Baird

SARASOTA – The equity markets finished unchanged last week but given the difficult news backdrop that included a potential shutdown of the government and skyrocketing commodity prices the performance was better than could be expected.  As stocks move deeper into the second quarter, the largest threat to the rally is the persistent decline in the U.S. dollar.  A weak currency has inflationary implications and is the principle cause for the explosion in commodity prices this year.

Commodity inflation has occurred with the labor market soft and home values falling and this has placed heavy burdens on many households.  If the dollar continues to weaken or inflation expectations increase, Bernanke could be faced with the task of removing stimulus prematurely.  This is important given that stocks have soared 27% since Bernanke initiated QE2 in August of 2010.  The prospects for the market in the absence of Fed running the printing presses are unclear.  In the previous example when QE1 expired in April 2010 stocks and commodities fell with the Dow losing 15%, oil dropping $10 and gold declining $100.  As a result the Fed’s meeting later this month is likely to overshadow the first quarter earnings season that is anticipated to show strong year-over-year gains.  This suggests that the financial markets will continue to trade in a narrow range over the next few weeks when the Fed shows its hand with a fresh policy statement at the end of April.  

The overall technical condition of the stock market argues for further gains despite rising investor optimism. The breadth trends are supporting the indexes with the NYSE advance/decline line hitting new highs last week.  In addition, more than 80% of the industry groups within the S&P 500 are above their 200-day moving averages.  It should be noted that while the advance/decline line for the S&P 500 has moved to a new high, the index itself has struggled at resistance just under its recent peak. Although we believe this divergence will soon be repaired, it is something that requires monitoring.

The area of most concern is investor sentiment that is moving towards extreme optimism. Put/call ratios have declined, as has the VIX, while bullish sentiment has expanded. This week’s AAII survey showed the most bulls and fewest bears in the past seven weeks and the NAAIM survey shows that active money managers have nearly doubled their exposure to the stock market (from 41% to 81%) over the past three weeks. The Investors Intelligence survey showed a surge in bulls from 52% to 57% and a decline in bears from 23% to 16%. At more than 3.6-to-1, the ratio of bulls to bears in this survey is at an optimistic extreme. 
 
The U.S. economic recovery remains on a measured upward path.  The larger question is the sustainability of the advance once government assistance is removed in the second half of the year. The Federal Reserve Open Market Committee meets later this month and it is widely believed that QE2 will be fully complete by June 30.  Increased inflation expectations are likely to prevent any notion of an introduction of QE3, which means the economy will have to go it alone for the remainder of the year. 

Although we do not anticipate an increase in the fed funds rate this year the fact that the euro zone and China are increasing rates is applying a great deal of pressure on the U.S. dollar.  The focus of attention this week will be on the March inflation reports due Thursday.  The headline numbers for the Producer Price Index (PPI) and the Consumer Price Index (CPI) are expected to be +1.0% and +0.5%.  Core inflation, which subtracts food and energy prices are anticipated to be up a moderate 0.2% at both the wholesale and consumer level.  An upside surprise in the core numbers would likely be a large negative for the financial markets.  Looking further out inflation pressures are likely to increase next year.

Historically, economies that run large budget deficits with rapid money growth and that allow their currency to depreciate inevitably experience widespread inflation.  Treasury prices fell for the third week in a row pushing the yield on the benchmark 10-year Treasury note to 3.55%, which is in the middle of our expected range of 3.25% to 3.75%.

Sector Recommendations along with selected buy ideas from PWM Equity Research
No. 1 Energy = Strongest sector – Marketweight/buy.
No. 2 Materials = Good RS but losing momentum – Marketweight/hold
No. 3 Telecom Services = Jump in RS  – Marketweight/hold. AMT, VZ
No. 4 Industrials = Continued strong RS – Marketweight/buy.
No. 5 Consumer Discretionary = Better jobs market helpful – Marketweight/buy.
No. 6 Health Care = RS improving – Marketweight/buy.
No. 7 Consumer Staples = Improving RS – Marketweight/hold.
No. 8 Financials = Drastic drop in RS. Marketweight/hold. 
No. 9 Information Technology = Falling RS & momentum– Marketweight/hold.
No. 10 Utilities = Declining RS - Marketweight/hold.

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

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