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Weekly Market Notes

September 30, 2013

Dow 15258– S&P 500 1691  

S&P 500 futures are down sharply in Sunday-night trading as concern over a government shutdown steepens. Failure to find common ground on the new health care law and the size of the federal budget over the weekend likely means the equity markets will remain on the defensive. Stocks also face the uncertainty surrounding a potentially more difficult fight over the debt ceiling in the next few weeks. In addition, third quarter earnings begin to flow next week. This is a concern given that more than 70% of CFOs have warned of potential revenue shortfalls. Given that P/E ratios are already at lofty levels it will be important that corporate earnings soon begin to show improving trends. A large potential problem looming over these events is the fact that sentiment indicators show widespread and deeply seated complacency among investors. This argues that many are little prepared for any negative surprises out of Washington or in the economy. As a result aggressive new buying should wait for stocks to enter the support zone of 1630 to 1655, using the S&P 500, or when investor complacency turns to fear. The strongest sectors are those closely tied to the economy including the industrials, materials and financials.      

The short-term technical indicators argue that the current consolidation/correction phase could continue into mid-October. This fits with the fact that the weakest seasonal period of the year for stocks is from mid-September to mid-October. The market has also lost upside momentum and market breadth is exhibiting signs of deterioration. At the two market peaks in September, the number of issues reaching new 52-week highs surprisingly fell and the percentage of industry groups in uptrends failed to improve into the rally. Investor sentiment, however, is likely the key to the next important move in the equity markets.  Over the previous four years the bearish camp has been quick to gather followers on negative news and shallow price declines. Should this pattern hold true in the current example it would add confidence to our anticipation of a resumption of the rally in November and December. Prior to becoming aggressive we would need to see the bears in the AAII Survey overwhelm the bulls by a ratio of 2 to 1.  Investors Intelligence data should show a drop in bulls to 30% and a rise in bears above 25%.  CBOE put/call ratios should soar above 100% and the NAAIM Report should show aggressive money managers have less than 25% in stocks. 

The U.S. economy remains fragile but there are some areas that show promise of improving trends. The U.S. economy grew at a 2.5% clip in the second quarter, which was below consensus of 2.8%. Average growth in the first half of 2013 was 1.8%, which matches the 1.7% rate for 2011 and 2012.  The economy has benefited from a boom in refinancing and more recently from lower gasoline prices. Nevertheless, persistent drags on growth remain including higher taxes and uncertainty over health care.  As a result the labor markets remain in disrepair despite the unemployment rate falling to 7.3% in August. More people continue to leave the labor force every month than those who find jobs. The difficulty in finding higher paying jobs is weighing on consumer spending that has been very uneven the past five months.  The demand for autos remains strong but it appears that buying a car on credit is subtracting from the consumers ability to spend elsewhere.

Developing trends in the housing market are mixed. New home sales rebounded in August as buyers attempted to front run the increase in mortgage costs.  New homes sales for the prior three months, however, were revised downward.    New home inventory rose in August to the highest level since the first quarter of 2011.   Pending home sales fell for the third month in a row in August. The sharp rally in the bond market the past two weeks could provide relief in mortgage rates that have been responsible for the slowdown in real estate transactions in the third quarter. In other reports, the Conference Board’s Consumer Confidence Index fell in September to 79.1 from 81.8.  It was the second drop in the past three months, a signal that consumers are less confident about the jobs market.  The lower level of confidence by consumers showed up in the latest retail statistics.  The ICS/Goldman Sachs Chain Store Sales Index fell 1.0% last week and Redbook sales declined 0.4% in the first three weeks of September.  Business reports of significance this week include the ISM Manufacturing Index to be reported on Tuesday.  The September ISM data is anticipated to be down slightly from the August figures.  The September Employment Report is due Friday with most economists anticipating that the economy generated 180,000 new jobs last month.  The unemployment rate is expected to be unchanged at 7.3%.   The economic reports this week are not anticipated to change Fed strategy with any reduction in bond purchases unlikely until 2014.   

Sector Rankings and Recommendations

No. 1 Industrials = Strongest sector - Buy. Groups expected to outperform:   Employment Services, Office Services & Supplies, Air Freight & Logistics, Construction & Farm Machinery, Electrical Components & Equipment and Aerospace & Defense

No. 2 Consumer Discretionary = Strong RS – Buy. Groups expected to outperform: Auto Parts & Equipment, Broadcast & Cable TV, Casinos & Gaming, and Consumer Electronics

No. 3 Materials = Gaining in RS – Buy. Groups expected to outperform:  Paper Packaging, Steel, Industrial Gases, Diversified Metals & Mining, and Diversified Chemicals

No. 4 Financials = Uptick in RS – Hold.  Groups expected to outperform: Investment Banking & Brokerage, Multi-line Insurance, and Insurance Brokers

No. 5 Health Care = Continued good RS – Buy. Groups expected to outperform: Health Care Distributors, Managed Health Care, and Biotechnology

No. 6 Information Technology = No improvement in RS – Hold. Groups expected to outperform: Application Software, Office Electronics, Computer Storage & Peripherals, Computer Hardware and Electronic Manufacturing Services

No. 7 Energy = Poor RS – Hold.  Groups expected to outperform:  Oil & Gas Equipment & Services and Oil & Gas Exploration & Production

No. 8 Consumer Staples = Losing RS – Hold.  Groups expected to outperform: Food Retail, Agricultural Products, Distillers & Vintners and Drug Retail

No. 9 Utilities = Small uptick in RS – Hold. Groups expected to outperform:  Gas Utilities and Independent Power Producers

No. 10 Telecom = Weakest sector – Hold. Groups expected to outperform:  Wireless Telecom Services   

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Article provided by Robert W. Baird & Co. with the authorization of its author for Evan Guido, Vice President, Financial Advisor at the Sarasota office of Robert W. Baird & Co., member SIPC. The opinions expressed are subject to change, are not a complete analysis of every material fact and the information is not guaranteed to be accurate. 

Evan R. Guido

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