Baird

Weekly Market Notes

June 3, 2013

Dow 15151 – S&P 500 1630

The Dow Industrial and S&P 500 indices fell for the second week in a row last week, the first back to back decline in seven months. Most of the weakness was confined to interest rate sensitive areas as the NASDQ and Russell 2000 ended the period virtually unchanged. Stocks entered the week overbought and overbelieved and therefore poorly positioned for unfriendly news. The trigger for the decline was a holdover from two weeks ago when Fed Chairman Ben Bernanke offered a conflicting statement pertaining to the future of quantitative easing. The impact of a shift in monetary policy, however, occurred last week with a jump in interest rates to a 12-month high. Rates rose all along the Treasury curve with the yields climbing to 2.16% from 1.95% the previous week. 

This was accompanied by a government report that showed inflation rates falling which caused a more dramatic rise in real interest rates. Downward pressure on inflation is seen in falling commodity prices, a 2.5% plunge in import prices and the first decline in nearly a year in the Personal Consumption Expenditures Index (PCE). The rise in rates was particularly unsettling to defensive areas of the market where investors have been drawn due to relatively high dividends. Hardest hit sectors included utilities, telecom and REITs. Growth stocks performed much better suggesting a rotation is underway from defensive areas of the market to cyclical and growth stocks that had been lagging. This is evident in our relative strength studies that show the industrial and information technology sectors gaining in relative strength. As a result we anticipate the next rally in the stock market will favor growth stocks over value stocks. Although stocks could remain under pressure until the Fed meeting in mid-June, we expect any weakness over the very near term will be followed by a summer rally that could carry into the third quarter. 

The short-term performance of the stock market is expected to be anchored by technical and economic factors. Despite the recent weakness, stocks remain overbought following the uninterrupted rally since November. Investor optimism remains elevated as seen in the Investors Intelligence numbers that recently showed three times as many bulls as bears. Record margin debt is also a concern as this group of investors is quick to exit on shift in momentum.

Considering the stock market is very sensitive to any change in Fed policy, this week’s flood of economic data is expected to keep stocks on the defensive. The upcoming reports include the May ISM Manufacturing and the May Nonfarm Payroll numbers. The largest threat to stocks is that the fresh data may be stronger than anticipated. This could lead to further speculation that Fed Chairman Bernanke will reduce the level of monetary stimulus that has helped inflate asset prices the past four years. Consensus estimates are that the May ISM number will be in the vicinity of 50.3, a slight downtick from the previous months report. The general view on employment is that the economy created 170,000 jobs in May. Should these reports be significantly stronger than anticipated it would rekindle fears of a shift in Fed monetary policy. The decline in the equity markets the past two weeks has pushed the S&P 500 Index into the support zone of 1600 to 1635.  

Any further weakness into the mid-June time frame that is accompanied by a change in investor psychology from optimism to caution or fear would be considered a buying opportunity. 

The latest economic data continues to offer mixed signals but the bias is moving toward increased economic activity later this year. The recent rise in interest rates tends to confirm that investors are looking for stronger growth going forward. Nevertheless, some confusion remains as seen in Friday’s Chicago PMI report which was much stronger than expected. This was followed by a surprisingly weak report from the Milwaukee district. Revisions to first quarter GDP showed growth slightly lower than expected with most of the 2.6% gain in GDP the result of aggressive consumer spending. Strong growth in consumer spending in the first quarter was likely related to large dividend payouts late in 2012 due to potential changes in tax rates.  

The data also shows that consumers sharply reduced savings early in the year which is not likely to carry forward. April retail sales show a drop in spending suggesting consumers will be far less aggressive in the second quarter. There is also concern that housing, which has been the backbone of the economic recovery, could slow as home mortgage rates rallied to the highest level in more than a year last week. The support for housing has been the lowest mortgage rates in 100 years. Although it is too soon to argue that the modest rise in rates will have a negative impact on the home sales, it should be noted that mortgage applications have drop sharply the past two weeks along with applications to refinance. 

Although the upside technical breakout of Treasury yields suggests rates could work higher over the near term, we do not feel that this marks the beginning of a bear market in bonds. The growth rate for the U.S. economy remains far below long term trends. The labor markets remain soft with most of the employment gains occurring for part-term workers. This can be seen in the April jobs data that showed a significant number of new jobs were created but the average work week contracted. Disposable personal income, which is the primary support for consumer spending, is expanding at the slowest pace since 1959. For the U.S. economy to grow above the long term average of 3.2%, we need to witness significant improvement in the labor markets including rising wages.  

Stronger growth in the global economy is also necessary as U.S. exports play an important role. Europe remains in recession with unemployment rising to a record 12.2% last month. China is also problematic as GDP growth slows and its trading partners report decreasing import activity. Considering the subpar growth rate at home, the weakness in the global economy and low inflation we anticipate that the yield on the benchmark 10-year Treasury will remain in a range of 1.75% to 2.50% in 2013.

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 Industrials = Improving RS – Buy. Groups expected to outperform: Airlines, Railroads, Building Products, and Environmental Services

No. 4 Health Care = Strong RS – Buy. Groups expected to outperform: Biotechnology, Managed Health Care, and Health Care Services

No. 5 Information Technology = Jump in RS – Buy. Groups expected to outperform: Home Entertainment Software, Semiconductors, Data Processing & Outsourced Services, and Systems Software 

No. 6 Materials = Downtick in RS – Hold. Groups expected to outperform: Diversified Chemicals, Specialty Chemicals, and Construction Materials  

No. 7 Energy = Decline in RS – Hold. Groups expected to outperform: Oil and Gas Storage & Transport and Oil & Gas Exploration & Production, Integrated Oil & Gas

No. 8 Consumer Staples = Significant decline in RS – Hold. Groups expected to outperform: Personal Products, Food Retail, and Drug Retail

No. 9 Utilities = Weakest sector – Hold. Groups expected to outperform: Independent Power Producers, Multi-Utilities & Unregulated Power

No.10 Telecom = Downtick in RS – Hold. Groups expected to outperform: Wireless Telecom 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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