Baird’s Market Notes: Week of 9/3/2012

Weekly Market Notes
September 4, 2012
Dow 13090 - S&P 500 1406

The S&P 500 fell for the second week in a row last week. The cumulative loss, however, was less than one percent. Considering the market was overbought in late August and the steady flow of negative news on the global economy, the markets have behaved better than could be expected. This is likely due to considerable attention paid to the prospects for additional Fed and Central Bank intervention.

One of the basic tenets of Wall Street is don’t fight the Fed. Money is the life-blood of Wall Street, and by embracing a policy of exceptional accommodation the Fed has provided significant support to the equity markets. Bernanke’s widely anticipated Jackson Hole speech indicated that he is leaning heavily toward more accommodation sooner than later.

By portraying the current economic situation as “far from satisfactory” and the labor markets of “grave concern” he signaled that additional easing will be forthcoming at the September 12 Open Policy Committee Meeting. Also telling was his strong belief that quantitative easing worked, and was effective in stabilizing the U.S. economy. The bottom line is that despite the stock market sitting on top of two years of gains and oil prices probing the $100 a barrel level, more stimulus in front of the election appears the strategy Bernanke intends to pursue.  

The second rule of Wall Street is don’t fight the Tape. In this area the outlook is less clear. At last week’s close 79% of the industry groups within the S&P 500 were in uptrends. This shows that most areas are in harmony with the primary trend. The good news on the Tape ends with that statistic. The most glaring divergence is seen in the non-confirmation by the Dow Transports versus the Dow Industrials. 

Also of concern is the fact that the recent high in the NASDAQ is unconfirmed by a falling NASDAQ Advance/Decline Line. Also, few stocks are hitting new 52-week highs this cycle suggesting fewer stocks are leading the surge. Of course, most of this could be eliminated with the Russell 2000 hitting a new high and the transports finding wheels.  But for now the Tape is neutral at best. Money flows are also a concern. Equity mutual funds have seen $40 billion of outflows through the first seven months of the year and the weekly report shows the trend may have intensified in August with $18 billion in outflows over the past four weeks.

Using contrary opinion, the public withdrawing from stock funds and putting the money in bond funds could be described as bullish. In the current example demographics, the aging population, and record low interest rates from ‘safe’ short-term government securities are playing a large role. Best estimates are that stocks will find support from expectations of more money printing into mid-September followed by the gravitational pull of the Presidential cycle that historically finds stocks on defense in front on November.   

Investor psychology remains optimistic but short of levels considered excessive or extreme. The magnitude of any weakness that might develop in front of a presidential election will likely depend on how quickly sentiment shifts to pessimism. A significant expansion in the bearish camp would argue that any weakness that unfolds in September/October will be limited in both time and price.

• Ten Day Put/Call Ratio surged to 94% last week from 86% the previous week - historically, 80% is bearish and 95% bullish. The increase in the demand for puts occurred prior to Fed Chairman Bernanke’s Jackson Hole speech as short term traders hedged against the Fed Chairman ignoring the topic of QE3. Following the speech it became clear the puts were an unnecessary expense. 
• The three Day CBOE Equity Put/Call Ratio rose to 75% last week, from 63% previous week; 60% is considered bearish and 72% bullish. The CBOE Volatility Index (VIX) climbed to 17.4 from 15.2 the previous week - below 16 is considered bearish with a reading above 23 bullish.
• American Association of Individual Investors (AAII): The latest survey shows a sharp drop in bulls to 35% last week from 42% the previous week. The bears in the AAII survey jumped to 33% from 26%. The AAII data is considered neutral. 
• Investors Intelligence (II) tracks the recommendations of Wall Street letter writers. The bullish camp climbed again last week to 48.9% from 47.3% the previous week. The bears fell to 24.5% from 24.7%. The advisory service data has moved into rally killing range which historically occurs when the bulls approach 50%.    
• National Association of Active Investment Managers (NAAIM): Exposure to equities by aggressive money managers soared to 83% last week from 70% the previous week.  The last time the level of exposure by active money managers reached these levels was in April of 2011. We use 15% exposure as a buy signal and 75% as a sell signal for this valuable indicator.
• Ned Davis Research Crowd Sentiment Poll remained in the excessive optimism zone last week.  

Interest rates were little changed last week with the yield on the benchmark 10-year Treasury note spending most of the period anchored at 1.62%. Although GDP was revised upward, nothing in the latest economic data suggests the economy is about to break-out on the upside that might cause rates to spike. Second quarter GDP was revised to 1.7% from 1.5% annual rate, which was in line with expectations.

The report was bolstered by stronger consumer spending in the quarter and from a favorable balance of trade. Both however, are suspect, with the consumer facing higher food costs due to the worst drought in many years in the second half of 2012 and the full effects of the impact on trade from the slowdown in the global economy. Business capital spending fell sharply and is growing at the slowest rate since 2009. The U.S. economy is ultimately driven by savings, investment and production. 

Weakness in these areas suggests an economy that is likely to remain in a slow growth mode into 2013. The good news is on the inflation front as pressures remain minimal. The PCE Index rose at a 0.7% annual rate, the least in two years. The core advanced at a 1.8% rate, below the Fed’s longer-term target of 2.0%.            

In separate business reports, the consumer became more aggressive at the mall with personal consumption expenditures rising 0.4% in July, the most in five months. Personal income rose 0.3%. The income figure was bolstered by the current transfer receipts from the government, which has developed into an important support to personal income. As a result of spending outpacing income, the personal saving rate took a hit falling to 4.2% from 4.3% the previous month.

Factory orders rose in July by the most in nearly a year. Unfortunately, manufacturing contracted in five of the eight reporting regions of the country in August suggesting the July data was a one-time event. Milwaukee activity contracted at its fastest pace since the second quarter of 2009, as new orders and production contracted.

The focus of attention this week will be on this morning’s August ISM Manufacturing Report and Friday’s jobs data. Consensus estimates are that the ISM number will be up slightly to 50.0 from 49.8 (a reading below 50 suggests the economy is contracting). August non-farm payrolls are executed to show the economy produced 125,000 new jobs with the unemployment rate unchanged at 8.3%. The employment report appears to be a win-win situation for the markets as a weak report would suggest QE3 is in the mail for delivery on September 12.      

Sector Rankings and Recommendations

No. 1 Information Technology = Strongest sector – Buy. Groups expected to outperform: application software, systems software, data processing services and computer hardware

No. 2 Telecom = Downtick in RS – Overbought – Hold. Group expected to outperform: telecom services

No. 3 Consumer Discretionary = Resiliency impressive – Hold. Groups expected to outperform: home building, home improvement, automotive, movies & entertainment, restaurants, general merchandise and home furnishing

No. 4 Financials = Improving RS – Buy. Groups expected to outperform: REITs residential, diversified financial services and diversified banks and insurance

No. 5 Health Care = Falling RS – Hold. Groups expected to outperform: biotechnology, pharmaceuticals, health care supplies and health care distributors and services

No. 6 Energy = Sensitive to QE – Buy. Groups expected to outperform: oil & gas equipment services

No. 7 Consumer Staples = Defensive areas giving ground – Hold. Groups expected to outperform: food retail, personal products, and drug retail, soft drinks, tobacco, and food distributors

No.8 Industrials = Wait for top 5 RS print – Hold. Groups expected to outperform: building products, industrial machinery, construction & engineering, diversified commercial services and transportation-railroads

No. 9 Utilities = Deteriorating RS – Hold. Groups expected to outperform: electric distributors and electric integrated

No.10 Materials = Wait for RS improvement –Hold. Groups expected to outperform: diversified chemicals, specialty chemicals, containers & packaging and gold

Market Overview

Short-Term Trading range with risk to 1365 and reward to 1425 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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