Baird’s Market Notes: Week of 1/23/2012

Weekly Market Notes

January 23, 2012

Dow 12684 - S&P 500 1312 

The equity markets rose for the third consecutive time last week supported by mounting evidence the U.S. economy is gaining positive momentum. The market also benefited from the fact that the news out of Europe was less threatening, which was reflected in the better than expected performance by the financial sector.  The rally last week carried the S&P 500 over the 1300 hurdle, which was felt to be resistance.  More importantly the advance was broad based as seen by the fact that 61% of the S&P industry groups are now in a defined uptrend versus 57% last week.  We would need to see 70% or more industry groups in an uptrend to trigger a buy signal from this valuable indicator.  The performance by the broad market becomes increasingly important given stocks can no longer rely on an oversold condition and excessive pessimism to support a rally.  With investor confidence beginning to soar it will be increasingly important that most areas of the market get in gear with the primary trend to allow for further intermediate-term gains and the potential for the market to challenge the 2011 highs at 1365 on the S&P 500. Very near-term stocks are overbought and could be vulnerable to a pull-back.  But with the trend and momentum positive, any weakness is expected to be confined to the vicinity of 1285 to 1300 on the S&P 500.  New buying should be focused on sectors that are show improving relative strength including industrials, health care, and materials.   

Investor sentiment indicators show a significant jump in optimism, which could result in a near-term pull back in stock prices.  The latest data from the Chicago Board of Options Exchange shows the demand for put options has fallen to levels not seen since the summer of 2011.  The 10-day CBOE put/call ratio is 81% (80% is considered bearish and 95% bullish). The three-day CBOE equity put/call ratio has plunged to 51%, which is a bearish reading (64% is considered bearish and 77% bullish).  The CBOE Volatility Index (VIX) dropped to 18 last week, also triggering a short-term sell signal (19 is considered bearish and 27 bullish).  The latest survey from the American Association of Individual Investors (AAII) shows a drop in bulls to 47% from 49% the previous week.  The outright bears in the AAII data rose to 24% from 17%.  The latest report from Investors Intelligence, which tracks the recommendations of Wall Street letter writers, shows a small drop in bulls to 50% from 51% the previous week and the bears unchanged at 29%.  To turn this indicator bearish would require a rise in bulls above 55% or a drop in bears below 20%.  The most recent report from the National Association of Active Money Mangers (NAAIM) shows a small increase in equity exposure to 54% (25% is considered bullish and 70% bearish).  The sentiment indicators argue that the odds of a short-term pull back in the market are high.  We do not feel, however, that the level of investor confidence is sufficient to disturb the intermediate trend. Pull backs in stock prices, therefore, are expected to be limited in both time and price. 

Economic reports on housing and the labor market indicate the economy is improving. The NAHB Housing Market Index for January came in at 25, up from 21 in December and the highest level since 2007. This was echoed by a surge in mortgage applications, which were up 23% in the second week of January. Initial jobless claims for the preceding week plummeted, dropping from 399,000 down to 352,000, the lowest level since 2008. The recent decline in claims increases confidence that the labor market is turning a corner. Even though claims are expected to rebound this week due to seasonal factors, the trend is decidedly lower. The other important news this week will be the first look at the Q4 GDP data, which will be released on Friday. Expectations are that growth accelerated from 1.8% in Q3 to 3.0% in Q4. Personal spending is expected to have accelerated from 1.7% to 2.4%. Wednesday brings the first FOMC decision of the year, and this one will be accompanied by expectations of increased transparency from the Fed as to the path of interest rates in the future. A message released late last week by the Fed suggests that we will see not only when rates might rise, but also the expected degree of tightening.   

Sector Rankings and Recommendations

No. 1 Health Care = Strongest sector – Buy. Groups expected to outperform: Pharmaceuticals, Managed Health Care, and Biotechnology

No. 2 Industrials = Improving RS – Buy. Groups expected to outperform:  Building Products, Industrial Conglomerates, and Industrial Machinery.

No. 3 Consumer Discretionary = RS trends stay strong – Hold. Groups expected to outperform: Tires & Rubber, Movies & Entertainment, and Homebuilding.

No. 4 Consumer Staples = RS remains strong – Buy. Groups expected to outperform: Food Retail, Packaged Foods & Meats, and Tobacco

No. 5 Materials = Improving RS – Buy. Groups expected to outperform: Diversified Chemicals, Metal & Glass Containers, and Diversified Metals & Mining.

No. 6 Utilities = Significant drop in RS – Hold. Groups expected to outperform:  Gas Utilities and Electric Producers

No. 7 Financials = Sector starting to gain strength – Hold. Groups expected to outperform: Diversified Banks, Regional Banks, and Thrifts & Mortgage Finance.

No. 8 Information Technology = Wait for RS improvement –Hold. Groups expected to outperform: Internet Software & Services, Data Processing & Outsourced Services, and Computer Hardware

No. 9 Telecom Services = Poor RS – Hold. Group expected to outperform:  Integrated.

No. 10 Energy = Reduce exposure on rallies - Hold. Groups expected to outperform:  Oil & Gas Exploration & Production, Oil & Gas Storage & Transportation and Integrated Oil & Gas.

Market Overview

Short-Term Trading range with risk to 1285 and reward to 1330 on the S&P 500

Long-Term Major support is 1100 on the S&P 500 and the reward is to 1400