Baird’s Market Notes: Week of 6/11/12

The stock market’s technical condition improved last week as the downside momentum was aborted on Wednesday when upside volume exceeded downside volume by a ratio of more than 10-to-1. It will be important for the current rally to be sustainable that the broad market show significant improvement during this rally phase. Despite last week’s gains, the percentage of S&P 500 industry groups that are in a defined uptrend fell to 49% last week from 50% the previous week. 

For the rally to have legs, we would expect the percentage of industry groups in an uptrend to move quickly above 72% and eventually to new highs. Further evidence that a bottom is in place would be a shift in relative strength away from defensive sectors of the equity markets to risk areas including energy, technology and materials.  Finally, a rise in the yield of the 10-year benchmark Treasury note above 1.90% would suggest fears of recession/deflation are overstated.

The equity markets enjoyed a strong rally last week on reports that the European Central Banks were preparing to offer additional monetary support to the banking system.  Over the weekend, euro zone finance ministers agreed to backstop the Spanish banks to the tune of more than 100 billion euros. This is a significant step in preventing massive outflows from Spain’s banks from continuing, at least for the near term. 

There is also speculation that the Federal Reserve Board will initiate another round of quantitative easing at their regularly scheduled meeting next week.  This would follow the Bank of China lowering interest rates for the first time since 2008 last week.  The seemingly coordinated effort by the world bankers is viewed as a necessary effort to reign in the threat of a global economic recession, which began in Greece and spread to Asia.  As a result of the overnight events in Europe, stocks are anticipated to add onto last week’s gains with a full test of the resistance, which is considered to be in the vicinity of 1340 to 1345 using the S&P 500.

Measures of investor psychology were little changed last week and remain a distance from excessive pessimism often seen at important lows in the market.  This is best illustrated in the Investors Intelligence data that tracks the mood of the advisory services.  Only 26% of stock market letter writers are outright bearish.  At previous lows in the market in 2010 and 2011, the bearish camp was close to 50%.  Overall the sentiment statistics argue that there is sufficient level of pessimism to support little more than a short-term rally.  

• Ten Day Put/Call Ratio fell to 110% from 111% the previous week - 80% is bearish and 95% bullish. Three Day CBOE Equity Put/Call Ratio dropped to 69% from 82% the previous week – 58% is considered bearish and 72% bullish.  CBOE Volatility Index (VIX) fell to 21 from 26 last week - below 16 is considered bearish and 23 bullish.

• American Association of Individual Investors (AAII): The latest report shows a small decline in the bullish camp to 27% from 28% the previous week.  The outright bears climbed to 46% from 42%.  Typically at a market low, the AAII survey shows at least twice as many bears than bulls. 

• Investors Intelligence (II) tracks the recommendations of Wall Street letter writers.  The bullish camp fell to 34.0% last week from 39.3% the previous week.  The outright bears among the advisors climbed to 26% from 24.5%.  Historically at a good bottom in the market, there are an equal number of bulls and bears for this valuable indicator to turn outright bullish.

• National Association of Active Investment Managers (NAAIM): Exposure to equities by aggressive money managers jumped to 49% last week from 29% the previous week. The NAAIM data is considered neutral (15% is bullish and 75% bearish).

• Ned Davis Research Crowd Sentiment Poll shows excessive pessimism zone, but short of what was seen at the October 2011 bottom.

The U.S. economy remains in low gear with growing concern that the European recession that is traveling around the globe will find a path to the U.S.  Last week’s economic data indicated that the economy was still growing but at a slow rate.  The ISM Non-Manufacturing Composite Index managed a small gain of 0.2 points in May, which was slightly better than expected.  Jobless claims fell but last week’s data was revised upward.  The four-week average of claims remains below the 400,000 threshold considered important for continued positive trends in employment. 

The Fed’s Beige Book showed the economy still growing but conditions remain fragile.  The nation’s trade deficit narrowed but both exports and imports declined, which is not surprising given the economic slowdown has gone global.  The economic weakness unfolding in most economies has not gone unnoticed by the bond market where yields in developed economies are approaching levels experienced by Japan for the past twenty years. The focus of attention this week will be on the report on retail sales for May.  The report is anticipated to be soft given an apparent slowdown in auto sales last month.  Overall retail sales last month are expected to be flat to down 0.2%. 

Producer prices for May to be reported on Wednesday are expected to show a sharp drop in core inflation (less food and energy) up 0.2%.  Consumer prices due Thursday are expected to also show little pricing pressures.  The inflation reports will be important because, if weak, would provide Bernanke a great deal of latitude in his decision on additional stimulus. The yield on the 10-year Treasury note is expected to vacillate between 1.60% and 2.00% into the fourth quarter of the year. 

Sector Strategies

No. 1 Telecom = Strong RS – Buy. Group expected to outperform:  telecom services

No. 2 Consumer Discretionary = Strong sector – Buy. Groups expected to outperform: home building, home improvement, automotive, movies & entertainment, restaurants, general merchandise and home furnishing

No. 3 Health Care = Improving RS – Buy. Groups expected to outperform: biotechnology, pharmaceuticals and health care supplies

No. 4 Consumer Staples = Rising RS – Buy. Groups expected to outperform: food retail, personal products, and drug retail, soft drinks, tobacco, and food distributors

No. 5 Utilities = Improving RS – Buy. Groups expected to outperform:  electric distributors and electric integrated

No. 6 Information Technology = Declining RS – Hold. Groups expected to outperform: application software, systems software, data processing services and computer hardware

No. 7 Industrials = Falling RS – Hold. Groups expected to outperform:  building products, industrial machinery, construction & engineering, diversified commercial services and transportation-railroads

No. 8 Financials = Deteriorating RS – Hold.  Groups expected to outperform: REITs residential, diversified financial services and diversified banks and insurance

No. 9 Materials = Weak RS – Hold. Groups expected to outperform: diversified chemicals, specialty chemicals, containers & Packaging

No. 10 Energy = Weakest sector – Hold. Groups expected to outperform:  oil & gas equipment services

Market Overview

Stocks
Short-Term              Trading range with risk to 1275 and reward to 1350 on the S&P 500
Long-Term              Major support is 1100 on the S&P 500 and the reward is to 1450

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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