Baird

Weekly Market Notes

June 24, 2013

Dow 14799– S&P 500 1592

The equity markets fell 2% last week in reaction to the suggestion that the Federal Reserve could begin draining the punch bowl later this year. The Fed’s improving outlook for the U.S. economy provided the ammunition for Bernanke to reduce bond purchases later this year. Assuming the growth rate of the economy will improve to 2,4% in 2013 and 3.50% in 2014, however, could be a leap of faith. Consumers are restrained by a lack of income and higher taxes. 

On the corporate front, capital spending shows no signs of improving. Large multinational corporations are battling the effects of a stronger dollar and weak overseas demand. Small companies that have more flexibility and that typically benefit from a stronger currency will be handicapped by rising taxes, increased regulation and unknowns surrounding health care expenses. Housing, which has been the beacon of strength, is likely to be influenced by higher mortgage rates. 

As a result it is debatable that the U.S. economy will reach the growth potential forecast by the Federal Reserve. This suggests that Bernanke is unlikely to pull the rug from the $85 billion in bond purchases this year. Before stocks find a secure rallying base, the bond market needs to stabilize and investor sentiment should turn 180 degrees from the excitement found in early May. Support is near 1550, which would represent a 7% correction from the recent highs.  A close below 1500 would indicate that in addition to the loss of momentum the trend has turned down.  

Technically, the largest hurtle for stocks is the mounting downside momentum. Recent breath figures argue that the correction is gaining downside momentum.  This implies a full test of support of 1550 using the S&P 500 in the weeks just ahead. Given that the bottom of the market is always the point of maximum pessimism we are looking for fear levels to become widespread.  

This can already be seen in the sharp increase in the demand for put options but yet to be found in surveys of investor psychology from the American Association of Individual Investors (AAII), Investors Intelligence (II) and the National Association of Active Investment Managers (NAAIM). Investor psychology moving toward extreme pessimism is important at this juncture as investors over the past four years have steadily drawn down cash reserves. 

According to the AAII survey, at the 2009 lows investors had 45% of assets in cash versus last month’s report that showed cash reserves at just 17%. The TAPE is showing signs of deterioration but overall breadth figures remain favorable and supportive of a summer rally. Divergences are few with the Russell 2000 Index just three trading days removed from closing at an all-time high of 999.99. 

Diverging trends in foreign markets that were prevalent in the first quarter remain problematic. New cycle lows in emerging markets including many sectors of Asia argue that global stock markets are out of gear with the U.S.  In addition to stability in the debt markets, we would like to see a halt to the free fall in equity markets in Brazil, China and India.

The most recent set of economic indicators suggest business conditions are slowly improving. Sales of existing homes jumped 4.2% in May, to a 5.2 million unit rate and the best level since the second quarter of 2007.  Housing inventory rose last month but remains below levels that are consistent with a balanced market. As a result housing prices have reached the best level since 2008.  

Real median prices climbed 11.2% from a year ago, which could provide support for consumer spending in the second half of the year. The NAHB/Wells Fargo Housing Market Index soared in June to the highest level since the first quarter of 2006. Housing starts rose nearly 7% in May, the third increase in the past four months. Building permits fell 3% but on a 12-month basis, both starts and permits have reached the highest level since late 2008.

In separate reports, the General Conditions Index in the New York region moved higher for the first time in four months. Deeper into the report the outlook was not as optimistic as new and unfilled orders declined. The Conference Board’s Leading Economic Index (LEI) moved ahead slightly climbing 0.1% in May. The Conference Board’s report was optimistic that economic conditions will continue to improve into the fourth quarter. The Philadelphia Fed General Activity Index rose nearly 18 points in June, the most since October 2011. 

Encouragement within the Philly report was provided by the Future Activity Index that suggested continued optimism about the outlook into year end. The Consumer Price Index (CPI) moved up 0.1% in May. Core CPI climbed 0.2%. On a year-over-year basis, CPI is up 1.4%. According to Ned Davis Research, the CPI has risen on average 2.5% since 1991. Most important is the fact that real average earnings fell 0.2% last month and on a year-over year basis, real earnings have declined to 0.5% from 0.8%.  

The fact that wages are growing below the rate of inflation argues against a strong consumer led broad based economic recovery. The economic data due this week includes May Durable Goods Orders, which are anticipated to show a small gain of 2.5%. The final revision to first quarter GDP is expected to be unchanged at 2.4%. The Chicago PMI due Friday is anticipated to show a downtick to 55 from 58.7 the previous month and the June Michigan Sentiment Index on Friday is likely to be virtually unchanged at 83.0. 

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 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 = Improving RS –Hold. Groups expected to outperform: Personal Products, Food Retail, and Drug Retail

No.8 Materials = Downtick in RS – Hold. Groups expected to outperform: Industrial Gases, 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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