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Weekly Market Notes
June 9, 2014
Dow 16924 – S&P 500 1949

The strongest support for the equity markets continues to be the historically low interest environment in the U.S. and overseas. The European Central Bank (ECB) reduced the level of interest rates to a record low 15 basis points last week and initiated a negative-rate policy for bank deposits. The ECB initiative fell short of adopting the strategy of quantitative easing but left open the door for further actions if Europe’s economy fails to respond to the latest measures.

The actions by the ECB sparked a global rally in equities that helped carried the Dow Industrials and S&P 500 Index to record highs. Unlike previous rallies this year, small and mid-cap stocks fully participated with the Russell 2000 and S&P Mid-Cap averages outperforming large caps.  This is seen as a significant development, which if it continues removes the cloud of negative divergences that has been overhanging the market.

Last week witnessed a growing percentage of S&P 500 industry groups in uptrends and a significant expansion in the number of issues hitting new 52-week highs. This raises the important question of whether the combination of improving market breadth and favorable monetary policy represents a new leg up in the cyclical bull market. The answer is complicated by the fact that along with higher prices, investor sentiment is fast approaching an extreme in optimism.

The CBOE Volatility Index (VIX), which measures the level of fear in the market, plunged last week to levels last seen at the peak in 2011. In addition, the bulls among the advisory services hit a 10-year high, and now sit at the second highest level on record.  For now we will assume that the breadth and Fed policy trump sentiment. Best course for investors, therefore, is to stay in harmony with the trend unless stocks violate support, which is considered to be 1880 using the S&P 500.    

The technical indicators remain mixed. The improvement in the broad market last week was offset by a big jump in investor optimism. The Russell 2000 Index, which is made up of small-cap stocks, followed large cap indices higher last week. Improvement in the trend and momentum suggests the benefit of the doubt should be given to the bulls. Continuing breadth improvement would argue for a full test of the 2000 level by the S&P 500.  Measures of investor psychology argue precisely the other way. Because of the inverse relationship between sentiment and liquidity we also have to include a cautionary note.  Record margin debt and low cash balances at brokerage firms and record low levels of cash at mutual funds and ETFs argue that the risks remain elevated.

The rise in investor confidence is occurring at a time when insiders are consistently selling stock. Although insiders can have many motives to sell, it is no less comforting finding them on the opposite side of rising pubic optimism. Offsetting the rapid rise in investor optimism is the fact that Main Street remains cautious.  The latest data on consumer psychology shows that while they are no-longer extremely pessimistic, consumers show none of the euphoria they displayed at other major peaks in stock prices.  As a result investors should maintain current asset allocation levels and we recommend new cash focus on the strongest sectors including information technology, energy, and materials.

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The steady flow of stronger economic data suggests that the U.S. economy has fully recovered from the plunge in activity in the first quarter. The ISM Non-Manufacturing Index (NMI) climbed in May to the highest level in nine months. According to Ned Davis Research, this level of the index is consistent with above-trend economic expansion.  Within the report, 17 industries reported growth and only one contracted. The single concern with the ISM numbers is that the price index rose for the third straight month and now sits at the highest level since October 2012, indicating rising price pressures.  Nonfarm productivity growth for the first quarter was revised down and unit labor costs were revised up.  On a year-over-year basis, however, unit labor cost is up only 1.0%, suggesting weak inflationary pressures.

In separate reports, the nation’s trade deficit expanded by more than $3 billion in April, the largest gap in two years. The trade numbers are an indication of strong domestic demand and a weaker global economy. Exports will likely be a drag on GDP growth in the second quarter. News on the housing sector was disappointing last week.  Despite the recent drop in mortgage rates, loan applications remain at low levels, indicating that the housing recovery could stall this summer. The Core Logic Home Price Index rose more than 10% in April. The index is now at its highest level since February 2008.  The advance in house prices, however, could exert upward pressure on rents and overall CPI.  This is not a deep concern unless wage pressures develop, which appears unlikely for now.

The Labor Department reported that the economy generated 217,000 new jobs last month.  The May Employment Report was in line with expectations of 215,000 new jobs.  The unemployment rate for May remained unchanged at 6.3%. Average hourly earnings rose 0.2% for the month, while the year-over-year change rose modestly to 2.1% from 2.0%.  Overall, the May jobs data was a plus for the financial markets.  The May job numbers were interpreted as bullish for the financial markets as it almost assures that there will be no change in policy by the Federal Reserve anytime soon.  Fed chair Janet Yellen is unlikely to move policy until the wage pressures begin to surface.  The Employment Cost Index rose just 1.8% in the first quarter and would likely need to rise above 3.0% before the Fed changes direction.  In addition, although the total job count has moved back above levels seen in 2008, the population has grown by 15 billion the past six years.  This argues that there remains a lot of slack in the U.S. economy.

Sector Rankings and Recommendations

No. 1 Information Technology = Strength confirmed by move to top of rankings – Buy. Groups expected to outperform: Semiconductor Equipment, Systems Software, and Electronic Manufacturing Services

No. 2 Materials = Good RS – Buy. Groups expected to outperform:  Aluminum, Fertilizers & Agricultural Chemicals and Metal & Glass Containers

No. 3 Industrials = Maintaining strong RS - Buy. Groups expected to outperform:  Air Freight & Logistics, Office Services & Supplies, Diversified Support Services and Railroads

No. 4 Energy = Strong RS – Buy.  Groups expected to outperform:  Oil & Gas Equipment & Services, Oil & Gas Exploration & Production, and Oil & Gas Storage & Transportation

No. 5 Health Care = Deteriorating RS trends – Hold. Groups expected to outperform: Health Care Distributors, Health Care Facilities, and Managed Health Care

No. 6 Utilities = Remains a near-term laggard– Hold.  Groups expected to outperform:  Gas Utilities and Independent Power Producers

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

No. 8 Financials = Poor sector RS but pockets of strength – Hold.  Groups expected to outperform: Insurance Brokers, Diversified REITs, Real Estate Services

No. 9 Consumer Staples = New highs and sub-industry strength support improving RS – Buy.   Groups expected to outperform: Packaged Foods & Meats, Drug Retail, Brewers, and Tobacco

No.10 Consumer Discretionary = Sub-industry weakness widespread – Hold. Groups expected to outperform: Movies & Entertainment, Cable & Satellite and Hotels, Resorts & Cruise Lines

Got Questions? Ask Guido 

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

One Sarasota Tower, Suite 1200

Two North Tamiami Trail

Sarasota, FL  34236-4702

941-906-2829 Direct Line

888 366-6603 Toll Free

941 366-6193 Fax

www.EVANGUIDO.com

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