Baird

Weekly Market Notes
July 1, 2013
Dow 14909– S&P 500 1606

The popular averages finished the first half of the year with double-digit gains. Stocks benefited for most of the period from low interest rates, low inflation and a friendly Federal Reserve. A combination of factors triggered a late second quarter correction that subtracted about 4% from the January through June result. The economy and corporate profits failed to keep pace with stock gains and following nearly six months of uninterrupted rally the market was overbought and overbelieved at the early May peak.

But it was the Fed’s announcement that quantitative easing could be reduced that sent bond yields rising 100 basis points that caused most of the damage to stocks as the second quarter expired. Over the very near term, uncertainty surrounding the strength of the economy and second quarter earnings just ahead is expected to keep stocks in a trading range.  The risk is seen to be 1550 using the S&P 500 with the reward to 1635. Looking further out, stocks are seen attacking the May highs later this summer as interest rates stabilize, inflation remains low and investor sentiment comes full circle from optimism to pessimism. 

The technical condition of the equity markets is improving. The longer-term overbought condition that developed in early May has been relieved. The bullish trend in the popular averages remains in effect with stocks finding good support in the vicinity of 1560 using the S&P 500. The downside momentum has stalled but before we can argue that momentum has shifted to the upside there should be at least one session where upside volume exceeds downside volume by a ratio of 10 to 1 or more. 

The largest technical improvement is seen in the shift in investor psychology.  Reports from the Chicago Board of Options Exchange show an unusual demand for put options. The CBOE Volatility Index (VIX) traded above 21 intraday last week but fell short of triggering an outright buy signal. Sentiment polls, however, show a significant shift away from optimism but short of what is considered extreme readings.  Investors Intelligence, which tracks the recommendations of Wall Street letter writers, showed the bears moving to the highest level since the November 2012 lows. The National Association of Active Investment Managers (NAAIM) reported a sharp decline in exposure to common stocks last week. 

The U.S. economy continues to have problems finding second gear but fresh data for May is encouraging. Personal Income in May rose 0.5%, the most in three months.  Wages, however, rose only 0.3% but government transfer payments jumped 1.2%, the most since 2011.  Real disposable personal income rose 0.4% and is up 1.0% on a year-over-year basis, which is far below the average yearly gain of 2.7%.  Personal consumption expenditures (PCE) jumped 0.3% last month.  The year-over-year real disposable income rose 1.9%, below the long-term average of 3.1%. 

This is troublesome given that disposable income could take a significant hit when ObamaCare comes on stream later this year. The PCE Price Index rose 0.1% in May, while core PCE prices remained at a record low 1.1%. The personal savings rate rose to 3.2%, up from 2.5% in the first quarter.  Jobless claims fell 9,000 last week allowing the four-week average to decline to 345,000 which is consistent with modest job growth.  The latest data on the economy suggests fair value for the benchmark 10-year Treasury note which is near 2.25%.

Looking back, first quarter GDP was revised sharply lower to a 1.8% annual rate from 2.4% in previous estimates.  Despite four years of zero percent interest rates and four installments of quantitative easing, the economy cannot gain enough momentum to move out of first gear.  The long-term trend in GDP growth is in the vicinity of 3.2%.  Weak final demand remains the problem.  Real final sales were revised down to a 1.3%, about half the historical average of 2.7%. The largest contributor to the downward revision was real personal consumption expenditures.  This is not expected to improve given the burden of higher taxes and the widely expected jump in health care costs that will subtract significantly from disposable income. Weakness in the global economy is likely to remain a significant headwind to growth. 

Exports were revised downward to a -1.1% annual rate from +0.8% in the previous estimate. In separate reports, consumer confidence rose in June for the third straight time to the highest level since early 2008.  Purchasing plans were positive, including plans to buy a home and car.  The important question centers on what higher mortgage rates will mean for the housing industry. Mortgage rates last week climbed to the highest level since July 2011. Higher interest expense has already impacted the refinance market that suffered its sixth decline in the past seven weeks.  Pending home sales surged in May but this could be due to homebuyers attempting to front run rising mortgage rates.

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 Consumer Discretionary = Maintaining good RS –Buy. Groups expected to outperform: Home Improvement Retail, Auto Parts & Equipment, Department Stores, Apparel Accessories & Luxury Goods, and Consumer Electronics

No. 3 Health Care = Good RS – Buy. Groups expected to outperform: Health Care Distributors, Managed Health Care, and Health Care Services

No. 4 Industrials = Continued improvement in RS – Buy. Groups expected to outperform:   Air Freight & Logistics, Railroads, Environmental Services, and Aerospace & Defense

No. 5 Consumer Staples = Improving RS –Hold.  Groups expected to outperform: Food Retail, Agricultural Products; Packaged Foods & Meats

No. 6 Energy = Wait for top 5 ranking in RS -Hold.  Groups expected to outperform:  Oil & Gas Drilling and Oil & Gas Exploration & Production

No.7 Information Technology = Wait for return to top 5 RS – Hold. Groups expected to outperform: Home Entertainment Software, Semiconductors, Data Processing & Outsourced Services, and Electronic Manufacturing Services

No. 8 Telecom = Downtick in RS. – Hold. Groups expected to outperform:  Wireless Telecom Services

No.9 Materials = Poor RS –Hold. Groups expected to outperform:  Industrial Gases, Specialty Chemicals, and Construction Materials 

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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