Baird

Weekly Market Notes
August 19, 2013
Dow 15081 – S&P 500 1655

Increased concern that the Federal Reserve will reduce the level of bond purchases this year helped cause the stock market to suffer the broadest weekly decline in more than a year last week. Worry about the impact on the economy of the Fed dialing back on monetary policy was the principal reason the popular averages lost more than 2.0% for the period. The yield on the benchmark 10-year Treasury note rallied toward 3.0%, a rate that was unfathomable prior to the 2008 recession but more than double the level seen just four months ago. Stocks entered the month overbought and overbelieved and this has helped exasperate the problem. Over the near-term the equity markets are likely to remain on the defensive.

Since 1987, August and September have been the two weakest months for stocks. High expectations for a strong rebound in corporate earnings in the second half of the year now appear to be a stretch, which could cause some buyers to hesitate. The rise in equity valuations do not necessarily mean stocks are vulnerable, but rising valuations do speak to the level of risk in the market and investor sentiment. Looking further out we anticipate a fourth quarter rally. To gain confidence that stocks will finish the year strong we would need to see investor sentiment turn pessimistic, interest rates to stabilize and corporate profit growth to reaccelerate.

The weight of the evidence is considered mildly bullish for stocks. This suggests that any further weakness would be limited. A normal correction in an ongoing cyclical bull market is 5% to 10%. Most important is the fact that the Federal Reserve policy remains friendly to the financial markets. Bernanke is on record indicating that short-term interest rates will remain near zero into 2015. Although the Fed could taper QE3 and QE4 next month we believe it is unlikely. The U.S. economy remains fragile as the lack of wage growth, higher taxes and rising interest rates are proving to be a heavy anchor on growth.

The Fed also has to be concerned about the housing market that is thought to be the backbone of the recovery. Japan and China have been very heavy sellers of Treasuries in recent months along with domestic bond funds and unless new buyers are found interest rates are likely to rise. A reduction by the Fed bond purchases by $15 to $20 billion a month has the potential of making a bad situation worse. Therefore if the Fed does decide to cut back on bond purchases it is more likely to be a much smaller amount, perhaps in the $10 billion range. Should Bernanke scale back to this level it would likely be well received by the Wall Street leading to a good rally.

The economic reports last week offered mixed signals relating to the strength of the U.S. economy. Inflation pressures remain non-threatening but housing and manufacturing appear to be weakening. The July Producer Price Index (PPI) was unchanged in July. Consensus estimates were that PPI climbed 0.2% last month. The Consumer Price Index (CPI) rose 0.2% in July. The core CPI also rose by 2.0%. On a year-over-year basis, CPI is up 2.0% with core up 1.7%. Considering that real average hourly earnings fell in July and are down 0.1% from a year ago, inflation driven excessive demand over supply looks very unlikely. 

Housing, which many consider the backbone of the U.S. economic recovery, is beginning to wobble. Building permits for single family houses experienced the largest drop since 2011. Housing starts in July climbed 5.9% but far below expectations of 8.9% growth. The combination of rising prices, sharply higher mortgage rates and weak income growth is slowing demand for houses. Refinance activity continued to contract last week, as the Mortgage Bankers Association Refinance Index fell to the lowest level since April of 2011. In addition, FHA and VA purchase applications volume was at its lowest since 2007. Although a slowdown in housing will act like a brake on the economy it is not expected to cause business activity to plunge as housing only represents 2% of the overall economy. We continue to believe the GDP growth for 2013 will be in the vicinity of 2.0%.

In separate economic reports, retail sales climbed 0.2% in July, which was slightly below expectations of 0.3%. Lower vehicle sales were responsible for the soft overall retail sales number. Excluding vehicles, sales rose 0.5% last month. Although higher taxes continue to be an anchor on consumer activity, evidence is mounting that households are taking on increased debt in response to the short-fall in discretionary income. Industrial production was unchanged in July versus a consensus of a 0.2% gain and the prior month was revised down. Industrial production has yet to recover its pre-recession peak despite four years of zero percent interest rates and 5 episodes of Fed money printing. Manufacturing fell 0.1%, giving rise to questions about the strong ISM Manufacturing Index that showed activity expanding significantly last month. 

Additionally, the Philly Fed General Business Activity Index dropped in August, indicating factory activity expanded at a slower pace. Business activity also slowed in New York State. The Empire State General Business Conditions Index fell in August indicating slower growth for the region. Non-farm productivity grew at an annual rate of 0.9% in the second quarter. Although this was a welcomed improvement over the first quarter decline of 1.7%, the loss of momentum in productivity will has negative implications for corporate profits and wage growth.  

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 Industrials = Continued RS leadership - Buy. Groups expected to outperform: Employment Services, Office Services & Supplies, Air Freight & Logistics, and Aerospace & Defense

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

No. 4 Financials = Strong RS – Buy. Groups expected to outperform: Life & Health Insurance, Regional Banks, and Diversified Banks

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

No. 6 Information Technology = Wait for top 5 RS reading – Hold. Groups expected to outperform: Application Software, Electronic Equipment Manufacturers, Communications Equipment, Computer Storage & Peripherals, and Electronic Manufacturing Services

No. 7 Consumer Staples = Downtick in RS – Hold. Groups expected to outperform: Food Retail, Agricultural Products and Packaged Foods & Meats

No. 8 Energy = Drop in RS – Hold. Groups expected to outperform: Oil & Gas Equipment & Services, Integrated Oil & Gas, and Oil & Gas Exploration & Production

No. 9 Utilities = Losing RS – 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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