

+/Term Premium

Longer-term bonds generally have higher yields to compensate for term risk.

+/Credit Risk Premium

Corporate bonds historically command higher yields based on credit risk relative to government bonds.

+/Valuation Change

Bond values are inversely related to changes in interest rates and positively related to changes in credit ratings.

+/Default losses

Bond yields are reduced by losses resulting from default.

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Equity Component Forecast Components

Historical Data Forecast

Comments

Domestic Dividend Yield

2.00%

2.20%

Historical yield is adjusted upward by 0.2% to account for increased share buybacks and a trend toward higher payout ratio.

Foreign Dividend Yield

3.00%

3.50%

The current divident yield of 3.0% is adjusted upward by .5% to account for expected share repurchases.

Domestic Real Earnings Growth

2.00%

2.00%

Real Earnings growth averaged 2.0% since 1950 and 2.3% for the last 20 years. We expect growth to slow as deleveraging continues.

Foreign Real Earnings Growth

N/A

2.00%

Above average growth for emerging economies will drive overall foreign earnings and valuation higher than in the U.S.

Domestic Equity Valuation Change

N/A

-0.30%

We assume a reversion to the mean for 10-year cyclically adjusted P/E ratios, resulting in a negative 0.5% impact on stock returns.

Foreign Equity Valuation Change

N/A

0.00%

Change in foreign developed country valuation is projected as neutral based on lower P/Es and the impact of emerging economies.

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Fixed Income Component Forecast Components

Historical Data Forecast

Comments

U.S. Government Bond Real Yield

2.70%

1.00%

The current 10 year U.S. Government bond yields 2.0% nominally and a -0.8% after inflation; we expect higher real yields going forward.

Inflation

3.00%

2.80%

Inflation has averaged 3.0% since 1926. Current breakeven yields for U.S. TIPs indicate expected inflation of 2.8% for the next 10 years.

Term Premium

N/A

N/A

Since we start with the 10 year U.S. Treasury yield, no term premium is need for our forecast.

Credit Risk Premium

0.40%

0.50%

Increased debt combined with slower economic growth is expected to marginally increase credit risk spreads.

Loss Rate from Default

-0.07%

-0.15%

We expect investment grade credit defaults to increase marginally in a slower growth economy.

U.S. Bond Valuation Change

N/A

-1.50%

We expect a normalization of interest rates over the next 10 years to negatively impact bond prices.

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Asset Class Returns Expected Returns

Historical Returns

10-Year Projected Return

U.S. Large-Cap Equity

9.80%

6.70%

Slower U.S. economic growth combined with deleveraging will restrict 10-year returns.

U.S. Small-Cap Equity

11.90%

8.70%

Historical U.S. small-cap equity premium of 2.0% is expected to continue.

International Developed Equities

9.10%

8.30%

Continued transistion of emerging markets and better relative valuation drives higher foreign returns.

Emerging Market Equities

12.81%

10.30%

Based on higher growth in emerging and frontier economies, we project a 2.0% risk premium over developed markets.

Blended Equity Portfolio (70% U.S./30% Foreign) 10.11%

7.58%

Projected 70/30 U.S/Foreign blend for U.S. investors.

Comments

U.S. Long-Term Government Bonds

5.70%

2.30%

Normalization in interest rates drives bond prices lower.

U.S. Intermediate-Term Government Bonds

5.40%

2.00%

Historical relationships expected to continue.

U.S. Investment-Grade Corporate Bonds

6.10%

2.80%

Risk premium over government bonds expected to moderately increase.

Broad U.S. Bond Market (60% Govt/40% Corp)

5.86%

2.41%

Additon of mortgage-backed bonds, high-yield, and foreign bonds could improve basic return projections.

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Portfolio Return Matrix Expected Returns Given Asset Class Combinations

8.0% 7.0% 6.0% 5.0% 4.0%

3.0% 2.0% 1.0% 0.0% 100F 10E/90F 20/80 30/70 40/60 50/50

60/40 70/30 80/20 90E/10F 100E

Expected Returns

Expected Return

100F 2.4%

10E/90F 2.9%

20/80 3.4%

30/70 4.0%

40/60 4.5%

50/50 5.0%

60/40 5.5%

Assumptions Equity Return Fixed Income Return

7.58% 2.41%

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70/30 6.0%

80/20 6.5%

90E/10F 7.1%

100E 7.6%

Sources Sources for Historical Data: • • • • •

Ibbotson Stocks, Bonds, Bills, and Inflation Classic Yearbook (Chicago: Morningstar, 2012). Shiller, Robert, Yale University (http://www.econ.yale.edu/~shiller/data.htm). Interactive Data Corporation FactSet Research Systems Morningstar

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Disclosures DISCLOSURES Capital Market Projections 1. 2. 3. 4.

5.

6.

7. 8. 9.

The information provided in this report is for general informational purposes only and should not be considered an individualized recommendation of any particular security, strategy or investment product, and should not be construed as investment, legal or tax advice. Past performance does not guarantee future results. Proffitt & Goodson, Inc. makes no warranties with regard to the information or results obtained by third parties and its use and disclaims any liability arising out of, or reliance on the information. The information is subject to change and, although based on information that Proffitt & Goodson, Inc. considers reliable, it is not guaranteed as to accuracy or completeness. Source information is obtained from independent financial data suppliers (Interactive Data Corporation, Morningstar, etc.) The Market Categories illustrated in this Financial Market Summary are indexes of specific equity, fixed income or other categories. An index is a reflection of the underlying securities in a particular selection of securities picked due to a particular type of investment. These indexes account for the reinvestment of dividends and other income, but do not account for any transaction, custody, tax, or management fees encountered in real life. 6. To that extent, these index numbers are artificial and cannot be duplicated in real life due to the necessity of paying those transaction, custody, tax, and management fees. Blended Composite Indexes are an attempt to combine different index categories using different allocation ratios to show the effect of different portfolio allocation strategies in the past. Each different portfolio allocation strategy produces a different rate of return, but no attempt is made to conclude that one strategy is better or worse than any other. These Blended Composite Indexes are hypothetical, with the benefit of hindsight, and do not have real life transaction, custody, tax, or management fees charged to the portfolios. Future events will cause these historical rates of return to be different in the future with the potential for loss as well as profit. Specific indexes may change their definition of particular security types included over time. These Indexes or rates of return are not intended to reflect the actual outcomes of any client of Proffitt & Goodson, Inc. These indexes reflect investments for a limited period of time and do not reflect performance in different economic or market cycles.

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