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Weekly Market Notes       
February 10, 2014
Dow 15794 – S&P 500 1797

The popular averages managed a small gain last week as market volatility climbed to the highest level in more than six months. The weakness experienced in January can be attributed to economic and monetary problems in the global economy and conflicting data on the state of the U.S. Economy. The technical posture of the stock market improved last week. The equity markets are no longer overbought and investor sentiment has moved substantially away from the extreme optimism found at the start of the year. This permitted stocks to easily dismiss the disappointing jobs report on Friday and allowed for the first weekly gain in the equity markets in a month.

Despite the weak Labor Department Report, the economic fundamentals appear to be improving. According to Ned Davis Research, the U.S. economy is being aided by the improvement in the trade deficit and federal budget deficit.  In addition, unemployment claims and trends in employment correspond to growth of 2.8% and 3.7% respectively for 2014. The strength in the economy, however, will not be fully known until the second quarter when weather conditions return to normal. Over the very near-term we anticipate that stocks will attempt to overcome resistance, which is in the vicinity of 1800 to 1820 using the S&P 500. A move above 1820 accompanied by improvement in market breadth would argue stocks are ready to challenge the 2013 highs.    

The weight of the evidence continues to argue that the primary trend remains to the upside. Federal Reserve policy continues to be friendly and we anticipate that the Fed will keep rates unusually low for the foreseeable future. The economy we rate as a neutral influence on stock prices as inflation expectations remain low. Valuations are elevated due to the fact that stocks enjoyed strong gains the last 24 months without a corresponding growth in corporate profits. Seasonally, the stock market has a bullish tailwind into mid-April. The Tape remains bullish but there has been some deterioration with only 67% of the S&P 500 industry groups in uptrends. At the start of the year nearly 90% of S&P 500 industry groups were in uptrends. It will be important that stock market breadth improve in the next rally. 

Sentiment, which was bearish at the start of the year, is now considered neutral. The Chicago Board of Options Exchange shows that the volume of put options rising last week. The CBOE Volatility Index (VIX) climbed very close to our 22 target ( a level that suggests extreme fear is present) but quickly slipped back into the zone we associate with complacency. The latest survey from the American Association of Individual Investors (AAII) shows more bears than bulls, which we interpret as a positive development. Investors Intelligence, which tracks the opinion of Wall Street letter writers shows a sharp drop in bulls but the bears camp remain too low. The National Association of Active Money Managers (NAAIM) showed a steep drop in the allocation to stocks last week, which moved this indicator to neutral from bearish.

The economy is issuing mixed signals some of which is likely due to the exceptionally harsh winter experienced by most of the country. The Labor Department reported that the economy generated 113,000 jobs in January. The weaker than expected report was in addition to the weak December data, which showed only 75,000 new jobs were created. The unemployment rate moved down to 6.6% a number that is very close to the Fed’s threshold for reducing stimulus. Best assumption is that the Fed will place less emphasis on jobs and focus on the level of inflation in determining policy. Although we are operating under the assumption that inflation will remain benign in 2014, there is concern that wage pressures could develop later in the year as the labor force shrinks. It should also be pointed out that the CRB Index broke out above its 50 and 200-Day moving averages last week. Should the inflation outlook deteriorate it would be a serious negative for the economy as the Fed could be forced into a defensive posture. The next scheduled meeting of the Fed’s Open Policy Committee is on March 18.  

In separate reports the ISM Manufacturing Index fell sharply in January but was offset by a stable number from the non-manufacturing sector of the economy. The ISM Manufacturing Index plunged in January by the largest amount since May of 2011. Severe weather likely played a role. The non-manufacturing component held up much better and remains at a level that is consistent with moderate economic growth. The trade deficit widened by the most in five months in December and this will subtract from fourth quarter GDP growth. The economic reports due this week  are not expected to be market movers. Consumer sentiment data is expected to reflect a small decline in optimism.  Industrial Production for January is expected to be flat month-over-month and retail sales are anticipated to show a small rise.

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 Materials = Improving RS – Hold. Groups expected to outperform:  Diversified Chemicals, Aluminum, Paper Products, and Construction Materials
No. 5 Financials = Improving RS – Buy. Groups expected to outperform: Diversified Banks, Regional Banks, Thrifts & Mortgage Finance and REITs
No. 6 Consumer Discretionary = Deteriorating RS – Hold. Groups expected to outperform: Homebuilding, Specialized Consumer Services, Automotive Retail, Hotels Resorts & Cruise Lines and Casinos & Gaming
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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