Baird

Weekly Market Notes
July 29, 2013
Dow 15558 – S&P 500 1691

The equity markets turned quiet last week with the popular averages virtually unchanged for the period. Considering that the first three weeks in July were the strongest in recent memory, last week’s performance should be considered very good. Stocks entered the week overbought and overbelieved which likely caused the stall. Second quarter earnings were mixed but the bias was to the upside. U.S. corporations have managed to maintain bottom line growth despite the struggle with revenues. Over the long-term, earnings closely mirror GDP growth.

Although earnings have played a supportive role this cycle, the gains have come from cost cutting, corporate buybacks and significantly lower financing costs that go straight to the bottom line. More important for stocks, the past four years witnessed the unprecedented aggressive monetary policy by the Federal Reserve Board.

This week the Fed’s FOMC Committee meets and it is widely anticipated that policy will remain unchanged. The markets, however, will be looking for an indication by Bernanke that quantitative easing will be ratcheted down late in the third quarter. Although the Fed could decide to modify QE3 and QE4, we believe this is unlikely given the fragile condition of the domestic and global economy. Given that the Bernanke ‘put’ remains in force, the odds favor a continuation of the summer rally into late August.

The weight of the evidence remains positive for the equity markets suggesting that any weakness that might develop near-term will be limited in both time and price. Fed policy remains bullish for stocks. Should Bernanke pull the string on quantitative easing zero percent interest rates are expected to remain in effect into 2015. The economy is considered a neutral influence on stocks. Slow growth is providing a challenge to business but the offset is that rates and inflation will remain low. Over the long-term, stocks have historically done best in a slow growth environment absent of inflation.

The fact that earnings growth has slowed has caused stock market valuations to expand into the expensive zone. Although high valuations raise the risk profile for stocks, equity prices can remain elevated for a considerable time before equities are negatively impacted. Investor psychology is considered bearish near-term but longer term indicators of investor sentiment show the market has more room on the upside. Typically, stocks do not find significant trouble until optimism becomes widespread and deeply seated, which is not the case in the present example.

Seasonal trends are favorable into late August but turn down later in the third quarter. The Tape is bullish with most industry groups in harmony with the primary trend. In a healthy bull market nearly all areas are in harmony with the primary trend. In the current example, nearly 90% of the S&P 500 industry groups are in uptrends.

The economic news was mixed last week. New home sales climbed more than expected in June. Sales of new homes in June rose to the best level in five years. Purchases climbed more than 8% to an annualized rate of 497,000 homes, the highest level since May 2008. The median selling price of a new home jumped 7.4% to $249,700 last month from $232,600 last year.The supply of new homes at the current sales rate was 3.9 months, down from 4.2 in May and the lowest in nine years. Homebuilders remain bullish on the housing market for 2013.

The National Association of Home Builders/Wells Fargo Index of Builder Sentiment climbed to a seven-year high in July. The largest threat to the housing market is the recent rise in interest rates. The average rate for a 30-year fixed mortgage is 4.40%, up from 3.31% at the November low.

We anticipate that mortgage rates would have to climb closer to 5% before seriously impacting the demand for homes. Rising home prices and new highs in the stock market helped consumer sentiment rise to a six year high in July. The fact that consumers are entering the third quarter with positive views argues for an improved selling environment for retailers. 

The Richmond Fed Manufacturing Activity Index plunged in July, indicating factory activity contracted sharply. New orders and backlogs fell significantly, suggesting future demand will be weak. The Service Sector Revenues Index declined by the most in a year led by the retail sector. The Kansas City Fed Composite Index, however, rebounded in July to the best level in nearly a year due to a recovery in manufacturing activity. The Kansas City report fits closely to the latest Durable Goods report that showed orders rose in June for the third straight month. The 12-month average of orders rose to the best level since the first quarter of 2012. The good news on the durable goods numbers was found in orders for aircraft. Outside of aircraft orders were flat. The discrepancies in the latest data show the recovery from the summer weakness thus far is uneven which raises the question of sustainability.  

This week brings a flood of economic reports that could offer a glimpse of business prospects for the second half of the year. The focus of attention will be on a report of second quarter GDP growth, the latest employment data and the July ISM Manufacturing Index. The consensus opinion of economists is that GDP grew 1% in the second quarter down from 1.8% in the first quarter of 2013. Growth in the second quarter was likely impacted by weaker retail sales, a soft export market and reduced government spending.

The July jobs report is anticipated to show the economy created 175,000 jobs last month, down from 195,000 in June. The unemployment rate is expected to downtick to 7.5% from 7.6%.  The ISM Manufacturing Index for July is expected to climb to 53.1 from 50.9 the previous month. The economic data next week should be a win-win for the bulls. Should the economic numbers come in weaker than expected the market is likely to interpret that as bullish given that Fed Chairman Bernanke would be less inclined to tinker with quantitative easing. 

Sector Rankings and Recommendations

No. 1 Financials = Strong RS with broad participation – Buy. Groups expected to outperform: Life & Health Insurance, Investment Banking & Brokerage, Other Diversified Financial Services, Regional Banks, and Specialized Finance

No. 2 Consumer Discretionary = Continued RS strength but sub-industry trends weakening – Buy. Groups expected to outperform: Auto Parts & Equipment, Broadcast & Cable TV, Specialized Consumer Services, Apparel Accessories & Luxury Goods, and Consumer Electronics

No. 3 Health Care = Remains a RS leader – Buy. Groups expected to outperform: Health Care Distributors, Managed Health Care, and Biotechnology

No. 4 Industrials = Continued RS leadership and conditions still improving – Buy. Groups expected to outperform: Employment Services, Electrical Components & Equipment, Industrial Conglomerates, Environmental Services, and Aerospace & Defense

No. 5 Energy = Moved into the top 5 in RS – Buy. Groups expected to outperform: Oil & Gas Equipment & Services, Integrated Oil & Gas, and Oil & Gas Exploration & Production

No. 6 Consumer Staples = Downtick in RS – Hold. Groups expected to outperform: Food Retail, Agricultural Products and Packaged Foods & Meats

No. 7 Materials = Weak RS persists – Hold. Groups expected to outperform: Paper Packaging, Paper Products, Industrial Gases, and Diversified Chemicals

No. 8 Utilities = Bounce off the bottom/ needs further RS improvement – Hold. Groups expected to outperform: Gas Utilities and Multi-Utilities & Unregulated Power

No. 9 Information Technology = Sharp Decline in RS – Hold. Groups expected to outperform: Application Software, Electronic Equipment Manufacturers, Data Processing & Outsourced Services, Computer Storage & Peripherals, and Electronic Manufacturing Services

No. 10 Telecom = Bottom of rankings – Hold. Groups expected to outperform:  Integrated 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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