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The equity markets ended a roller coaster performance last week with mixed results. Large-cap issues lost ground on a stronger dollar but the Russell 2000, which is made up of small cap issues, gained 1.2%. The financial markets are expected to remain hostage to the increasing volatility in the currency markets.

The consolidation phase in the stock market that began three weeks ago is anticipated to continue. The problem is that no less than 24 central banks have lowered interest rates this year. The U.S. is on the other side of this trade with the Fed’s QE program already expired and a rate increase widely anticipated as just around the corner the dollar has soared. This has resulted in short-term trend divergences developing in U.S. markets with small-cap companies outperforming the S&P 500 Index. Although the dollar is very overbought short-term, we anticipate the currency trends to continue longer term due to the fact the U.S. economy will likely remain strong relative to Europe, Japan and emerging markets.

As a result investors should focus on those groups and sectors that benefit from a strong dollar. Many of these can be found in the consumer discretionary sector such as retailers that import much of their inventory. Health care is likely to benefit as this sector is primarily driven by domestic demand from an aging population. The financial sector moved into the top 5 last week. The financials are often a reliable leading indicator of the general health of the stock market. We are less inclined toward the energy sector where oil prices could remain under pressure for a considerable period of time. In the current environment size does matter and we favor small-cap and mid-cap issues over S&P 500 and Dow Industrial types.

The technical condition of the stock market is mixed. Short-term trends are diverging and the loss of momentum moved stocks into a consolidation phase that is now three weeks old. The good news is that the excessive optimism that was worrisome earlier in the month is fading. Unfortunately, this has not translated into widespread pessimism. The CBOE put/call data shows a measure of fear entering but the widely followed CBOE Volatility Index (VIX) showed no visible signs of life last week despite the wide price swings.

Over the past six years, the best rallies in the stock market have occurred when stocks were oversold and investors were fearful. As a result the sentiment indicators argue that the market will remain in a trading range with the risk to 2000 using the S&P 500 and the reward to 2090. Small-cap stocks could do better as the seasonal patterns are favorable into mid-year.

** Denotes Current Relative Strength-Based Overweight Sectors ** 1 ranking = strongest sector - 10=ranking weakest sector

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Article provided by Robert W. Baird & Co. with the authorization of its author for Evan Guido, Senior 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

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