Baird

Weekly Market Notes

May 20, 2013

Dow 15354 – S&P 500 1667

The equity markets enjoyed another week of record highs by the popular averages as stocks ride a powerful wave of bullish momentum.  A great deal of the credit for the success of the stock market the past four years has been given to the Federal Reserve and their policy of free money. But we believe there is much more than quantitative easing that has triggered one of the broadest based moves in market history.  The most important underlying ingredient in a secular bull market is low or declining real interest rates. Low inflation is the second most powerful factor that drives stock market gains.  The fact that inflation pressures have remained low despite four episodes of quantitative easing is the bullish surprise factor that has helped drive stocks to new heights. Therefore credit for much of the success of the equity markets can be attributed to the slow growth economy and the fact that this has been the weakest recovery on record. The soft economy has dampened loan demand, which has helped anchor interest rates and prevented inflation from gaining a foothold.  This has enabled the Federal Reserve to run two quantitative easing programs side-by-side (QE3 and QE4) and thereby providing a friendly environment for stocks that could carry into 2014.

The long term technical condition of the stock market has improved into the rally.  Minor divergences that existed last month have vanished with all the major equity market indices in gear and hitting new highs.  In addition to small and mid-cap indices moving back in harmony with the S&P 500 and Dow Industrials, the NYSE Advance/Decline line has also reached new high ground.  Given the powerful trend and strong momentum, the fact that the broad market is fully participating argues that any weakness that does develop will be limited in both time and price.  Over the very near term the risks to the market center on the overbought condition entering a new week.  Investor sentiment   ratcheted higher last week as seen in the equity put/call statistics and Investors Intelligence numbers.  In addition, analysts have become more aggressive in forecasts and target prices.  But given the bullish trend and strong breadth thrust, sentiment will likely need to move to an extreme reading and show widespread signs of capitulation before the market encounters more serious problems.  Seasonal indicators continue to point to higher prices into late summer or early September with the potential for a short-term pull back in late May, early June.

The two most significant economic reports last week were April retail sales that beat estimates and the latest data on inflation that shows pricing pressure unusually weak.  Retail sales were reported only marginally higher for April but the data was stronger than the headline number suggested.  Gas station sales plunged 4.7%, the most since February 2009, the result of lower gasoline prices.  This is very bullish for consumer spending as the decline in gas prices acts like a tax cut giving consumers more discretionary spending power.  Excluding vehicles and gasoline, retail sales rose 0.6%, the most in five months. Inflation remains elusive as seen in the latest Producer Price Index (PPI) Report.  The PPI dropped 0.7% in April, the most since February 2010. A large measure of the decline in wholesale prices was due to energy prices that fell 2.5%.  Core PPI (less food and energy) rose 0.1% last month, which was slightly less than anticipated.   Low inflationary pressures likely mean continued monetary support from the Federal Reserve.  The Consumer Price Index (CPI) fell 0.4% in April, the most since December 2008.  Core CPI, which excludes food and energy, edged up 0.1%.  On a year-over-year basis, CPI is up just 1.1%, the least since the third quarter of 2009.

In separate economic reports, Industrial Production declined 0.5% in April, the most in eight months.  In addition Industrial Production was revised down in March and February.  Manufacturing declined along a broad front 0.4%, the third decline in the past four months.  On a year-over-year basis, industrial production is up 1.9%, which is in line with GDP growth of less than 2.0%.  Capacity Utilization fell 0.5%, the most in eight months to 77.8%. This argues that inflation pressures will remain benign for the remainder of 2013.  Reports from regional Fed offices show growth difficult to achieve in many parts of the country. The Empire State General Business Conditions Index fell 4.5 points in May to -1.4, suggesting weakness in manufacturing will continue into mid-year.  Housing remains a solid area of growth for the U.S. economy despite a drop in housing starts last month.  But building permits, a sign of future construction activity soared more than 14%, the second most on record.  On a year-over year basis, both starts and permits continue to show double-digit gains.   The yield on the benchmark 10-year Treasury note improved slightly last week to 1.95% from 1.90% the previous week.   Given inflation pressures are weak and manufacturing activity sluggish, we anticipate that the yield on the 10-year T-note will remain locked in a trading range of 1.50% to 2.25% into 2014.   This week’s economic data includes existing home sales due Wednesday, which are expected to show a small gain over the previous month, and Durable Goods Orders for April that are expected to show a large improvement over the negative reading the previous month.

Sector Rankings and Recommendations

No. 1 Financials = Strongest sector –Buy.  Groups expected to outperform: Multi-line Insurance, Life & Health Insurance, REITs, Consumer Finance, and Specialized Finance

No. 2 Consumer Discretionary = Strong RS –buy. Groups expected to outperform: Movies & Entertainment, Footwear, Home Improvement Retail, Household Appliances, Auto Parts & Equipment, and Consumer Electronics

No. 3 Health Care = Ongoing good RS – Buy. Groups expected to outperform: Biotechnology, Managed Health Care, and Health Care Services

No. 4 Consumer Staples = Good RS – Buy.  Groups expected to outperform: Personal Products, Food Retail, and Drug Retail

No. 5 Industrials = Improving RS – Buy. Groups expected to outperform:  Airlines, Railroads, Building Products, and Environmental Services

No. 6 Telecom = Downtick in RS. – Hold. Groups expected to outperform:  Wireless Telecom Services

No.7 Materials = Improving RS –Hold. Groups expected to outperform:  Diversified Chemicals, Specialty Chemicals, and Construction Materials  

No. 8 Information Technology = Downtick in RS – Hold. Groups expected to outperform: Home Entertainment Software, Semiconductors, Data Processing & Outsourced Services, and Systems Software

No.9 Energy = Decline in RS -Hold. Groups expected to outperform:  Oil and Gas Storage & Transport and Oil & Gas Exploration & Production, Integrated Oil & Gas

No. 10 Utilities = Plunge to last place in RS – Hold. Groups expected to outperform:  Independent Power Producers, Multi-Utilities & Unregulated Power

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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