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Weekly Market Notes
February 3, 2014
Dow 15698 – S&P 500 1782

The equity markets last week completed one of the worst January performances in recent memory. Large-cap stocks suffered the most damage with the Dow falling more than 5.0% for the month and the S&P 500 losing 3.6%. The concern is that the volatility in the currency and equity markets of emerging nations will spread and reduce economic activity in the global economy. A combination of factors including the Fed’s program of reducing quantitative easing by $10 billion a month and the economic slowdown in China are responsible for generating a good measure of the volatility in the underdeveloped markets.

Despite the loss of momentum in the stock market the S&P 500 has managed to hold support on a number of occasions the past two weeks.To become aggressive, however, investors should wait for a reversal in momentum to the upside as measured by a trading session where upside volume overwhelms downside momentum by a ratio of 9-to-1 or more. This should also be accompanied by a shift in investor psychology from optimism to pessimism.

The weight of the technical evidence for stocks is mixed. The overbought condition found in January has been eliminated and stocks are now oversold. The broad market, however, has weakened with only 73% of the S&P 500 industry groups now in uptrends versus 93% in early January. The percentage of groups in uptrends is now at the lowest level since the first quarter of 2014. World markets have also deteriorated with only 27% trading above their 50-day moving averages. As a result the Tape is in jeopardy of turning negative.  A reduction in the percentage of industry groups in uptrends below 65% would trigger a sell signal from this valuable indicator. Investor sentiment indicators remain problematic. The recent weakness has caused sentiment to move away from excessive optimism but short of outright pessimism. 

To generate a buy signal from the sentiment data would require the 10-day put/call ratio to rise to 95%, the CBOE Volatility Index to climb above 22, the advisory services would need to show a drop in bulls to 45% and we would need a rise in bears to 30%. In addition, we would like to see the Active Money Manager’s Asset Allocation fall to 30%. Improvement last week was seen in the survey from the American Association of Individual Investors (AAII) that showed more bears than bulls. Historically, a good bottom in the stock market occurs when there is twice the number of bears to bulls in the AAII data

The U.S. economy appears to be gaining steam despite the harsh winter.  Real GDP rose at a 3.2% annual rate in the fourth quarter. The economy grew at a 3.7% average rate in the second half of the year versus the 1.8% in the first six months. The improvement occurred despite the government shutdown and unusually cold weather for most of the country. The principal drivers of the economy in the final quarter of the year were personal consumption and exports. Government spending subtracted from the results and the rise in capital spending was disappointingly small. The surge in exports was led by energy products as the transformation of energy dominance continues to shift from the eastern hemisphere to the western hemisphere.

Government spending fell at an annual rate of nearly 5.0% in the fourth quarter. According to Ned Davis Research, government spending is now at its lowest level since the third quarter of 2006. Going forward, consumer spending is likely to slow. Extraordinary increases in heating costs will serve as a tax hike for most families, which translates into less to spend at the mall. More importantly, personal income was unchanged in December. Real disposable income rose 0.7% for all of 2013 and the weakest growth since the recession. As a result, the increase in retail sales at the close of 2014 occurred at the expense of the savings rate, which fell to 3.9% from 4.3%.

The likelihood that the first half of 2014 will witness a slowdown in spending has not gone unnoticed by the bond market. The yield on the benchmark 10-year Treasury note fell to 2.65% last week from 2.72% the previous week. Some of last week’s rally in bonds was a flight to safety from the turbulence in emerging market economies. Nevertheless, with the Fed likely to keep short-rates at zero into 2015 and deflationary pressures gaining momentum overseas the yield on the benchmark 10-year Treasury note is anticipated to remain in the vicinity of 2.50% and 3.00%.

The focus of attention this week will be on the ISM Manufacturing Index for January, which is expected to show a slight drop to 56.0 from 57.0 in December. Factory orders are also anticipated to show a drop along with construction spending. The January Employment Report due Friday is anticipated to show the economy generated 180,000 jobs last month with the unemployment rate remaining steady at 6.7%.

Sector Rankings and Recommendations

No. 1 Health Care = Strongest sector – Buy. Groups expected to outperform: Health Care Distributors, Health Care Services, Biotechnology and Health Care Facilities

No. 2 Information Technology = Good RS – Buy. Groups expected to outperform: IT Consulting & Other Services, Data Processing & Outsourced Services, Application Software, Communications Equipment, Computer Storage & Peripherals, Electronic Equipment Manufacturers and Home Entertainment Software 

No. 3 Industrials = Good RS – Buy. Groups expected to outperform: Aerospace & Defense, Building Products, Construction & Farm Machinery Employment Services, Railroads and Airlines

No. 4 Financials = Improving RS – Buy. Groups expected to outperform: Diversified Banks, Regional Banks, Thrifts & Mortgage Finance and REITs

No. 5 Consumer Discretionary = Deteriorating RS – Hold. Groups expected to outperform: Homebuilding, Specialized Consumer Services, Automotive Retail, Hotels Resorts & Cruise Lines and Casinos & Gaming

No. 6 Materials = Global economy slowing – Hold. Groups expected to outperform: Diversified Chemicals, Aluminum, Paper Products, and Construction Materials

No. 7 Utilities = Improving RS – Hold. Groups expected to outperform: Gas Utilities, Electric Utilities

No. 8 Energy = Weak RS – Hold. Groups expected to outperform: Oil & Gas Storage & Transportation and Oil & Gas Refining & Marketing

No. 9 Consumer Staples = Deteriorating RS – Hold. Groups expected to outperform: Drug Retail and Distillers & Vintners

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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