Baird’s Market Notes: Week of 9/24/12

Weekly Market Notes
September 24, 2012
Dow 13579 - S&P 500 1460

With the news out from the Federal Reserve and the ECB, stocks by and large spent the week consolidating recent gains. The notable exception was the Dow Transports, whose non-confirmation of the gains in the Dow Industrials remains the most glaring unresolved breadth divergence among the domestic markets. Internationally, the new multi-year low in China’s Shanghai Composite should attract attention and call into question the health of the global economy. So long as the equity markets are generally focused on central bank stimulus, stocks could continue to build on their recent gains (particularly if the sentiment surveys show renewed skepticism among investors of all types). If the focus instead shifts to the deteriorating fundamentals both domestically and abroad, stock market gains could narrow and the rally could be on borrowed time.

The initial reaction to the Fed’s announcement of QE3 was that this move was aimed primarily at helping the labor market recovery more quickly, perhaps shaving a few tenths of a percent off of the unemployment rate. This now appears to be a very limited view of the Fed’s motivation (brought on by the nature of the Fed’s mandate which focuses on employment and Ben Bernanke’s comments at his post-FOMC press conference). Upon further reflection, the Fed appears to be moving in reaction to the actual weakness that is being seen across many areas of the domestic economy, and/or in anticipation of potential weakness that could occur if the fiscal cliff becomes a reality (one of the key features of the open-endedness of the announced asset purchase plan is the flexibility it offers). The various economic surprise indexes have moved significantly higher in recent weeks and this has brought increased confidence that economic conditions themselves are improving. At this point, it seems just that expectations have been ratcheted lower, not that the data flow has improved in an absolute sense.

The technicals at this point are generally supportive of further gains in stocks. Broad market divergences (outside of the two mentioned above) have largely resolved themselves and most areas of the market have joined in the rally. A consolidation phase at this point would be welcome, as it could allow the widespread overbought conditions to be worked off. It would be particularly helpful if this coincided with an easing in optimism and increased skepticism. However, with many investors more focused on the Bernanke put than those available on the options exchanges. If selling does emerge, the 50-day average (currently near 1400 using the S&P 500) would be expected to be a strong support level. During periods of weakness investors should focus on the strongest sectors and groups. This includes Financials, Technology, Energy, Materials, and Biotech.

Investor sentiment is on the cusp of excessive optimistic, and could soon turn problematic for stocks in the near-term:

• Ten Day Put/Call Ratio drifted lower, falling to 77% from reading of 79% the previous week - historically, 80% is bearish and 95% bullish. The put/call ratio continues to be at its lowest level since January 2011 and is on a sell signal. The Three Day CBOE Equity Put/Call Ratio rose to 64% last  week, up from 55% the previous week and, leaving it on the border between a sell signal and a more neutral reading: below 63% is considered bearish and above 72% bullish. 
• The CBO Volatility Index (VIX) finished the week just below 14 - 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 38% from 36% the previous week. The outright bears in the AAII survey rose from 33% to 34%. 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 54% bulls from 51% the previous week.  A reading above 50% is considered a danger zone for stocks. The bears, among the letter writers ticked back to 24% from 25% 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 surged last week, rising to 82%, from 73% the previous week. This indicates that active money managers are essentially fully invested. 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.

• Both the Ned Davis Research Crowd Sentiment Poll and the NDR Trading Composite continues to show investor optimism is elevated.

Economic data remained generally mixed last week, with housing offering the sole bright spot for an economy struggling to find growth. The report on residential construction showed that housing starts in August were somewhat ahead of the pace seen in July (a 750,000 unit annual rate, vs. 746,000 in July), while building permits slowed somewhat in August, but came in ahead of expectations. Existing home sales accelerated in August, rising to 4.82 million (annual rate) from a 4.47 million pace in July. Initial jobless claims last week remained elevated at 382,000 , while both the Empire and Philly Fed Manufacturing surveys shows that business activity is contracting in September. The Philly Fed data were better than expected, but when the components are weighted on an ISM-basis, the translate to a PMI of 42.7. On problem facing the economy right now is that the imbalance between orders and inventories means that production may not soon recover. The data flow intensifies this week, although most of the data is expected to have only a limited market impact. With the Fed focusing so much attention on the labor market right now, the annual revisions to the employment data, due on Thursday, could receive greater than normal scrutiny. Also on Thursday we will get the weekly jobless claims data and the monthly durable goods orders. Order jumped in July on some one time transportation-related orders, so headline reversal is expected there. 

Sector Rankings and Recommendations

No. 1 Consumer Discretionary = Top-ranked sector – Buy. Groups expected to outperform: Tires & Rubber; Consumer Electronics, Homebuilding; Household Appliances; Hotels, Resorts & Cruise Lines; Broadcasting & Cable TV; Movies & Entertainment; Publishing; Internet Retail; Home Improvement Retail

No. 2 Information Technology = Moving higher after downtick last week – Buy. Groups expected to outperform: Internet Software & Services; Computer Hardware

No. 3 Financials = Sector breadth and momentum favorable – Buy.  Groups expected to outperform: Other Diversified Financial Services; Regional Banks;

No. 4 Telecom = Relative strength trends deteriorating – Hold - Group expected to outperform:  Wireless Telecom Services

No. 5 Health Care = Making new highs – Buy. Groups expected to outperform: Biotechnology; Health Care Facilities

No. 6 Energy = Improving RS - Buy. Groups expected to outperform:  Oil & Gas Refining & Marketing

No. 7 Materials = Relative trends gaining traction – Hold. Groups expected to outperform: Construction Materials; Aluminum; Diversified Metals & Mining; Gold

No. 8 Consumer Staples = Defensive areas have ceded leadership – Hold. Groups expected to outperform: Personal Products

No.9 Industrials = Struggling to make relative strength gains – Hold. Groups expected to outperform:  Building Products

No.10 Utilities = Weakest sector – Hold. Groups expected to outperform:  Gas Utilities

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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