Baird

Weekly Market Note
February 4, 2013
Dow 14009 – S&P 500 1513

The equity markets rallied for the fourth week in a row, pushing the Dow Industrials and S&P 500 within striking distance of their 2007 highs. The Dow Industrials gained 6% in January and the S&P 500 5%. Last month’s performance was the best January in 15 years, triggering a buy signal from the January Barometer boding well for the remainder of the year. Ned Davis Research reports that since 1928, when the S&P 500 rose in January, the S&P 500 rose another 8% over the next 11 months. 

Stocks are benefiting from stronger than expected fourth quarter earnings. Earnings growth for the final quarter of 2012 is likely to be close to 4% versus consensus estimates of just 2%. Other supporting factors for the market include a friendly Federal Reserve and a bullish technical backdrop. Despite some evidence that the economy is gaining traction, Fed Chairman Ben Bernanke is not expected to move away from the policy of easy money. The Federal Reserve is currently purchasing $85 billion of mortgage back and Treasury securities and we anticipate the program to continue for most of 2013.

The technical picture also favors further upside for stocks this year. The January rally has been broad based with 91% of the S&P 500 industry groups in uptrends. In addition, the NSYE advance/decline line is at a new high and the number of issues hitting new 52-week highs has expanded. As a result, the long-term picture looks favorable for stocks. Near-term, however, the outlook is less favorable for stocks. 

Overbought/oversold indicators show the market vulnerable, momentum has stalled and trend experiencing increasing resistance. Seasonally, the market faces a headwind as pullbacks are more prevalent in February. We are also seeing improving relative strength in defensive sectors including consumer staples and utilities, which usually occurs as the market becomes vulnerable. Over the longer-term we anticipate the equity markets will work higher in 2013 but there is reason for caution near term. 

Sentiment indicators show investor optimism continues to surge, which suggests that the stock market is vulnerable to a short-term pull back or consolidation phase. Fortunately, the majority of the technical indicators are throwing off bullish signals. This argues that any weakness will be limited in both time and price. Nevertheless, we cannot overlook the fact that over the past four years when investor psychology has reached an extreme the stock market has experienced a short-term correction.

The U.S. economic recovery continues at a remarkably slow pace. Real GDP contracted 0.1% in the fourth quarter, the first decline in nearly three years. The final quarter of 2012 was influenced by upcoming changes in the tax environment in 2013. This prompted a host of companies to issue special dividends that boosted personal income and consumption for the period. A stronger consumer was offset by a large drop in defense spending by the government. 

Inventory investment suffered due to the uncertainty of policy from Washington. Negative growth in the fourth quarter is expected to be a one-time event with first quarter 2013 estimates signaling a return to positive, albeit slow growth of 1.5%. Lower paychecks in 2013 due to the increased taxes will likely anchor the economy in the first half of next year. Reduced take-home pay is hurting consumer psychology. The Conference Board’s Consumer Confidence Index plunged in January to the lowest level since the fourth quarter of 2011.

The December employment report issued on Friday was mixed. Payrolls climbed 157,000, which was slightly less than forecast. More encouraging was the fact that the prior two months jobs numbers were revised up by a total of 127,000. Less inspiring, the average workweek was revised down to 34.4 from 34.5. The unemployment rate ticked up to 7.9% from 7.8%. Overall the employment data showed the labor markets continue to struggle. The latest jobs data is not expected to encourage the Fed to change policy. 

The ISM Manufacturing Index unexpectedly rose in January. The increase to 53.1 from 51.0 was the biggest jump since the first quarter of 2010. Most important, new orders rebounded to the best level in eight months. It is becoming increasingly clear that the fiscal cliff negotiations had little impact on business plans late last year. This suggests that the coming sequester battle will not have a significant impact on the economy. Treasury yields rose last week. The 10-year T-note climbed to 2.02% from 1.95% the previous week. The yield on the benchmark 10-year Treasury note is at the highest level since April 2012.

Considering the U.S. economy continues to operate well below capacity and with the Fed buying $45 billion in Treasuries every month, the government bond prices are likely to remain in a relatively narrow range. We anticipate the yield on the 10-year Treasury to remain in the vicinity of 1.75% to 2.25%. 

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 Health Care = Ongoing RS – Buy. Groups expected to outperform: Biotechnology, Health Care Facilities and Health Care Distributors

No. 4 Industrials = Good RS – Buy. Groups expected to outperform: Industrial Conglomerates, Construction & Farm Machinery, Employment Services, Airlines and Building Products

No. 5 Energy = Improving RS – Buy. Groups expected to outperform: Oil & Gas Refining & Marketing, Oil & Gas Storage & Transportation and Oil and Gas Equipment & Services

No.6 Consumer Staples = Falling RS – hold. Groups expected to outperform: Agricultural Products, Personal Products, Drugs Retail, Food Retail and Food Distributors

No. 7 Materials = Falling RS – Hold. Groups expected to outperform: Diversified Chemicals, Fertilizers & Agricultural Chemicals, Commodity Chemicals, Construction Materials and Steel

No. 8 Utilities = Weakest sector– Hold. Groups expected to outperform: Independent Power Producers

No. 9 Telecom = Deteriorating RS – Hold. Group expected to outperform: Wireless Telecom Services

No. 10 Information Technology = Losing RS – Hold. Groups expected to outperform: Application Software, Data Processing & Outsourced Services, and Internet Software & Services

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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