Baird’s Market Notes: Week of 9/17/2012

Weekly Market Notes
September 17, 2012
Dow 13593 - S&P 500 1465

The Federal Reserve finally unleashed QE3 last week causing a huge rally in the stock and commodity markets. Since the June lows the financial markets have been anticipating another round of Fed easing and Bernanke filled all expectations and much more with last week’s announcement. While QE3 was signaled in advance with Bernanke’s Jackson Hole remarks, the aggressiveness caught the market by surprise and sent stocks and gold soaring.

The unprecedented actions by the Fed were prompted by concerns the labor markets were continuing to decline as witnessed in the August jobs report. The Fed is also worried that the European debt crisis represents a real risk to trade. In addition, Bernanke sees the Fed as filling a void that sound fiscal policy typically assumes. The bottom line is that the Fed is unconditionally committed to the strategy of improving asset prices as a method to encourage the economy forward. This is anticipated to bolster stocks into early next year.

Very near-term the market enters the new week in an overbought condition with bullish sentiment rising. Looking further out, the technical condition of the stock market continues to improve suggesting that any weakness should be shallow and limited to the 1385 to 1425 zone on the S&P 500. Divergences that were pervasive just a month ago have almost completely vanished. New highs in the Russell 2000 and S&P Mid-cap averages have moved back in gear with the large cap averages. Net new highs are expanding and NYSE Advance/Decline line has climbed to a new high.

Volume has soared and the trend and momentum indicators point north. The immediate concern is that the market is overextended, the news on the Fed is out and short-term options traders have abandoned put options. Finally, defensive sectors in the equity markets have reverted to the back of the class as aggressive areas have taken over market leadership. During periods of weakness, investors should focus on the strongest sectors including financials, information technology, energy and materials.

Investor sentiment turned increasingly optimistic last week. Most notable was the huge drop in the demand for put options last week.  Although the weight of the sentiment data is not yet at extreme readings, it is close to the edge of signaling that optimism has entered the room. The various surveys of investor psychology remain mixed, with money managers and advisors very bullish and the public still skeptical.

•     Ten Day Put/Call Ratio plunged to 79% last week from 90% the previous week - historically, 80% is bearish and 95% bullish. This is the first sub-80 reading since January 2011 triggering a sell signal.
•     The Three Day CBOE Equity Put/Call Ratio dropped to 55% last week from 60% previous week and is also on a sell signal; 63% is considered bearish and 72% bullish. 
•     The CBOE Volatility Index (VIX) was unchanged finishing the week at 14.6 - below 16 is considered bearish with a reading above 23 bullish.

•     American Association of Individual Investors (AAII): The latest survey shows a small increase in bulls to 36% from 33% the previous week. The outright bears in the AAII survey were unchanged at 33%. The AAII data is considered neutral. We would need to see twice as many bulls than bears in the AAII to trigger a sell signal.

•     Investors Intelligence (II) tracks the recommendations of Wall Street letter writers. The bullish camp crawled higher last week to 51.1% bulls from 51% the previous week. A reading above 50% is considered a danger zone for stocks. The bears, among the letter writers climbed to 25.5% from 24% the previous week. Twice as many bulls than bears in the II numbers indicates excessive optimism.

•     National Association of Active Investment Managers (NAAIM): Exposure to equities by aggressive money manager’s fell to 73% last week from 77% the previous week. Although exposure to stocks was recently cut, exposure to stocks by aggressive money managers has been above 70% four weeks in a row.  At the bottom of the market in the summer of 2011, these managers had zero exposure to stocks.  We use 15% exposure as a buy signal and 75% as a sell signal for this valuable indicator.

•     Ned Davis Research Crowd Sentiment Poll continues to show investor optimism is elevated.

The U.S. economy is showing renewed signs of weakness. The Fed countered with a new stimulus plan that included allowing Operation Twist to continue into year end.  This means that the Fed will purchase $85 billion bonds monthly.  

The Fed took the unusual step in making the new stimulus program open-ended. This means that until the labor market improves, the Fed will be in the business of buying bonds and printing money. Finally, the Fed announced that it would be highly accommodative for a considerable period of time after the economic recovery. In other words, the Fed is swinging for down-town with their unprecedented actions last week. The Fed’s statement that labor market conditions will dictate future policy means that the strategy of buying bonds and printing money will persist until it works. The precious metals markets exploded on the upside on the news. Near and intermediate-term, the Fed’s actions can only be described as bullish for stocks.

Although the markets celebrated the Fed’s wide-ranging plan, the strategy is not without long-term risks and future costs. The move immediately sent the dollar lower, which will improve U.S. international competitiveness at the expense of our trading partners. By their recent actions the Fed’s balance sheet will expand beyond the $3 trillion mark, which means the Fed would need to be significantly in front of a recovering economy and inflation as to dodge the problem of unwinding their long positions at a time when bond prices are falling. The Fed’s low interest rate policy through 2015 will punish savers and those on fixed income retirement plans. Bernanke’s plan will also exasperate an already difficult social problem of inequality as most of the population does not have significant exposure to stocks or commodities, the principal benefactors during previous excursions into quantitative easing programs.

In separate reports last week, the federal government reported a budget deficit slightly lower than expected for July. The Office of Management and Budget projects the deficit will reach $1.2 trillion by the end of this month. This suggests that the federal debt limit will be reached near the end of 2012. On the inflation front, producer prices soared 1.7% in August, the most since June of 2009. A large increase in energy prices was responsible for most of the gain. Industrial production dropped 1.2% in August, the biggest drop since March 2009 and manufacturing output fell across the board.

The 3-month change in industrial production is negative for the first time since the recession officially ended in June of 2009. Finally, capacity utilization fell below its 12-month average for the first time since 2009. The yield on the benchmark 10-year Treasury broke-out on the upside last week finishing at 1.87%, suggesting a test of the 2.00% level is likely. The jump in Treasury yields is the result of a renewed weak dollar policy on the part of the Fed, and by investors moving into more risky assets at the expense of Treasuries. Given that the U.S. economy has a large measure of over capacity, we feel bond yields are likely to remain in the 1.50% to 2.00% area into 2013.

Sector Rankings and Recommendations

No. 1 Financials = Strongest RS – Buy.  Groups expected to outperform: REITs residential, diversified financial services and diversified banks and insurance

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

No. 3 Telecom = Downtick in RS – Hold. Group expected to outperform: telecom services

No. 4 Information Technology = Strongest sector – Buy. Groups expected to outperform: application software, systems software, data processing services and computer hardware

No. 5 Energy = Improving RS – Buy. Groups expected to outperform: oil & gas equipment services

No. 6 Materials = Improving RS – Hold. Groups expected to outperform: diversified chemicals, specialty chemicals, containers & packaging

No. 7 Health Care = Falling RS – Buy. Groups expected to outperform: biotechnology, pharmaceuticals, health care supplies and health care distributors and services

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

No. 9 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. 10 Utilities = Weakest sector – Hold. Groups expected to outperform:  electric distributors and electric integrated

Market Overview

Short-Term Trading range with risk to 1425 and reward to 1485 on the S&P 500

Long-Term Major support is 1100 on the S&P 500 and the reward is to 1500

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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