Baird

Weekly Market Notes

August 5, 2013

Dow 15658 – S&P 500 1709

The summer rally continued last week with the Dow Industrials and S&P 500 indices hitting new record highs. The Dow gained 0.6% and the S&P 500 1.00% with the NASDAQ Composite soaring 2.00%. Stocks benefited from improvement in the manufacturing side of the economy. However, economic growth for most areas of the economy remains soft and this is expected to keep the Fed from reducing the level of quantitative easing. Considering the Tape remains bullish with more than 93% of the industry groups in uptrends, the path of least resistance for stocks remains to the upside. Evidence is building, however, that the market could be vulnerable later in the third quarter. 

Corporate profits have not matched the gains in stock prices causing valuations to become elevated. Market leadership in recent weeks has shifted to the NASDAQ, which is a reason to be alert given this is typically a late cycle phenomena. Seasonal patterns that have provided a tailwind for stocks this year will become a headwind as we move into the late August early September time frame. The good news is that prior to a peak market breadth typically deteriorates and investor sentiment becomes excessively optimistic.  At this juncture sentiment and breadth are non-threatening. 

The technical condition for equities has improved. The trend and momentum for stocks remains positive. The equity market, however, is overbought. The fact that the overbought condition persists intermediate term, underscores the strength of the trend and momentum.  Breadth figures for the market show some deterioration but this is due to the weakness in the bond market. Bond equivalent stocks that trade on the NYSE are a substantial part of the overall mix. A rise in interest rates impacts interest rate sensitive stocks, a great number of which are listed on the NYSE, which can distort the overall breadth figures. From a flow of funds perspective the picture has also improved for stocks.  Stock funds have enjoyed inflows for three consecutive weeks with most of the money going into domestic areas.  

Investor sentiment, which was growing worrisome in mid-July, has witnessed a slight reversal. It appears that the brief consolidation phase in the stock market caused the bullish camp to quickly withdraw. This can be seen in the reduced number of bulls in the Investors Intelligence data and from the survey from the American Association of Individual investors. Given that the top of the market is always the point of maximum optimism, the sentiment data argues that the summer rally has additional room on the upside. 

The economic data remains mixed. Second Quarter GDP was reported stronger than expected. Real GDP rose at a 1.7% annual rate led by a jump in capital expenditures. The first quarter, however, was revised down to 1.1% from 1.8%. Non-residential fixed investment rebounded, reversing a decline in the previous quarter. Housing remains a driving force. Residential investment climbed at a 13.4% rate. 

Personal Consumption Expenditures rose at a 1.8% annual rate, down from 2.3% in the first quarter. Surprisingly, exports rose at a 5.4% annual rate and imports expanded by 9.1%. The PCE Price Index was unchanged indicating that inflation pressure has yet to gain a foothold despite the uptick in business activity. 

The personal savings rate was 4.5% in the second quarter. The ISM Manufacturing Index showed the largest gain in July since June of 1996. The Index jumped 4.5 points to 55.4 versus 50.9 the previous month. New orders rose 6.4 points, the most since August of 2009. Manufacturing in the U.S. represents only 10% of the overall economy, which helps explain why growth remains far below trend. 

The July Employment Report was a major disappointment suggesting the U.S. economy continues to operate in first gear. Nonfarm payrolls increased 162,000 in July, below the consensus of 183,000  In addition, the prior two months were revised downward. The average workweek fell to 34.4 hours from 34.5 hours, the lowest level in six months.  Average hourly earnings fell 0.1% last month and nearly half the new jobs were in low paying industries including retail and restaurants.

The U.S. economy has created 950,000 jobs in 2013, 77% of which are part-time work. The unemployment rate fell to 7.4% in July from 7.6% in June. This was due primarily by workers leaving the labor market and therefore no longer considered unemployed. This suggests that the economy remains in stall mode.  If the economy were gaining steam the reverse would hold true and workers would be out aggressively looking for work. The job numbers argue that interest rates are likely to return to a range of 2.25% to 2.75% into year end. 

Sector Rankings and Recommendations

No. 1 Consumer Discretionary = Number one sector for most of the rally– Buy. Groups expected to outperform: Auto Parts & Equipment, Broadcast & Cable TV, Specialized Consumer Services, and Consumer Electronics

No. 2 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. 3 Industrials = Continued RS leadership and conditions still improving – Buy. Groups expected to outperform:   Employment Services, Electrical Components & Equipment, Industrial Conglomerates, Air Freight & Logistics, and Aerospace & Defense

No. 4 Health Care = Remains a RS leader – Buy. Groups expected to outperform: Health Care Distributors, Managed Health Care, and Biotechnology

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 Utilities = Bounce off the bottom needs further RS improvement – Hold. Groups expected to outperform:  Gas Utilities and Multi-Utilities & Unregulated Power

No. 8 Materials = Weak RS persists – Hold. Groups expected to outperform:  Paper Packaging, Paper Products, Industrial Gases, and Diversified Chemicals  

No. 9 Information Technology = Falling RS problematic – 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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