Baird

Weekly Market Notes

August 26, 2013

Dow 15010 – S&P 500 1663 

The equity markets, following three weeks of falling prices, rebounded last week. Gains of more than 1.0% were seen in the Russell 2000 and NASDAQ. Large-cap indices underperformed with the S&P 500 gaining 0.5% and the Dow finishing the week with a small loss. The weakness in August can be attributed to several factors including an overbought condition and seasonal headwinds. The overriding factor is the uncertainty over Federal Reserve policy for the remainder of 2013. Bernanke first raised the prospects of the Fed cutting back on bond purchases four months ago. This would suggest that a modest shift in Fed policy is already built into current prices.

Bernanke’s decision to taper QE3 and QE4 is complicated given the uneven growth patterns in the U.S. economy and the questionable state of the labor markets. Bernanke also has to contend with the impact on foreign economies that his decision on reducing the level of stimulus could have. Since the Fed raised the prospect of a modest shift in policy, money has poured out of emerging market countries causing severe volatility and economic upheaval. Considering the multitude of moving parts, we are assuming that the Fed will either maintain the current rate of bond purchases at $85 billion a month or offer a token withdrawal of just $10 billion. The equity markets are expected look favorably on this outcome. The Fed meets on September 17 and 18. 

The technical condition is improving suggesting that any further weakness will be limited in terms of time and price. The most significant change is in the area of investor sentiment. Entering August, psychology was approaching extreme optimism, which historically is worrisome as it implies liquidity is contracting. Investors, however, have turned increasingly cautious the past two weeks with sentiment moving away from complacency and toward caution. This can be seen in the most recent data from the American Association of Individual Investors, the data compiled by Investors Intelligence and the numbers from the National Association of Active Money Managers.

Last week also witnessed large outflows from stock and ETF funds and into money market funds. Given that the Fed is on record to keep short-term interest rates at zero, the funds tied to money markets are ready sources of reinvestment later this year. Bond market sentiment has reached an extreme, which we view as a positive for stocks. The bond market enters the late August/September time frame oversold and underbelieved suggesting interest rates are at or near a cycle peak. 

The first sign that rising interest rates are having an impact on the economy surfaced Friday with the July New Home Sales Report. The report was a shock to most economists who were looking for only a modest pull back in demand. The reality was new home sales plunged 13.4% versus consensus estimates of a slight 1.4% decline. In addition, the prior three months were revised sharply downward suggesting a peak in the housing cycle could be in place.  

The drop in new home sales in July was the largest one-month drop since the second quarter of 2010. The weakness was broad based with sales falling in all four regions of the country. As a result, inventories surged causing the inventory/sales ratio to climb to the highest level since January 2012. The combination of higher prices, higher mortgage rates and a weak labor environment are impacting housing demand. Earlier in the week it was reported that sales of previously owned homes soared in July. Existing home sales rose more than 6% in July, the most in nearly three years. A large percentage of the July sales, however, had locked in the lower mortgage rates in May and June when mortgage rates were considerably lower (3.35% in May versus 4.58% in August). 

In separate reports, the Conference Board’s Leading Economic Index rose 0.6% in July. The improvement was broad based, with eight of the ten indicators advancing suggesting the economy will grow slightly stronger into year-end. Initial unemployment insurance claims jumped 13,000 last week. Nevertheless the four week average fell to 330,500, the fewest since the fourth quarter of 2007. The Bloomberg Consumer Comfort Index fell two points to -28.8, as consumers raised concerns of the state of the economy.  

This suggests that the labor markets did not improve in August and likely slowed from the previous two months. The focus of attention this week will be on the latest revision to second quarter GDP due Thursday. Consensus estimates are that the U.S. economy grew a revised 2.2% last quarter versus last month’s reading of 1.7%. The second quarter GDP number may have an impact on the Fed’s decision to taper bond purchases later this year. Less than 2.0% second quarter GDP growth would likely cause the Fed to pause in September. Should the GDP this week show growth substantially stronger than expected (above 2.5%) Bernanke may use that number to begin reducing very slowly the level of bond purchases. 

Sector Rankings and Recommendations

No. 1 Industrials = Continued RS leadership – Buy. Groups expected to outperform: Employment Services, Office Services & Supplies, Air Freight & Logistics, and Aerospace & Defense

No. 2 Consumer Discretionary = Retail sales mixed – Hold. Groups expected to outperform: Auto Parts & Equipment, Broadcast & Cable TV, Specialized Consumer Services, and Consumer Electronics

No. 3 Financials = Weakening RS trends – Hold. Groups expected to outperform: Life & Health Insurance, Regional Banks, Insurance Brokers, and Diversified Banks

No. 4 Materials = Gaining in RS – Buy. Groups expected to outperform: Paper Packaging, Steel, Industrial Gases, Diversified Metals & Mining, Gold and Metal & Glass Containers

No. 5 Health Care = Slipping in RS – Buy. Groups expected to outperform: Health Care Distributors, Managed Health Care, and Biotechnology

No. 6 Information Technology = Improving RS – Buy. Groups expected to outperform: Application Software, Electronic Equipment Manufacturers, Communications Equipment, Computer Storage & Peripherals, and Electronic Manufacturing Services

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

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

No. 9 Utilities = Weak RS – Hold. Groups expected to outperform: Gas Utilities

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