Baird

Weekly Market Notes
June 10, 2013
Dow 15248 – S&P 500 -1643

The equity markets finished higher last week aborting a late May/early June decline that was threatening to extend to three weeks. The S&P 500 found support at the 1600 level limiting the correction to 5% from the peak of 1687 on May 22. The market benefited last week from mixed economic data that implied the U.S. economic recovery remains too fragile for the Fed to risk abandoning the policy of easy money. As a result, Bernanke is more likely to stay the course with $85 billion a month of stimulus and zero percent interest rates. Although we cannot rule out a retest of last week’s lows, best estimates are that the correction in the equity markets has run its course.

The largest threat to stocks is that the recent rise in interest rates will carry far enough to threaten the economy, particularly housing, which has been responsible for much of the increase in consumer spending. The change in the trend in interest rates is historically a negative for stocks. But unless the yield on the benchmark 10-year Treasury rises sufficiently to threaten rate sensitive sectors such as the financials, we continue to feel a summer rally is likely. The broker/dealer group is often a leading indicator of the overall health of the financials. The fact that this group hit new highs last week argues that yields will have to rise significantly higher to upset the cyclical bull market in stocks.

The most important shift in the stock market technicals last week occurred in the area of investor sentiment. The latest data suggests that the modest decline in the market was enough to cause investors to turn skeptical and cautious toward stocks. This can be seen in the activity on the options exchanges where there was a dramatic shift in the demand for put options. Puts are a bet on a market decline. The change in sentiment is confirmed by the latest report from the American Association of Individual Investors (AAII) that did a complete 180 with bears now outnumbering bulls last week. Another sign of capitulation is seen in the actions of aggressive money managers who cut their exposure to stocks to just 51% from 85% at the recent peak.

The quick shift in investor psychology fits with our assumption that the optimism seen in early May was only skin deep and it would reverse at the slightest sign of trouble. Over the near-term the equity markets must still contend with the uncertainty surrounding the Federal Reserve meeting on June 18. As a result we anticipate stocks will stay in a trading range with support at 1300 with resistance in the vicinity of 1360. Investors should direct new money into the strongest areas including financials, information technology, health care, consumer discretionary and industrials. 

The latest economic data argues that the U.S. economy remains in a slow growth mode that is likely to continue deep into the third quarter. The May employment report showed nonfarm payrolls increased by 175,000 and the unemployment rate upticked to 7.6% from 7.5%. The job data was in line with expectations and not expected to be an influence on Federal Reserve policy in the upcoming meeting on June 18. The May employment report included a downward revision of 16,000 jobs in the April figures and showed most of the new jobs were in areas where wages are below the national average. Early in the week it was reported that the ISM Manufacturing Index fell last month to the lowest level since June 2009. 

The 49.0 reading for May is an indication that business activity is contracting. The latest ISM reading suggests that GDP growth is in the vicinity of 2.0%. Within the report new orders dropped 3.5 points to 48.8, which shows the pace of new orders contracting for the first time this year. Inventories also fell, suggesting manufacturers expect demand to remain muted over the near-term. Price pressures also declined as the Price Index moved under 50 for the first time in 10 months.

The ISM Non-Manufacturing Index rose 0.6 points in May to 53.7, indicating continuous growth in services activity. Pricing pressure remained low in the service sector as well with the Prices Index reaching the lowest level in nearly a year. The yield on the benchmark 10-year Treasury note climbed to 2.18% last week from 2.13% the previous week and 1.63% in early May. We anticipate the T-note yield will trade in a range of 1.75% to 2.50% into the fourth quarter.

In separate reports, the nation’s trade deficit widened to $40.3 billion in April, below the consensus of $41.5 billion. Most significant was the petroleum trade deficit narrowed further, reaching its lowest level in nearly 20 years. Weekly retail sales jumped 1.9%, the most in two months, and up 4.3% on a year-over-year basis, the fastest pace in a year. Vehicle sales rose 2.5% in May to 15.2 million unit annual rate. The improvement in consumer spending is related to improving trends in confidence, in part due to the increase in home prices this year.

The latest data from Core Logic shows gains exceeding 12% in home prices from a year ago, the best performance since the first quarter of 2006. The concern is that given the biggest backup in mortgage rates since February 2011 the momentum in the housing market could stall. This is already being seen in the latest mortgage applications figures that show a dramatic drop the past three weeks. In addition, the Mortgage Bankers Association (MBA) Refinance Index plunged to the lowest level since November 2011. Economic data this week for May is not anticipated to be an important influence on stock or bond prices. Retail sales are anticipated to be 0.4% versus 0.1%; wholesale inflation 0.1% versus -0.7%; industrial production 0.4% versus -0.5%.

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 = Strong RS – Buy. Groups expected to outperform: Biotechnology, Managed Health Care, and Health Care Services

No. 4 Industrials = Improving RS – Buy. Groups expected to outperform: Airlines, Railroads, Building Products, and Environmental 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 Energy = Wait for top 5 ranking in RS – Hold. Groups expected to outperform: Oil and Gas Storage & Transport and Oil & Gas Exploration & Production, Integrated Oil & Gas

No. 7 Consumer Staples = Significant decline in RS – Hold. Groups expected to outperform: Personal Products, Food Retail, and Drug Retail

No.8 Materials = Downtick in RS – Hold. Groups expected to outperform: Diversified Chemicals, Specialty Chemicals, and Construction Materials 

No. 9 Telecom = Downtick in RS. – Hold. Groups expected to outperform: Wireless Telecom Services

No. 10 Utilities = Weakest sector – 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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