Baird

Weekly Market Notes

June 17, 2013

Dow 15070 – S&P 500 1626

Stocks gave ground last week for the third time in the past four weeks. For the first time since November 2012, the equity markets are experiencing a significant increase in volatility. Uncertainty surrounding the U.S. and global economies and mixed signals from the Central Banks has triggered wide swings in the equity and debt markets. From a technical perspective, increased volatility is seen as bullish because it eventually leads to investor psychology moving from complacency to fear. 

Solid market bottoms are almost always associated with rising levels of fear and skepticism. Evidence of this is already surfacing as seen in the sentiment indicators. This is important because there is an inverse relationship between sentiment and liquidity. As investors become more cautious, cash builds on the sideline that eventually provides the fuel for the next advance. Last week for the first time in several months money has flowed out of stock and bond funds into money markets. We will likely need to see this trend continue before stocks are ready for a sustainable rally into the heat of the summer. As a result, investors should wait for the weight of the sentiment indicators to turn overwhelmingly bullish. This would require the CBOE Volatility Index to move above 22 and the AAII survey to show twice as many bears than bulls. Investors Intelligence should show less than 40% bulls among the advisors and aggressive money managers’ exposure to stocks should fall under 30% as seen in the NAIIM data.   

The focus of attention this week will be on Tuesday/Wednesday meetings of the Federal Reserve’s Open Market Committee.  Considering that the Fed has been largely responsible for the rally in asset prices the past four years, any indication that the Fed will play a lesser role is seen as a negative for stocks.  We view the likelihood that the Fed will substantially change monetary policy as remote for the following reasons: 1) the U.S. economic recovery is not accelerating and remains fragile, 2) inflation rates around the globe are falling, 3) the unemployment rate is above Fed targets, 4) inflation is below Fed targets, 5) the global economy is in recession and growth rates falling, 6) final demand is weak in the U.S., China, Japan and Europe, which makes up 50% of the global economy, 7) commodity prices are falling with copper -14%, steel -30% and lumber prices off 31% from this year’s peak suggesting stronger growth is not imminent.  

Overall the environment is unprepared to prosper without a continuation of massive Central Bank intervention. In a recent statement, Fed Chairman Bernanke stated that the policy remains flexible giving the Central Bank room to add or subtract from quantitative easing.  Given the circumstances surrounding the U.S. and global economies a case could be made that Bernanke’s next move will be to become more aggressive with monetary policy. In any event, we believe that this week’s Fed meeting will not be a threat to the financial markets. 

Employment growth remains the key element in the Fed’s decision on monetary policy for the remainder of 2013. Job growth remains anemic but there are signs that the labor conditions are stable.  The Conference Board’s Employment Expectation Index rebounded 0.6% in May, hitting the best level in five years. The latest reading of this index supports the assumption that payroll growth will remain positive this year but the rate of growth will remain weak. The Manpower Employment Outlook Survey for the third quarter moved up slightly, another indication that the labor markets are stable. Small business sentiment is on the rise which is a positive for the economy and jobs over the next six months. 

The NFIB Small Business Optimism Index rose in June for the fifth consecutive time, to the best level in a year and just slightly below what was seen in in 2007. Within the report, eight of the ten index components improved; most notable was the 10 percentage point increase in the outlook for the economy. Nevertheless, taxes and government regulations were two of the most important issues facing small business, followed by poor sales.  In a separate report, retail sales rose in May more than expected.  Sales growth was powered by vehicles, which jumped 1.8%.   With vehicles removed from the data, sales were up a modest 0.3%.  The consumer continues to be the primary driver in the economy, despite higher payroll and income tax rates in 2013.  The consumer will be saddled with significantly higher health care costs next year.  A reduction in disposable income due to the implementation of Obamacare could have an important impact on retail sales and the economy in 2014. 

The yield on the benchmark 10-year Treasury note fell to 2.12% last week from 2.18% the previous week.  Given the soft economy and low level of inflation the yield on the 10-year T-note is anticipated to move in a range of 1.75% to 2.50% into the fourth quarter. The Producer Price Index (PPI) climbed 0.5% in May, its first increase in three months. The increase was largely due to a 1.3% gain in energy prices. The recent rise in crude oil prices is related to the escalation of the war in Syria.  Core PPI rose 0.1% in May, which argues that pricing pressures remain weak.  Industrial Production was unchanged in May.  On a year-over-year basis, industrial production is up a modest 1.6%, which is further evidence that the economy continues to have difficulty gaining traction.     

Sector Rankings and Recommendations

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

No. 2 Industrials = Continued improvement in RS – Buy. Groups expected to outperform:   Airlines, Railroads, Building Products, and Aerospace & Defense

No. 3 Consumer Discretionary = Maintaining good RS –Buy. Groups expected to outperform: Home Improvement Retail, Household Appliances, Auto Parts & Equipment, Department Stores, Apparel Accessories & Luxury Goods, and Consumer Electronics

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

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

No. 6 Consumer Staples = Improving RS –Hold.  Groups expected to outperform: Personal Products, Food Retail, and Drug Retail

No.7 Materials = Downtick in RS –Hold. Groups expected to outperform:  Industrial Gases, Specialty Chemicals, and Construction Materials  

No. 8 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. 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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