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Weekly Market Notes
November 11, 2013
Dow 15762– S&P 500 1771

Stocks surged on Friday, sending the Dow Industrials to a new all-time high and pushing the S&P 500 toward the top-end of the near-term trading range that has emerged since late October. On a weekly basis, the S&P 500 rallied for the fifth week in a row, and made a new all-time weekly closing high. The new daily high on the Industrials has not been confirmed by a new high on the Dow Transports, and while the consolidation range on the S&P 500 is horizontal, the comparable pattern for the small-cap Russell 2000 has a distinctly downward bias. Momentum trends on both a short-term and intermediate-term basis argue for some consolidation, Friday’s broad gains notwithstanding. Trends in our shorter-term breadth indicators have rolled over, consistent with the pauses in the rally that have been seen previously this year. These indicators will likely have to turn higher to provide conviction that we have returned to sustainable rally mode for stocks.

In addition to the more cautious tone from the near-term price, breadth, and momentum trends, expectations for some consolidation in the popular averages are supported by the nearly universal optimism that can be found in the financial markets. As can be seen in the Sentiment Indicator table below, optimism in the sentiment surveys is widespread and the options data shows building complacency. The pattern so far this year is that excessive optimism is quickly relieved at the first sign of trouble for stocks. We will see in coming weeks whether that behavior is still intact. Ideally, we would see the AAII and Investors Intelligence surveys show a move towards an even split between bulls and bears and also see the NAAIM survey show a reading below 50%. Importantly, however, the strength of the cyclical rally is such that we do not need to see excessive pessimism, but are looking for relief from the excessive optimism. 

Any consolidation that is seen (and consolidation can occur either by price correction or the passage of time) should be understood within the context of an ongoing cyclical rally, of which there is little evidence that a top is in place. Longer-term breadth trends remain strong, with 94% of industry groups in uptrends, and historically, when stocks have coming into the final months of the year with a head of steam, strength tends to persist. According to Ned Davis Research, of the 14 times that the S&P 500 has been up 20% or more through the end of October, stocks have been up over the final two months on 12 occasions. The median return in those situations has been twice what is normally seen over the November–December time frame. Given the strong seasonal patterns and persistent broad market support, downside for the popular averages is expected to be limited. Good support is near 1730 on the S&P 500 and 1065 on the Russell 2000. Tactically, we would look to rotate out of underperforming areas on strength and look to add exposure to areas of emerging leadership on weakness.

From macro perspective, three news items generated much of the attention last week. The European Central Bank (ECB) provided a surprise rate cut of 25 basis points, the first look at Q3 GDP surprised on the upside, as 2.8% growth was reported, and the October employment report came in stronger than expected, with the economy generating over 200,000 new jobs in the month. Beneath the headlines on the GDP and employment reports, economic trends that have been intact for much of the past two years are little changed. A cyclical upswing in inventories in recent quarters has provided headline strength to the GDP data, but the growth in real final sales has been stuck at 2.0% for six of the last eight quarters (the outliers were the 3.4% growth in sales in Q1 12 and 0.2% growth in Q1 13). On the jobs front, over the past eighteen months, the yearly change in aggregate hours worked has moved in a narrow range around 2.0%. While these news items provided late-week volatility in equities, at the end of the day, the backdrop is little changed – global central banks are continuing to provide ample liquidity and the U.S. economy continues to plod along at a 2% growth rate.

The data flow this week will likely be quieter. The first look at November business activity will come with Friday’s release of the Empire Manufacturing Survey. Friday will also bring the release of the October Industrial Production data. Expectations are the production was up 0.2% in October, down from the 0.6% increase seen in September. We are moving towards the completion of Q3 earnings season and with 89% of the companies in the S&P 500 having now reported, EPS growth in the quarter is tracking at 3.4%, below the 7.2% growth that was expected at the beginning of the third quarter. Sales growth is close to 3%, but M&A activity appears to be driving much of this gain. Earnings expectations for Q4 have been reined in slightly, and for the full year, EPS growth is now expected to be about half of what was forecast at the beginning of the year (4.9% versus 9.5%). This is something to keep in mind when looking at expectations of 11% EPS growth in 2014.

Sector Rankings and Recommendations

No. 1 Industrials = Strong RS supported by strong breadth - Buy. Groups expected to outperform: Office Services & Supplies, Air Freight & Logistics, Industrial Conglomerates, Airlines and Construction & Engineering

No. 2 Consumer Discretionary = Strong RS but industry groups showing deterioration – Buy. Groups expected to outperform: Leisure Products, Advertising, Housewares & Specialties and Consumer Electronics

No. 3 Information Technology = Moved into RS leadership group – Industry group breadth remains narrow – Hold. Groups expected to outperform: Systems Software, Semiconductors and Application Software

No. 4 Consumer Staples = Sharp RS in recent weeks, but off a low level – Hold. Groups expected to outperform: Agricultural Products, Distillers & Vintners, Household Products, Tobacco, and Drug Retail

No. 5 Health Care = Sector continues to fade – Hold. Groups expected to outperform: Health Care Distributors, Health Care Facilities, and Health Care Equipment

No. 6 Materials = Sector RS has pulled back, but group-level trends still strong – Buy. Groups expected to outperform: Steel, Aluminum, Diversified Metals & Mining, and Specialty Chemicals

No. 7 Utilities = Finally out of the RS cellar – Hold. Groups expected to outperform: Gas Utilities and Independent Power Producers

No. 8 Financials = Poor RS – Hold. Groups expected to outperform: Asset Management & Custody Banks, Specialized Finance, and Insurance Brokers

No. 9 Energy = Poor RS – Hold. Groups expected to outperform: Oil & Gas Equipment & Services and Oil & Gas Refining & Marketing

No. 10 Telecom = RS improvement proved temporary – 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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