Business and Financial Baird

Weekly Market Notes
December 17, 2012
Dow 13135 – S&P 500 1413

The equity markets continue to be held hostage to December tax related cross currents and indecision on economic policy from Washington. Despite the likelihood that tax related selling peaked last week, there is no indication that the nation’s fiscal problems will be addressed before year-end. Historically, stocks begin a firming trend the week before Christmas. But with the fiscal issues unresolved the typical year-end pattern for the market is uncertain. 

Should a breakthrough occur in Washington, we would anticipate that stocks would move higher into year end and extend into the opening weeks of January. Seasonal trends are very favorable and the Federal Reserve has made it clear that monetary policy will continue to be a tailwind for stocks. In addition, potential changes in tax policy have encouraged corporations to pay significant special dividends in December, some of which is expected to find its way back into the stock market. Over the near-term the dividend windfall could also support consumer spending, which could provide for a stronger retail sales event this holiday. 

The technical condition of the stock market is improving. Stocks are in the early stages of the one-year cycle that argues for strength off and on into April. The percentage of S&P 500 industry groups in uptrends improved to 57% last week from 53% the previous week. In addition, the momentum remains favorable as stocks continue to ride two sessions where upside volume overwhelmed downside volume by a ratio of more than 10 to 1. The strongest sectors include health care, industrials, financials and consumer discretionary.

The weight of the sentiment indicators argues that investors are growing increasingly optimistic. Historically, sentiment tends to run more bullish in December as many view the upcoming year as a new beginning. As a result, we view the current sentiment data as mildly bullish. We will become concerned when investor psychology becomes excessively bullish. When optimism becomes extreme it typically means investors are fully positioned for a rise in stock prices.   

• Ten Day Put/Call Ratio fell for the fourth week in a row to 86% from 87% the previous week. This indicator is considered neutral (80% is bearish and 95% bullish). The Three Day CBOE Equity Put/Call Ratio fell slightly to 64% from 65% the previous week, a neutral reading (64% is considered bearish and 72% bullish).
• The CBOE Volatility Index (VIX), which is considered a reliable gauge of the level of fear in the market, climbed to 17 from 16 the previous week. The latest VIX readings suggest investors are too complacent (16 is considered bearish and 23 bullish).
• American Association of Individual Investors (AAII): The latest survey shows the bullish camp unchanged at 43%. The bears rose slightly to 30% from 29% the previous week.  This indicator remains neutral. We would need to see twice as many bulls than bears to trigger a sell signal.
• Investors Intelligence (II) tracks the recommendations of Wall Street letter writers. The bullish camp rose for the third week in a row to 45.7% from 43.6% the previous week and 39.3% two weeks ago. The outright bears among the advisors fell to 23.4% from 25.5% and 27.7% two weeks ago. The bearish camp is now the lowest in more than six months (less than 20% bears or more than 50% bulls would place this valuable indicator in the get ready to sell mode). Currently we rate this valuable indicator as neutral.   
• National Association of Active Investment Managers (NAAIM): Exposure to equities by aggressive money managers climbed sharply for the second week in a row to 83% from 76% last week 55% two weeks ago. This indicator is rated bearish (30% exposure to stocks is considered bullish and 70% bearish). The fact that this group of aggressive money managers is nearly fully invested is considered bearish using contrary opinion.
• Ned Davis Research Crowd Sentiment Poll upticked for the third week in a row and is currently in the neutral zone.

The Federal Reserve, on Wednesday, initiated another round of quantitative easing (QE4). The new program replaces Operation Twist. The significant difference is that the Fed will buy long-dated Treasuries but unlike the previous effort the Fed will not offset this by selling short-term Treasuries. As a result the Fed’s balance sheet will expand from $2.8 trillion in 2012 to $3.8 trillion in 2013, representing 23% of GDP. In a surprise move, the Fed’s Open Policy Committee announced future decisions on rates would be tied to the unemployment rate and inflation expectations.  

Heretofore Bernanke had set a date, the middle of 2015 for potential rate increases. The process now depends on an unemployment falling to 6.5% and or inflation rising above 2.5%. As the economy improves these workers will rejoin the job market and make it very difficult for the unemployment rate to decline substantially. The inflation environment offers a similar outlook of little chance of a shift in policy anytime soon. Import prices are plunging. The output gap is at - 0.6%. The Consumer Price Index (CPI) is near 0.1% and the Fed’s preferred inflation gauge, the Personal Consumption Expenditures (PCE) index is 1.6% and falling.

This week brings a host of economic data that are expected to offer modestly improving trends. The final revision to third quarter GDP is expected to boost the growth rate to 2.8% from 2.7%. This is anticipated to be one-time event as with fourth quarter expectations near or below 1.0%. Improvement is expected in the December Philadelphia Fed Survey but business activity for that region is likely to remain in negative territory. November Personal Income is expected to improve to 0.3% from zero in October. Personal Consumption is expected to have increased to 0.4%, which means the savings rate fell again last month.

Durable Goods for November are expected to be unchanged from October and the December Michigan Confidence number is expected to show a small uptick. November existing home sales are anticipated to be down from the previous month. Overall the data is not expected to alter the outlook for economic growth in early 2013. The yield on the benchmark 10-year Treasury note rallied to 1.70% from 1.63% the previous week. We see little change in the interest rate environment next year with Bernanke maintaining a policy to force savers to move out further on the risk curve.  

Sector Rankings and Recommendations

No. 1 Health Care = Strong RS – Buy. Groups expected to outperform: Managed Health Care, Biotechnology, Health Care Facilities

No. 2 Industrials = Large gain in RS – Buy. Groups expected to outperform: Industrial Conglomerates, Construction & Farm Machinery, Employment Services, Environmental Services, Airlines and Electrical Components

No. 3 Financials = Continued good RS – Buy. Groups expected to outperform: Thrifts & Mortgage Finance, Asset Management & Custody Banks, Investment Bank & Brokerage and Multi-line Insurance

No. 4 Consumer Staples = Improving RS – Buy. Groups expected to outperform: Agricultural Products, Personal Products, Drugs Retail, Food Retail and Food Distributors

No. 5 Consumer Discretionary = Weakening RS – Buy. Groups expected to outperform: Automobile Manufacturers, Auto Parts & Equipment, Home Furnishings, Education Services, Apparel Retail and General Merchandise Stores

No. 6 Telecom = RS deteriorating – Hold. Group expected to outperform: Wireless Telecom Services

No. 7 Materials = Improving RS – wait for top 5 reading – Hold. Groups expected to outperform: Commodity Chemicals, Diversified Metals & Mining, Gold and Specialty Chemicals

No. 8 Energy = Poor RS – Hold. Groups expected to outperform: Oil & Gas Refining & Marketing, Oil & Gas Storage & Transportation

No. 9 Information Technology = Poor RS – Hold. Groups expected to outperform: Application Software, Data Processing & Outsourced Services and Internet Software & Services

No. 10 Utilities = Weakest sector – Hold. Groups expected to outperform: Gas Utilities

Market Overview

Short-Term Trading range with risk to 1375 and reward to 1430 on the S&P 500

Long-Term Major support is 1100 on the S&P 500 and the reward is to 1470

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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