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Weekly Market Notes
December 9, 2013
Dow 16020–S&P 500 1805

The equity markets, responding to a better than expected November jobs report, rallied sharply on Friday breaking a five day string of losses that allowed the popular averages to end the week unchanged. Earlier in the week there was concern that in the wake of some favorable economic reports the Fed could reduce the level of stimulus sooner than expected. By Friday the prospects of a Fed taper had already been built into stock prices and perhaps more importantly into bond prices. The fact that bond yields did not rise appreciably despite the best string of economic data in recent memory set the stage for stocks to soar on the good jobs data. The Fed meets on December 18 and despite the improving economic numbers it is unlikely Bernanke will change policy.

The Fed Chairman has previously stated that before reducing the level of quantitative easing unemployment would need to fall to 6.5% and inflation to rise above 2.0%. Improving business conditions, a seasonal tailwind and a friendly Fed provides a strong argument that stocks could enjoy a good finish to an exceptional year for investors. Historically, the year-end or Santa Claus rally does not get underway until very close to Christmas. The first half of December is often frustrating as stocks tend to be anchored by cross currents related to tax considerations. Areas of the market that typically do best at year-end are small caps and growth issues. Looking further out, long-term trends remain favorable but we are also concerned about rising stock market valuations and excessive investor optimism.

The technical condition of the stock market is mixed. Breadth indicators have exhibited little improvement in recent weeks. We view this as part of a consolidation phase following one of the strongest stock market performances since 2003. Market breadth will take on significantly more importance in January which typically sets the tone for the rest of the year. There has also been deterioration in foreign markets, most notably Europe. It will be important that global markets gain traction early in the New Year. 

Investor sentiment remains our largest concern. The weakness in early December has cooled some of the enthusiasm as seen in the jump in the CBOE Volatility Index and fewer bulls showing up in the survey from the American Association of Individual Investors (AAII). The report from Investors Intelligence (II), which tracks the recommendations of the Wall Street letter writers, is more worrisome. Bears among the advisors have fallen to levels last seen in 1987 and the number of bulls among the letter writers is approaching 60%, which historically has been the number that stops a rally. Should investor optimism continue to rise early next year stocks could experience a significant pull back sometime in the first quarter of 2014.

The economic data that had been running mixed for most of 2013 broke-out on the upside with last week’s series of favorable reports. November payrolls increased by 203,000, the average workweek upticked and the unemployment rate fell to the lowest level in five years. The improvement in the labor markets increases the odds the Fed will reduce the level of quantitative easing by March of 2014. Third quarter GDP growth was revised up to a 3.6% annual rate from 2.8%. The third quarter number was the biggest since the first quarter of 2012 and considerably above the average gain the past three years.

The principal source of the upward revision was inventory investment and capital expenditures. The only flaw within the report was final demand. Final sales, excluding inventories, was revised down to a 1.9% rate versus 2.0%. Jobless claims for unemployment insurance plunged 23,000 last week to the second lowest level since 2007. Typically, consumer confidence is most closely tied to the trend in stock prices and the health of the labor markets. Bloomberg’s Consumer Comfort Index rose 2.4 points last week just in time perhaps for Christmas sales that thus far have been disappointing. 

In separate reports last week the ISM Manufacturing Index rose in November to the best level since April 2011. The latest reading of 57.3 is historically consistent with above trend output growth. The ISM Price Index fell in November indicating low inflationary pressures. Stronger growth with no inflation offers stocks a goldilocks scenario into 2014. The ISM Non-Manufacturing Index, however, fell slightly last month indicating services activity grew at a slower pace. According to Ned Davis Research, the latest ISM data corresponds to a 2.5% real GDP annual growth rate.

Next week’s economic reports include November retail sales which are anticipated to show an increase of 0.6% versus 0.4% the previous month. The November Producer Price Index (PPI) is expected to show wholesale prices rose 0.1% for the month versus a drop of 0.2% in October. The low level of inflation offers the Fed a pass on redefining the level of quantitative easing. The yield on the benchmark 10-year Treasury note climbed to 2.86% from 2.74% the previous week. Bond prices behaved better than expected given the strong chain of economic data last week. This offers further evidence that a reduced level of bond buying next year is already built into current prices.   

Sector Rankings and Recommendations

No. 1 Consumer Discretionary = Strong RS – Buy. Groups expected to outperform: Leisure Products, Housewares & Specialties, Department Stores, Specialty Stores and Consumer Electronics

No. 2 Information Technology = Good RS – Buy. Groups expected to outperform: Systems Software, Application Software, Office Electronics, Data Processing & Outsourced Services, Computer Hardware and Internet Software & Services  

No. 3 Health Care = Regaining RS – Buy. Groups expected to outperform: Health Care Distributors, Health Care Equipment, and Pharmaceuticals

No. 4 Industrials = Strong RS – Buy. Groups expected to outperform: Office Services & Supplies, Air Freight & Logistics, Industrial Conglomerates, Construction & Engineering, Industrial Machinery, and Aerospace & Defense

No. 5 Financials = Improving RS – Buy. Groups expected to outperform: Asset Management & Custody Banks, Life & Health Insurance, Specialized Finance, and Insurance Brokers

No. 6 Consumer Staples = Improving RS – Buy. Groups expected to outperform: Agricultural Products, Distillers & Vintners, and Drug Retail

No. 7 Energy = Losing RS – Hold. Groups expected to outperform: Oil & Gas Drilling, Integrated Oil & Gas, and Oil & Gas Refining & Marketing

No. 8 Materials = Deteriorating RS – Hold. Groups expected to outperform: Aluminum, Steel, and Metal & Glass Containers

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

No.10 Telecom = Deteriorating RS – 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

Vice President of Private Wealth Management

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