Baird’s Market Commentary

SARASOTA -- The equity markets exhibited signs of vulnerability last week for the first time since Labor Day. Although the Dow Industrials kept its string of weekly gains alive the broad market faired far worse with the Russell 2000 Index falling more than 4%. The divergence in performance by small caps versus large caps is worth noting because most stock market peaks occur when sectors within the market are moving in opposite directions. One week’s performance, however, is not particularly meaningful unless it persists. Historically the broad market peaks six to nine months before the leading averages top. From here further correction/consolidation are likely and before a sustainable rally can be expected investor sentiment is expected to shift from optimism to caution. The Federal Reserve meets this week and is widely anticipated to keep policy friendly to the financial markets. Stocks also enjoy an improving business climate with most stocks beating earnings expectations. Further weakness into the 1240 to 1260 zone on the S&P 500 is expected to provide buying opportunities in the energy, materials, financial and material sectors.

Extreme investor optimism suggests that investors appetite for equities has been, at least, over the near-term satisfied. Although optimism is beginning to wane in the face of the first correction in 2011 there are few signs that optimism is being replace by caution and skepticism. The latest report from Investors Intelligence, which tracks the recommendations of Wall Street letter writers, shows a modest drop in bulls to 56.0% from 57.3% the previous week. The outright bears among the advisors climbed to 20.9% from 19.1%. The latest survey from the American Association of Individual Investors (AAII) shows a drop in bulls to 51% from 52% and a rise in bears to 29% from 23%. The percentage of bears in the latest AAII survey is the highest since mid-November. The CBOE 10-day put/call ratio climbed to 79% last week from 74% the previous week (75% is considered bearish and 95% bullish. The CBOE 3-day equity put/call ratio increased to 58% from 45% last week (52% is considered bearish and 63%) bullish). Overall the sentiment statistics argue that optimism has cooled somewhat but remains elevated suggesting caution near-term.

Last week’s economic data suggests the U.S. economy is gaining momentum but the numbers are not strong enough to have a significant impact on interest rates. The Leading Economic Index (LEI) jumped 1.0% last month, consensus estimates were for half that amount. The LEI rose for the sixth straight time in December and is up 19 of the past 21 months. Existing home sales climbed a significant 12.3% in December, almost three times the gain most economists were anticipating. The inventory of unsold homes fell to just 8.1 months supply, down from 9.5% and home prices fell 1.0%. Improvement was also seen in the labor markets. Initial jobless claims fell 31,000 to 404,000 last week suggesting the January Employment Report, due the first week in February, will show stronger job growth. Finally the Philly Fed Report indicated expansion for the fourth straight month, which should translate into a rise in the January ISM when reported on February 1. The modest improvement in business data caused rates to rise slightly last week with the yield on the benchmark 10-year Treasury climbing to 3.24% last week.

Article provided by Robert W. Baird & Co. for Evan Guido, Vice President, Financial Advisor at the Sarasota office of Robert W. Baird & Co., member SIPC.