Baird

Weekly Market Note
January 22, 2013
Dow 13649 – S&P 500 1485

The equity markets added to the early January gains last week with most of the popular averages gaining more than 1% for the period. Stocks are benefiting from a friendly Federal Reserve, a stable economy and an improving technical backdrop. Fourth quarter earnings have been mixed, but with low expectations, bottom line disappointments have not had an impact on overall market performance. Revenue growth has been impacted by the reluctance of the economy to move out of first gear.

Fourth quarter GDP is anticipated to be in the vicinity of 1.0%. First quarter GDP is expected to be negatively impacted by increased taxes with growth projected to be near 1.5%. Slow economic growth has not influenced the equity markets as the soft economy has prevented inflation from gaining a foothold, allowing the Fed to continue with the strategy of zero percent interest rates and quantitative easing. Furthermore, the market is a forward looking mechanism. Most economists believe that the U.S. and global economy will gain traction in the second half of 2013.

The equity markets also enjoy a favorable technical backdrop that is expected to allow the rally to continue over the near term. Divergences that raised concern last year have disappeared with the Dow Transports and small–cap indices moving again in harmony with the primary trend. Market breadth continues to expand with new highs in the Advance/Decline Line. The percentage of industry groups within the S&P 500 improved to 83% last week from 79% last week and 72% two weeks ago. Further evidence of internal market strength is found in the expanding number of issues hitting new 52-week highs.

Momentum remains on the side of the bulls with two sessions where upside volume overwhelmed downside volume by a ratio of 9 to 1 or more. Leadership in the market has been wrestled away from defensive sectors. Groups and sectors showing the strongest relative strength include industrials, financials, consumer discretionary and materials. The area of concern and the most significant threat to the current rally is rapidly rising investor optimism.  Investor psychology is close to slipping into the extreme optimism zone that in the past has caused rallies to stall.

The sentiment indicators last week showed confidence among investors growing closer to what is considered excessive. The sentiment statistics indicate the highest level of optimism since last September, when the summer rally began to slow.  The rise in investor confidence in recent weeks, if it continues, represents the most significant risk to the current rally.

The most recent economic reports were mixed with the most bullish data related to the housing sector and jobless claims numbers. As a result of the contradicting data, the yield on the benchmark 10-year Treasury note was virtually unchanged last week at 1.84%. Housing Starts jumped 12.1% in December to the best level since June of 2008. Unseasonably warm weather and continued recovery from the hurricane helped support the strong numbers. Initial Claims for unemployment insurance plunged to the lowest level since January 2008.

It was the biggest decline in two years but due partly from seasonal distortions. Nevertheless, the housing and jobs data suggest the economy is stabilizing and could be gaining momentum later this year. Encouragement could also be found in the latest Industrial Production figures that rose 0.3% in December along with Capacity Utilization rates that climbed to 78.8% (86% represents full capacity).

Retail sales in December rose more than expected climbing 0.5% versus consensus estimates of 0.2%. Automobile sales led the way, as has been the case for the past six months Vehicle sales now represent nearly 19% off all retail sales, the most since the first quarter of 2008. The positive news on retail sales was dampened by the fact that for the first two weeks of 2013, retail sales fell 0.3%.

The January weakness could be related to the increase in payroll taxes that nearly every wage earner will experience as a result of the fiscal cliff negotiations. It is anticipated that the $120 billion payroll tax increase will subtract as much as 0.8% from GDP in 2013. This can be seen in the latest survey from Bloomberg that showed consumer sentiment deteriorated in early January, presumably because of smaller paychecks. 

In separate reports, inflation in the U.S. remains tame. The Producer Price Index (PPI) fell 0.2% in December, the third month in a row that wholesale prices have deflated. The PPI rose 1.3% in 2012 and core PPI (less food and energy) 2.0%. Manufacturing activity in the New York region contracted for the sixth straight month in January. Hiring plans by manufacturers were less upbeat than 2012 (27% expected to increase their workforce down from 51% 12 months ago). Weakness was seen in the Philly Fed Report, which surprised on the downside. Manufacturing activity in the Philadelphia area contracted in January to -5.8 from +4.6 in December. The NY and Philly Fed numbers translate into a below 50 reading for the National ISM numbers when they are released on February 1.

The nation’s trade deficit soared in November to $45.4 billion from $38.4 billion in October. The deficit is at the highest point since the second quarter of 2007. This will have a negative influence on fourth quarter GDP and likely drag growth to below 1.0%. As a result the yield on the benchmark 10-year Treasury note is expected to remain in a range of 1.50% to 2.00%.

Sector Rankings and Recommendations

No. 1 Financials = Strongest sector – Buy. Groups expected to outperform: Thrifts & Mortgage Finance, Banks, Asset Management & Custody Banks, Investment Bank & Brokerage and Multi-line Insurance

No. 2 Consumer Discretionary = Strong RS – Buy. Groups expected to outperform: Automobile Manufacturers, Auto Parts & Equipment, Drug Retail, Broadcast and Cable TV, Household Appliances and Tires & Rubber

No. 3 Industrials = Good RS – Buy. Groups expected to outperform: Industrial Conglomerates, Construction & Farm Machinery, Employment Services, Airlines and Building Products

No. 4 Health Care = Ongoing RS – Buy. Groups expected to outperform: Biotechnology, Health Care Facilities and Health Care Distributors

No. 5 Materials = Improving RS – Buy. Groups expected to outperform: Diversified Chemicals, Fertilizers & Agricultural Chemicals, Commodity Chemicals, Construction Materials and Steel

No. 6 Energy = Wait for top 5 RS reading – Hold. Groups expected to outperform:  Oil & Gas Refining & Marketing, Oil & Gas Storage & Transportation

No. 7 Consumer Staples = Falling RS – hold. Groups expected to outperform: Agricultural Products, Personal Products, Drugs Retail, Food Retail and Food Distributors

No. 8 Telecom = Deteriorating RS – Hold. Group expected to outperform: Wireless Telecom Services

No. 9 Information Technology = Losing RS – Hold. Groups expected to outperform: Application Software, Data Processing & Outsourced Services and Internet Software & Services

No. 10 Utilities = Weakest sector– Hold. Groups expected to outperform: Independent Power Producers

Market Overview

Short-Term Trading range with risk to 1460 and reward to 1500 on the S&P 500

Long-Term Major support is 1250 on the S&P 500 and the reward is to 1550

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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