Baird

Weekly Market Notes

August 12, 2013

Dow 15425 – S&P 500 1691 

The scorching summer rally cooled last week with most of the leading indices suffering modest declines. Stocks gave ground despite a litany of economic reports that showed improving business trends. Stronger economic data, however, is considered a two-edged sword. A better business environment is supportive of corporate earnings growth but improving economic conditions are also associated with a less-friendly Federal Reserve Board. 

Over the very near term, we anticipate that the summer rally will resume and could carry into early September. But the rise in stock values this summer has also introduced more risk in the market. Valuations are stretched. Liquidity has been drawn down as seen in the reduction in money market assets and stocks will be faced with unfriendly seasonal trends beginning later this month. The recommended strategy is to use rallies above 1700 on the S&P 500 to move in line with asset allocation models. For the vast majority of investors, a 55% allocation to stocks is suggested. Investors should also concentrate efforts in the strongest sectors including consumer discretionary, health care and industrials. 

The economic fundamentals for the stock market are considered neutral with the strongest support for stocks continuing to be Federal Reserve policy. The latest economic data is mixed. GDP in the second quarter improved over the first quarter but growth remains anchored near 1.7%. The manufacturing and service sectors upticked in July but were overshadowed by the July labor market statistics and the slowdown in the housing market this summer. Considering that consumers represent 70% of the U.S. economy, the lack of wage and income growth places a cap on growth. Disposable income is the engine that gives consumers the ability to spend.

Although job creation has been steady this year, most of the demand has been for part-time workers. In addition, a large percentage of the jobs have been in low-wage industries including retail and restaurants. Perhaps due to the increase in asset prices (homes and equities), consumers have again turned to debt markets to maintain a level of spending. This is unsustainable unless the labor markets improve. Consumer spending is not likely to be strong enough to move the economy into second gear. Housing, which has been the backbone of the recovery, is now suffering from a modest correction as home buyers are faced with higher prices and increased mortgage expense. 

The latest economic data shows the U.S. economy gaining a measure of upside momentum. The ISM Non-Manufacturing Index (NMI) jumped in July to 56.0 from 52.2 the previous month and now sits at the best level since February 2012. The improvement in the service sector was stronger than most economists were expecting. The most significant negative numbers within the report were a decline in order backlogs, which suggest less robust growth in the future and the prices index rose the most since October 2010. 

The overall improvement in the NMI data was a positive compliment to the ISM Manufacturing Report the previous month which also contained a strong upside surprise. In separate reports, the nation’s trade deficit contracted in June and according to JOLTS, the labor markets remain weak. The trade deficit shrank by nearly $10 billion, the lowest number since October 2009. Exports rose 2.2%, the most in nine months and imports dropped. Year-over-year, exports have increased 2.2%, while imports have fallen 0.7%.  The better-than-anticipated trade numbers could push second-quarter GDP growth to 2.5% or more from the reported 1.8%. 

The volatility in the bond market has receded in recent weeks. The yield on the benchmark 10-year Treasury note broke out in early June when Fed Chairman Ben Bernanke first introduced the notion that the quantitative easing could be reduced later this year. Of course, the Fed quickly reminded the markets that the Bernanke “put” was still in place should the economy or financial markets misbehave. Over the past four weeks, stability has returned to the fixed income markets.  

Considering that the U.S. economic recovery remains fragile with Europe and Asia struggling to grow, the yield on benchmark 10-year Treasury is anticipated to remain in a range of 2.25% to 2.75%. This is also supported by the fact that outflows from bond funds has slowed and investor sentiment has reached levels that show pessimism is excessive. Economic reports to be issued next week including retail sales, home mortgage applications and wholesale prices are not expected to be market movers. 

Sector Rankings and Recommendations

No. 1 Consumer Discretionary = Retail sales slowing - hold. Groups expected to outperform: Auto Parts & Equipment, Broadcast & Cable TV, Specialized Consumer Services, and Consumer Electronics

No. 2 Health Care = Remains a RS leader – Buy. Groups expected to outperform: Health Care Distributors, Managed Health Care, and Biotechnology

No. 3 Financials = Strong RS – Buy. Groups expected to outperform: Life & Health Insurance, Investment Banking & Brokerage, Other Diversified Financial Services, Regional Banks, and Specialized Finance

No. 4 Industrials = Continued RS leadership and conditions still improving – Buy. Groups expected to outperform: Employment Services, Office Services & Supplies, Air Freight & Logistics, and Aerospace & Defense

No. 5 Materials = Wait for additional RS evidence – Hold. Groups expected to outperform: Paper Packaging, Paper Products, Steel, Industrial Gases, and Diversified Chemicals  

No. 6 Energy = Slight drop in RS – Buy. Groups expected to outperform: Oil & Gas Equipment & Services, Integrated Oil & Gas, and Oil & Gas Exploration & Production

No. 7 Information Technology = Falling RS problematic – Hold. Groups expected to outperform: Application Software, Electronic Equipment Manufacturers, Communications Equipment, Computer Storage & Peripherals, and Electronic Manufacturing Services

No. 8 Consumer Staples = Downtick in RS – Hold. Groups expected to outperform: Food Retail, Agricultural Products and Packaged Foods & Meats

No. 9 Utilities = Bounce off the bottom needs further RS improvement – Hold. Groups expected to outperform:  Gas Utilities, Electric Utilities and Multi-Utilities & Unregulated Power

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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