Weekly Market Notes
June 30, 2014
Dow 16851 – S&P 500 1961
The equity markets lost a step last week but the decline by the popular averages was almost unnoticeable. Stocks ignored the negative news backdrop choosing to focus on estimates of when the Fed would begin to raise interest rates. Two weeks ago the Fed reduced its asset purchase program by another $10 billion to $35 billion. Asset purchases by the Fed are widely expected to conclude in October. This raises the spectrum of when the Fed will begin to ratchet short-term interest rates upward. As a result, the financial markets are now zeroing in on second quarter GDP.
The prospects for an economic revival later this year appear high due in part to the vacuum created by the weather-induced shortfall in the first three months. Consensus opinion among economists is that second quarter GDP growth could be in the vicinity of 4.0% or better. For the remainder of 2014 the outlook is for the economy to grow at a 3.0% clip. The bullish forecasts are supported by the latest reports on industrial production, personal income and retail sales that show upticks in all three areas. This is important because the history of the stock market shows that rarely do stocks experience a significant problem without interest rates rising in advance.
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Despite the economy experiencing a weak first quarter, inflation pressures have already started to edge higher. The latest CPI report showed inflation running at 2.1%, which is double the 1.0% number reported last October and above the Fed’s target of 2.0%. The rise in inflation does not appear to be a fluke given service sector inflation is now running at 2.8% clip. The PCE Price Index, which is the Fed’s favored measure of inflation, rose 0.2% last month, the most in a year. On a year-over-year basis, the PCE Price Index is up 1.8%, the most since October 2012.
Although inflation remains below levels that could trigger the Fed to raise rates, the trend in the inflation numbers hold the potential of being more important than the absolute rate. The jobs report from the Labor Department this week is due Thursday, in front of the long weekend. Consensus estimates are that the economy generated 215,000 new jobs last month and the unemployment rate likely remained unchanged at 6.3%. The data on wage growth embedded within the report could offer the most important information. Since inflation is closely tied to income, a surge in wage growth would suggest the recent climb in inflation pressures this year could become more acute. This is likely the largest threat the financial markets face.
The technicals for the stock market offer no clear guidance as the second half of 2014 comes into focus. The trend of the market remains bullish but momentum and volume are unconvincing as to the prospects for further gains near-term. The breadth of the latest advance also remains suspect with fewer issues reaching new 52-week highs. On the flip side, the new low list has remained dormant. Typically, at a market peak the number of issues hitting new 52-week lows begins to expand.
Diverging trends in small versus large-cap stocks that surfaced earlier this year has improved but remain problematic. Investor sentiment data continues to show psychology somewhere between complacency and extreme optimism. Measuring investor psychology and applying it to forecasting the next important move in the stock market is more an art form than science. Adjustments have to be made whenever there is a shift in interest rates or Fed policy. In a low interest rate environment, a significantly higher level of optimism is required to signal a potential top in the stock market than when rates are rising. Support is near 1880 to 1915 using the S&P 500 and resistance is near the 2000 level.
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The final revision to first quarter GDP numbers caused economists to scramble to adjust full year forecasts. The revision was a shocker as real GDP contracted at a 2.9% annual rate, down from -1.0%, which was the previous estimate. The first quarter decline was the largest in five years. This argues that the U.S. economy will turn in another below trend growth number in 2014 unless growth accelerates. Five years of weak economic growth makes this recovery the weakest in U.S. history. In separate reports, durable goods orders fell for the first time in four months in May.
The weak durable goods data was offset by the latest reports on housing and consumer sentiment. The housing market performed better than expected in May. New home sales climbed 4.9%, the most since the third quarter of 2011. Existing home sales have now increased for two consecutive months. May’s strong results were due entirely to single-family sales, which rose nearly 6.0%, the most since December 2010. The Reuters/University of Michigan Consumer Sentiment Index rose above consensus estimates in June, which could translate into increased consumer spending this summer. Overall the U.S. economy appears paused for solid growth in the second half of the year. The yield on the benchmark 10-year Treasury note fell to 2.52% last week, a one month low. We continue to believe the yield on the 10-year T-note will vacillate between 2.50% and 3.00% for most of 2014.
Sector Rankings and Recommendations
No. 1 Energy = Strongest sector – Buy. Groups expected to outperform: Oil & Gas Equipment & Services, Oil & Gas Exploration & Production, and Oil & Gas Storage & Transportation
No. 2 Health Care = Continues in top RS – Buy. Groups expected to outperform: Health Care Distributors, Health Care Equipment, and Managed Health Care
No. 3 Information Technology = Continuing to enjoy broad strength – Buy. Groups expected to outperform: Semiconductor Equipment, Semiconductors, and Internet Software & Services
No. 4 Materials = Good RS – Buy. Groups expected to outperform: Aluminum, Paper Products and Metal & Glass Containers
No. 5 Utilities = Uptick in RS – Hold. Groups expected to outperform: Gas Utilities and Independent Power Producers
No. 6 Consumer Discretionary = Improving RS – Hold. Groups expected to outperform: Publishing, Cable & Satellite and Specialized Consumer Services
No. 7 Financials = Continues to lag in RS – Hold. Groups expected to outperform: Insurance Brokers, Consumer Finance, Real Estate Services
No. 8 Industrials = Large drop in RS - Hold. Groups expected to outperform: Office Services & Supplies, Diversified Support Services and Railroads
No. 9 Consumer Staples = Plunge in RS - Hold. Groups expected to outperform: Food Distributors, Brewers, and Distillers & Vintners
No.10 Telecom = Weak RS – Hold. Groups expected to outperform: Integrated Telecom Services
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.
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Evan R. Guido
Vice President of Private Wealth Management
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