Baird

SARASOTA – The popular averages were mixed last week reflecting the uneasy backdrop of reduced expectations for global economic growth in 2011.  Rising inflation pressures caused China to increase bank reserve requirements over the weekend and the European Central Bank indicated that higher interest rates will be employed in the event inflation pressures remain strong. The only holdout in the battle against inflation is the Federal Reserve.  The Fed meets later this month, and with the next meeting two months away the policy statement this month regarding QE2 will now be the focus of attention. The problem Bernanke faces is that although the U.S. economy is growing, housing and the labor markets remain problematic and inflation is rising in the wrong places.  The average household is faced with falling asset values (home prices) while discretionary income is under stress due to the sharp price increases for food and gasoline.  This is raising concerns that the economy could enter a period of stagflation. Considering stocks have risen more than 100% from March 2009, and given the unstable global environment, the RW Baird Investment Policy Committee is recommending reducing exposure to equities by 5%, placing the money in investment grade corporate bonds with a one to three year maturity.  For the average investor the suggested asset allocation now is 55% stocks, 35% bonds and 10% cash.

Indicators of investor psychology are mixed. The increased demand for put options indicates a rising level of fear among short-term traders but the other measures of sentiment suggest that investors with a longer-term horizon are extremely optimistic.  The divergence of mood among investors argues for a continuation of the tight trading range that has prevailed the past three weeks but with increased risk.  The CBOE 10-day put/call ratio climbed to 92% last week from 82% the previous week (75% is considered bearish and 95% bullish). The CBOE three day equity put/call ratio jumped to 66% late last week issuing a short-term buy signal (51% is considered bearish and 62% bullish).  The most recent survey from the American Association of Individual Investors shows 42% bulls and 31% bears. The latest report from Investors Intelligence, which tracks the recommendations of Wall Street letter writers, shows the bullish camp at 55.4% and only 6.3% bears. The three to one ratio of bulls to bears among the advisors is the most since the February peak in the stock market. The CBOE Volatility Index (VIX) finished last week at a new cycle low (15), suggesting investors are too complacent.

The U.S. economy continues to grind higher. Industrial Production and Capacity Utilization rose in March.  Both measures of economic strength, however, are significantly below their 2007 peaks, indicating the output gap is still large despite climbing steadily the past two years.  This has favorable implications for overall inflation and something the Fed watches closely.  Over the near-term inflation pressures continue to be influenced by soaring commodity prices.  The Consumer Price Index (CPI) climbed 0.5% last month, the most in two years.  Most disturbing is the fact that purchasing power for U.S. households declined as real average hourly earnings for all workers dropped 0.6%, hitting the lowest level since October 2008.  It is anticipated that the Fed will address this problem in April and that Bernanke will allow QE2 to expire on schedule but continue to buy Treasury bonds with the proceeds of maturing bonds that are already on their balance sheet. This would position the Fed as market neutral.  We anticipate that foreign and domestic buyers of Treasuries will help fill the void once the Fed leaves. Given the Fed has been the largest buyer of Treasuries the yield on the benchmark 10-year Treasury note yield could rise toward 3.75%, which is the upper level of our expected range of (3.25% to 3.75%) into the third quarter.   

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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