Business and Financial Baird

Weekly Market Notes
October 1, 2012
Dow 13437 - S&P 500 1440

The popular averages enjoyed a large gain in the third quarter with the peak in stock prices occurring in mid-September. Renewed economic weakness, ongoing trouble in the euro zone and an overbought market caused stocks to slide the past two weeks. Encouraging is the fact that the mood of investors quickly moved away from extreme optimism, suggesting any further weakness should be limited in both time and price.

The focus of attention in October will be on the election and the impact that rising taxes and lower government spending will have on the economy in 2013. Best estimates are that the fiscal cliff will eventually be postponed after the election for 90 to 180 days as policy makers are likely to punt on these issues until the second quarter of next year.  As a result the pressure will remain on the Federal Reserve and Chairman Bernanke to urge the economy forward, wich opens the possibility of a new round of quantitative easing (QE4) in December, focusing on Treasury bonds when Operation Twist expires.

The technical condition of the equity markets weakened with the selloff in late September. Despite the two week drop in prices the overbought condition has not been fully worked off. Sentiment, which had approached extreme optimism has reversed, which is important if the averages are to hold support. Market breadth deteriorated last week with a drop in the NYSE advance/decline ratio.  Sector breath also weakened particularly in the information technology and energy sectors, which had been market leaders this summer.

Although many of the negative divergences that were present a month ago have clear up, the Dow Transports remain problematic due to their failure to match the action in the Dow Industrials. Of somewhat greater concern is the fact that following last week’s action most of the averages are now trading below levels seen when Bernanke introduced unlimited money printing.  As a result resistance is at 1470 using the S&P 500 and 850 using the Russell 2000. The bottom line is stocks enter the new month facing election year uncertainty and deteriorating economic fundamentals. Aggressive new buying should wait for sentiment to turn more cautious and stocks to enter the support zone, which is considered to be 1385 to 1425 using the S&P 500.

Measures of investor psychology moved away from excessive optimism last week.  Most notable was the renewed interest in put options last week. This suggests that optimism is not deeply seated and can quickly disappear with only a modest decline in the averages.  The most recent sentiment numbers argue for more rally attempts once the overbought condition is relieved.

• Ten Day Put/Call Ratio rose to 84% last week from 79% the previous week - historically, 80% is bearish and 95% bullish.  This indicator is now rated neutral. 
• The Three Day CBOE Equity Put/Call Ratio jumped to 70% last week from 55% the previous week. As a result this indicator is now considered neutral; 63% is considered bearish and 72% bullish. 
• The CBOE Volatility Index (VIX) climbed to 15.5 last week from14.6 the previous week - below 16 is considered bearish with a reading above 23 bullish.
• American Association of Individual Investors (AAII): The latest survey shows the bullish camp unchanged last week at 36%.  The outright bears climbed to 36% from 33% the previous week.  We would need to see twice as many bulls than bears in the AAII to trigger a sell signal.
• Investors Intelligence (II) tracks the recommendations of Wall Street letter writers. The bullish camp declined to 51.0% last week from 54.2% the previous week.  The bears among the advisors were unchanged at 24.4%.  More than twice as many bulls than bears in the II report indicate excessive optimism from this group of investors.
• National Association of Active Investment Managers (NAAIM): Exposure to equities by aggressive money managers fell to 70% last week from 81% the previous week. Although exposure to stocks was recently cut, exposure to stocks remains elevated and has been above 70% for five weeks in a row. At the bottom of the market in the summer of 2011, these managers had zero appetite for stocks.   We use 15% exposure as a buy signal and 75% as a sell signal for this valuable indicator.
• Ned Davis Research Crowd Sentiment Poll fell last week but continues to show investor optimism is elevated.

The most recent economic data suggests that attempts to spur growth have had little impact on the economy.  Despite massive deficits and four years of zero percent interest rates sustainable growth remains elusive.  Second quarter GDP was revised down to 1.3% from 1.7%, the slowest rate in nearly a year.  Personal consumption was also revised lower with no bottom in sight as personal income rose just 0.1% the last two months.  As a result spending is being supported by borrowing and reduced savings, which is unsustainable.  The savings rate, which is the most important element in the long term prospects for the economy fell to 3.7% from 4.1%.   Over the past 50 years the savings rate in the U.S. has averaged better than 7%, which is the level needed to provide a platform of consistent long-term growth. Consumer confidence has experienced a small uptick recently but remains at recessionary readings.  Meanwhile, the Business Roundtable CEO Survey Index fell for the second consecutive quarter with 19% of the companies reporting cutbacks to capital spending plans.

The focus of attention this week will be in the ISM Index and Employment Report for September.  Regional reports on economic activity indicate that the ISM manufacturing number will again be negative (readings below 50 suggest negative growth) when reported this morning.  Consensus estimates are for a reading of 49.8 versus 49.6 the previous month.  The widely followed Employment Report due Friday, is anticipated to show the economy created 115,000 new jobs last month versus 96,000 in August.  The unemployment rate is expected to uptick to 8.2% from 8.1%.  The Federal Reserve has made it clear that further deterioration in the economy will be met with more stimulus.  As a result we anticipate more stimulus if the economy continues to underperform in the final quarter of 2012. The technical condition of the bond market improved last week on the back of a large revision by the Investment Company Institute in the cash reserve positions by bond fund managers, which can only be described as bullish for bonds. Interest rates are anticipated to remain low and stable well into 2013 with the yield on the benchmark 10-year Treasury note locked in a range of 1.50% to 2.0%.  

Sector Rankings and Recommendations

No. 1 Consumer Discretionary = Strongest Sector – Buy. Groups expected to outperform: home building, home improvement, automotive, movies & entertainment, restaurants, general merchandise, home furnishing and home improvment

No. 2 Financials = Strong RS – Buy.  Groups expected to outperform: Banks, REITs residential and diversified banks and insurance (life and health)

No. 3 Health Care = Big jump in RS – Buy. Groups expected to outperform: biotechnology, pharmaceuticals, and health care facilities

No. 4 Telecom = Deteriorating RS – Hold - Group expected to outperform:  telecom services

No. 5 Information Technology = Losing RS – Hold. Groups expected to outperform: application software, systems software and semiconductor equipment

No. 6 Energy = Losing RS - Hold. Groups expected to outperform:  oil & gas equipment services

No.7 Materials = Losing RS –Hold. Groups expected to outperform: diversified chemicals, specialty chemicals, containers & packaging and gold mining

No. 8 Consumer Staples = Defensive areas giving ground – Hold. Groups expected to outperform: food retail, personal products, and drug retail and soft drinks

No.9 Industrials = Downtick in RS – Hold. Groups expected to outperform:  building products, industrial machinery, construction & engineering, diversified commercial services

No.10 Utilities = Weakest sector – Hold. Groups expected to outperform:  electric distributors and electric integrated

Market Overview
Short-Term Trading range with risk to 1400 and reward to 1470 on the S&P 500
Long-Term Major support is 1100 on the S&P 500 and the reward is to 1500

 

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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