Baird’s Market Notes: Week of 10/29/12

Weekly Market Notes
October 29, 2012
Dow 13107 - S&P 500 1412

The equity markets continue to suffer over corporate earnings, deteriorating economic conditions globally and the uncertainty surrounding the November elections. A flood of third quarter earnings reports were in line with low expectations. Investors, however, were more concerned over the conspicuous shortfall in top line growth. Weak final demand is playing havoc with profit margins resulting in disappointing earnings growth. Considering the economy is growing at an anemic 1.7% for the year, revenues are likely to remain under pressure well into 2013.

Friday’s better than expected GDP report failed to provide encouragement due to the fact that most of the uptick in economic activity was related to a one-time burst in government defense spending. Although consumers have turned more upbeat in recent months, business has remained very skeptical and that has resulted in weak capital spending. The S&P 500 Index fell into the heart of the support zone last week (1375 to 1425). A period of weakness/consolidation followed by a rally after the election is typical in a presidential election year. Given the deteriorating technical conditions, a close below 1375 would require a more cautious approach.

Although the S&P 500 Index has moved sidewise since early September, there has been significant breadth deterioration. This is seen in the fact that just 62% of the industry groups within the S&P 500 are in uptrends, down from 83% four weeks ago. Small-cap averages have performed worse with the Russell 2000 falling to its 200-day moving average last week and below levels seen when the Fed introduced QE3. This is also seen in foreign markets where less than 50% are trading above their 50-day moving averages, down from 90% two months ago. Seasonal patterns and investor sentiment offset the weakening trends and momentum and offer the market the best chances for a year-end rally.

The market has entered a bullish period from November 1 to April 30 where stocks historically have outperformed. In addition, December is one of the strongest months of the year for equities.  Using contrary opinion, investors pulled nearly $11 billion from stock mutual funds in early October, the most since the lows in August 2011. This suggests there is sufficient liquidity on the sidelines to support a November-December rally.  

Investor optimism that was evident in September has given way to concern and skepticism. Unfortunately there is little sign that fear and pessimism, which is typically found at a trading low, is present. As a result the market is expected to remain in a trading range into the election next week.

• Ten Day Put/Call Ratio was little changed, rising to 92% last week from 91% the previous week - historically, 80% is bearish and 95% bullish. This indicator is now rated neutral, but the last decisive signal was the mid-September (and 20-month) low near 76%, indicating widespread complacency. 
• The Three Day CBOE Equity Put/Call Ratio climbed to 74% from 70% the previous week. This indicator is considered bullish; 63% is considered bearish and 72% bullish.
• The CBOE Volatility Index (VIX) rose to 17.8 last week from 17.1 the previous week - below 16 is considered bearish with a reading above 23 bullish.
• American Association of Individual Investors (AAII): The latest survey shows little change over the previous week. The bullish camp was steady at 29% and the outright bears fell slightly to 43% from 45%. This is the second highest number of bears since June. The negative tone of the Presidential election and looming fiscal cliff are weighing on individual investors. We rate this indicator as mildly bullish.
• Investors Intelligence (II) tracks the recommendations of Wall Street letter writers. The bullish camp declined to 41.4% from 43% the previous week and 54.2% in mid-September. The bears among the advisors climbed to 27.7% from 26.6% the previous week. We now rate this indicator as neutral.
• National Association of Active Investment Managers (NAAIM): Exposure to equities by aggressive money managers was unchanged at 65% last week. This indicator has been particularly useful over the past year. Its rise from extreme lows has accompanied a climb in stock prices. While its retreat from excessively high levels (like we have seen over the past eight weeks) has been accompanied by weaker price action in equities.
• Ned Davis Research Crowd Sentiment Poll continues to show investor optimism retreating from excessive levels. Nevertheless, this valuable indicator is a distance from signaling a new uptrend is imminent.  

The most significant economic news occurred on Friday with a report the U.S. economy expanded at a 2% annual rate in the third quarter. This caused some optimism given the numbers were an improvement over the second quarter growth of just 1.3%. But following four years of zero percent interest rates, massive government deficit spending and three episodes of quantitative easing the numbers are far from overwhelming evidence that the economy is on a new growth path. This was underscored by the action in the bond market where the yield on the benchmark 10-year Treasury note fell to 17.6% from 18.4% the previous session. 

On other reports last week the data continues to show consumers growing increasingly optimistic but businesses remaining cautious. New home sales rose 5.7% in September, the best in more than six months and the highest level since April 2010. The large percentage gains in housing are somewhat deceptive because they are coming off a very low number. As a result, total sales of new homes remain subpar by historical measure. Nevertheless, the trend and momentum in the housing market is bolstering consumer confidence which could mean more spending overall. The labor markets are also an important factor in maintaining the momentum in the housing market. Initial unemployment claims fell 23,000 last week. The October jobs report due Friday is expected to show the economy created 124,000 new jobs with the unemployment rate rising to 7.9% from 7.8%.

Other data that measure the health of the U.S. economy including durable goods orders and regional Fed reports offer a mixed outlook. Durable goods orders jumped nearly 10% in September, the most since 2010 and far above expectations. But this could be a snap back from the previous month when durable goods orders were unusually weak. Most of the gain in September was due to a sharp rise in civilian aircraft. Excluding transportation, orders climbed 2.0%, a number most economists believe is healthy for future growth.

Reports from Federal Reserve districts are less encouraging on balance. Manufacturing activity in the Richmond area fell in October. The report also showed weakness in new orders and employment with backlogs also losing ground. The Chicago Fed National Activity Index was reported flat in September and slightly better than expected. The latest report from the Mid-West indicates the U.S. economic recovery remains fragile. Finally, the Kansas City Fed manufacturing index mirrored the Richmond report by falling in October as employment, production, orders and backlogs declined. Overall, the data is indicative of an economy that is soft and fragile.

Sector Rankings and Recommendations

No. 1 Health Care = Strongest sector- Buy. Groups expected to outperform: Managed Health Care, Biotechnology, Health Care Facilities

No. 2 Financials = RS trend improving – Buy. Groups expected to outperform: Thrifts & Mortgage Finance, Asset Management & Custody Banks, Investment Bank & Brokerage and Multi-line Insurance

No. 3 Consumer Discretionary = RS trends remain strong –Buy. Groups expected to outperform: Automobile Manufacturers, Casinos & Gaming, Education Services, Computer & Electronics Retail

No. 4 Telecom = RS deteriorating – Hold. Group expected to outperform: Wireless Telecom Services

No. 5 Utilities = Gaining in RS – Buy. Groups expected to outperform: Gas Utilities

No. 6 Consumer Staples = Wait for top 5 ranking – Hold. Groups expected to outperform: Agricultural Products, Personal Products

No. 7 Energy = Weakening RS - Hold. Groups expected to outperform: Oil & Gas Refining & Marketing

No. 8 Materials = RS remains problematic – Hold. Groups expected to outperform: Paper Packaging, Diversified Metals & Mining, Gold

No. 9 Industrials = RS weak – Hold. Groups expected to outperform: Industrial Conglomerates

No. 10 Information Technology = Steep drop in RS – Hold. Groups expected to outperform: Home Entertainment Software, Data Processing & Outsourced Services

Market Overview

Short-Term Trading range with risk to 1400 and reward to 1455 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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