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Weekly Market Notes
May 19, 2014
Dow 16491– S&P 500 1877

The S&P 500 and Dow Industrials hit new all-time record highs early last week. The celebration was brief as stocks quickly drifted back into what is now a very familiar trading range of 1840 to 1880 on the S&P 500. The failure to hold new high ground last week can be traced to the fact that stocks have been unable to generate positive momentum this year due to the pervasive lack of volume. Volume peaked in May of 2013 and has continued to contract in the first and second quarters of 2013.

Despite last week’s disappointing performance, there is yet not enough evidence to argue that the bullish trend has run its course. It would be rare for the equity markets to encounter significant trouble with interest rates falling and the Fed trying to encourage the economy into a higher gear. At the start of the year very few were anticipating a correction but following the market’s failure in January the correction camp has steadily grown. It appears the correction camp grows larger at the precise moment stocks appear to be breaking out on the upside. Historically, the stock market will do whatever is required to prove the majority wrong. As a result, we anticipate over the near term that the equity markets will make another run at the 1900 area on the S&P.

The technical indicators continue to offer mixed signals suggesting a continuation of this year’s trading range is likely. Two areas we are watching closely that could offer evidence of the next important move in stocks include market breadth and investor psychology. Investor sentiment is divided with the so-called pros mostly bullish and the public more skeptical and cautious. The demand for put options in recent weeks has expanded suggesting often wrong options traders are pessimistic. 

The CBOE Volatility Index (VIX) that measures the level of fear in the market argues that investors are too complacent. Stock market breadth continues to weaken. The percentage of industry groups within the S&P 500 declined to 69% last week. A reading below 65% would turn the Tape indicator negative from neutral. The lack of leadership can be seen in the fact that more stocks are now hitting new 52-week lows than new highs. Volume, which often precedes price, is down after peaking in May of 2013. Absent volume, it is very difficult to generate sustainable upside momentum, which has been problematic since the start of the year. The risk to the stock market is seen to 1810 and the reward 1915 using the S&P 500.

The economic data last week was disappointing but does not subtract from the likelihood that second quarter growth will be robust. Retail sales for April were weaker than expected almost across the board. April sales were up 0.1%, which was below expectations of 0.4%. The previous month, however, was revised up 1.5% from 1.2%. Subtracting vehicle sales from last month’s figures, retail sales were flat. On a year-over-year basis, retail sales have increased 3.3%. This argues that the trend in retail sales remains positive despite last month’s short-fall. In separate reports small business optimism rose in April to the best level since October 2007. Industrial production data fell 0.6% in April and a disappointing start for the second quarter. A large part of last month’s decline was due to utilities, which fell 5.3%, the most in eight years. This was likely due to improving weather conditions in much of the country. On a year-over-year basis, industrial production is up 3.5%, which is consistent with modest economic growth. 

Inflation pressures are expected to rise later this year given the surprise uptick in wholesale prices last month. The Producer Price Index (PP) jumped 0.6% in April, the most since January 2010. Consensus estimates were that the April PPI would rise 0.2%. Higher producer prices eventually will find their way to consumer prices. The Consumer Price Index (CPI) rose 0.3% in April, the most in ten months. Excluding food and energy, core CPI rose 0.2% last month, the largest gain since the summer of 2011. On a year-over-year basis, CPI has increased 2.0% and core CPI 1.8%. Inflation is closely tied to income. Given that real average weekly earnings, on a year-over-year basis, are down 0.1%, inflation pressures are not likely to be sustainable.  This could be an important reason the bond market completely ignored the higher than expected inflation number. The yield on the benchmark 10-year Treasury note fell  under 2.50%, the lowest print for 2014.  

Bond prices are ultimately determined by supply and demand, which partially explains the unexpected decline in long-dated Treasury yields this year. The federal government posted a budget surplus in April, which is typical due to increased revenue collections at the end of tax season. Year-over-year the deficit fell more than 37%. The Office of Supply Management and Budget anticipates the full fiscal year deficit will be the smallest in six years. A smaller fiscal deficit means that fewer Treasury securities will be issued thereby cutting into the supply of new government paper. Other events causing yields to fall include aggressive buying by foreigners and the powerful demographics found in most developed nations with the fast growing segment of the population 65-year olds and up. We continue to expect the yield on the 10-year T-note to vacillate between 2.50% and 3.00% in 2014. New and existing home sales are the important economic data due this week. Existing home sales are expected to be up modestly, month-over-month but new home sales are expected to jump nearly 10%.

Sector Rankings and Recommendations

No. 1 Energy = Strong RS – Buy. Groups expected to outperform: Oil & Gas Equipment & Services, Oil & Gas Exploration & Production, Oil & Gas Storage & Transportation and Integrated Oil & Gas

No. 2 Industrials = Improving RS - Buy. Groups expected to outperform: Construction & Farm Machinery, Diversified Support Services and Railroads

No. 3 Health Care = Deteriorating RS – Hold. Groups expected to outperform: Health Care Equipment, Health Care Facilities, and Managed Health Care

No. 4 Materials = Good RS – Buy. Groups expected to outperform: Diversified Chemicals, Aluminum, Steel, Fertilizers & Agricultural Chemicals and Metal & Glass Containers

No. 5 Utilities = Downtick in RS – Buy. Groups expected to outperform: Gas Utilities and Independent Power Producers

No. 6 Information Technology = Decline in RS – Hold. Groups expected to outperform: Electronic Components, Systems Software, and Communications Equipment

No. 7 Telecom = Decline in RS – Hold. Groups expected to outperform: Integrated Telecom Services

No. 8 Consumer Staples = Improving RS – Buy. Groups expected to outperform: Packaged Foods & Meats, Drug Retail, Brewers, Tobacco, Household Products and Distillers & Vintners

No. 9 Financials = Poor RS – Hold. Groups expected to outperform: Insurance Brokers, Diversified REITs, Real Estate Services

No. 10 Consumer Discretionary = Weakest sector – Hold. Groups expected to outperform: Consumer Electronics, Movies & Entertainment and Leisure Products

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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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