Weak economics, cautious earnings outlooks and fiscal year end for mutual funds combined to push the indexes to their lowest levels in three weeks.

Market Statistics

October ended with a thud as the indexes closed at multi week lows. Thursday's +200 point short squeeze was completely erased and had time not expired the markets would probably be even lower. There were multiple factors in play and I will try to cover all of them.

Starting with Friday's economic reports the Michigan Consumer Sentiment survey fell to 70.6 from 73.5. This should not have been a surprise since the October consumer confidence report fell off the cliff earlier in the week. Growing concerns about the economic outlook was blamed for the drop in sentiment. The present conditions component actually rose to 73.7 from 73.4. However the expectations component fell sharply to 68.6 from 73.5. Clearly consumers are concerned about what the economy will look like in the future. Concerns over rising taxes are also weighing on consumers. Rising gasoline prices and worries about job security and home values continue to be negative issues.

Thomson Reuters reported that only 31% of consumers surveyed had a favorable economic outlook in 2010. That is only 3% above the 28% recorded in October 2008 at the bottom of the crisis. The majority of consumers reported their finances had worsened in October. That is the 13th consecutive month and the longest and steepest decline in the 66-year history of the Consumer Sentiment survey. Only 12% reported improvement in their finances and that was also the lowest on record. Also, for the first time in sixty years the majority of families expected their incomes to be flat or lower in the year ahead.

Consumer Sentiment Chart

The Personal Income report for September showed incomes were flat from August when incomes rose +0.2%. Wages are currently more than 5% below last years level. Real spending fell sharply by -0.6% led by a drop in auto sales after the cash for clunkers program ended. Overall durable goods spending fell by a whopping -7%. In the same report the core PCE deflator rose +0.1% for the fifth consecutive month. This shows that prices are rising while spending is slowing. The savings rate rose to 3.3% and the second month of growth after years of declines.

Of all the economic reports on Friday the drop in spending was the worst for investors. This suggests the recovery is slipping and is dependent on government spending to continue. Since no government in history has been able to spend itself into prosperity the long-term outlook is not good. Eventually the government will have to quit supplying stimulus and raise taxes to pay for the credit incurred for the stimulus. If the consumer has not recovered to take up the consumption slack by time the government quits then it will be a very long recovery road.

The Chicago ISM report (formerly PMI) was very positive with a jump from 46.1 to 54.2 on the headline number. Positive inputs came from strong gains in New Orders, Backorders and Production. However, employment fell slightly and suggests the non-farm payrolls on Friday could be worse than expected. The manufacturing trends in the Chicago area have improved significantly since the automakers went back to work.

ISM Table

ISM Chart

The ISM New York (formerly NAPM-NY) was also released on Friday and it also showed improvement although not on the scale of the ISM-Chicago. The difference is clearly the resumption of production by automakers in the Chicago report. The conditions in the New York area are recovering but they are far less robust than Chicago.

However, the current conditions component fell to 60.8 from 72.9 in October and the employment component fell to 45.7 from 47.3. The employment component was 26.1 last October so conditions have improved significantly but any number under 50 remains a contraction. Employers are still cutting jobs but the pace of layoffs is slowing. At this point New York is still in recession but it is moderating. On Monday we will get the national ISM and it is expected to show a minor gain.

ISM-NY Chart

The economic calendar for next week has some huge events that could be market movers. I already mentioned the national ISM on Monday followed by the ISM Services on Wednesday. Gains are expected on both reports. The Factory Orders on Tuesday is expected to show an increase of +0.8%. The really big reports are the Fed meeting announcement on Wednesday and the Jobs report on Friday.

Nobody expects the Fed to change rates on Wednesday. What they are expecting is some tough talk about what to expect in the rate department. With Australia and Norway already hiking rates and seven other central banks announcing rate decisions next week the Fed will be under the gun to take a strong stand on U.S. rates. If they don't and other nations raise rates that will further weaken the dollar.

The Fed will try to walk the tightrope between taking a hard line towards future rate hikes while at the same time trying to keep rates low until the last possible minute to stimulate the recovery. They will also comment on what they see as the state of the economy. They will have advance info on Friday's jobs report so any decision they make will be done with that in mind. The FOMC statement at 2:15 on Wednesday will be a market mover.

The Non-Farm Payrolls on Friday will be the real read on the economy and the state of the recovery. The ISM may tell us in economic terms that a recovery is underway but if the payroll report says we are still losing jobs at a higher than expected rate then the payroll report will be the deciding factor.

Consensus estimates are for a loss of 175,000 jobs in October. This would be down from the 263,000 lost in September. However, nearly every regional economic report of late has seen a drop in the employment component. That suggests that there will be more jobs losses than currently expected. Obviously there are as many opinions as there are analysts. Moody's Economy.com is predicting only 75,000 jobs lost. I am not going to speculate on the number of jobs but I don't expect much change in the unemployment rate and that is what is going to keep the U.S. from recovering. Using the U6 unemployment there are over 15 million people out of work and growing. Those people are not consuming, not buying cars or houses or flat screen TVs. They are also not paying takes so that is another drain on the deficit. This is why the payroll report is so important. It provides information on the actual heartbeat of the economy, the actual consumer.

Economic Calendar

While I am on the subject of economics I want to touch on the Q3-GDP. The headline number at 3.5% is totally bogus for measuring the strength of the recovery. This is the GDP for Q3, not year to date. The GDP was dramatically influenced by the cash for clunkers program, which added 1.66% to the headline number, homebuyer incentives, etc. Government spending rose 7.9% in the quarter also adding significantly to the GDP. In short the government bought the 3.5% GDP for Q3 with its various incentives. This is a short-term bounce not the beginning of a trend. For instance estimates for Q4 GDP are being quoted at +1.8% to +2.2% in most cases or roughly half of Q3. There will still be some stimulus in the Q4 GDP so it is still not a true picture of our economic health. Stimulus tends to move buying events forward leaving a void when stimulus ends. We saw that with cash for clunkers. Everyone thinking about buying a car in Q4 rushed to do it in Q3 instead. Now auto sales in Q4 are nearly non-existent. As these facts become more widely accepted the idea that the economy is rebounding sharply from the recession will eventually fade. With 15 million people out of work it will be nearly impossible to create a quick economic recovery. Analysts are now saying it could be the second half of 2010 before a credible recovery appears.

These factors are giving more credibility to the "VV" recovery scenario. High unemployment and earnings built on cost cutting rather than revenue growth are not a recipe for recovery. Growth will eventually come and when it does the companies who cut the most costs will have stellar earnings and their stock prices will soar. That growth may not arrive for several more quarters.

The strength of the dollar continues to rule our equity markets. Last week the dollar gained ground on four of the five days and the equity markets posted losses of 3%-9%. The dollar gained strength last week on rumors of central bank intervention in other currencies. The Swiss National Bank was rumored to have intervened in the Franc against the Euro and the dollar. Shorts in the dollar had a bad week and this is a very crowded trade. The U.S. dollar will remain under pressure simply because our debt is growing rapidly and our economy is not. Interest rates are nearly zero and the only reason anyone would buy the dollar today is due to its apparent safety. How much longer that will last is anybody's guess.

Art Cashin was interviewed last week and he said a disaster was building in the dollar. With everyone short the dollar and long term expectations for a continued decline there was an imbalance building. He theorized that an eventual geopolitical event like Israel or the U.S. bombing Iran would create a stampede to the safety of the dollar while short positions were at record levels. He said this could seriously undermine our markets, both currency and equity, and create a massive disaster. Remember, the derivative trades in currencies have far reaching impacts. If traders are short the dollar they may be long another currency or basket of currencies. If everyone suddenly rushed into the dollar those interlocking currency trades would be wiped out. This could be another major financial crisis and it could occur overnight under the right circumstances. This is why weeks like we had last week are good in a down trending trade. It reminds investors that there is risk involved and all trades are not guaranteed winners. I would not be surprised to find out that the Fed or Treasury spiked the dollar just to keep everyone on their toes.

Dollar Index Chart

Oil stocks and especially oil service stocks had a tough week. The rising dollar crushed oil prices while services companies and majors alike reported sharply lower revenues and earnings. Crude oil has no fundamental basis over $80 at present. OPEC still has millions of barrels of production shutdown despite cheating by nearly every OPEC member. Inventories are very high and there is simply no justification for these prices. I believe support at $77 will break and we should see $70 oil before we see $85 oil.

Crude Oil Chart

Oil Service Index Chart

The FDIC closed 9 banks on Friday with locations in California, Illinois, Texas and Arizona. That brings the 2009 total to 115. All were owned by a privately held bank holding company named FBOP Corp. US Bank agreed to assume the deposits and most of the assets. The banks had combined assets of $19.4 billion and deposits of $15.4 billion. The banks had 153 locations all of which will open as US Banks on Saturday. The closings will cost the FDIC $2.5 billion plus shared losses on $14.4 billion in USB assumed assets. The FDIC expects hundreds more to fail over the next two years. There were 25 failures in 2008 and three in 2007. The FDIC has spent more than $25 billion so far in 2009 on bank closures. There will be more next week because the FDIC is currently seeking bids on several other pending closures.

The Volatility Index (VIX) exploded for a 41% gain for the week with 24% of that gain coming on Friday alone. The VIX had been slowly bleeding value as investors bought the earnings expectations in early October. That calm exterior exploded with a rebound from 20.10 last week to a high of 31.59 on Friday. This was also a reminder that bulls should not become complacent in their long only positions. The VIX at 30 is historically a level where traders felt comfortable buying the market but after the last year of volatility where the VIX hit 89 in October 2008 I am not sure there is a comfortable reentry point today.

VIX Chart

The month of October was not kind to traders if you failed to exit during the peak of earnings. The Dow finished unchanged for the month but the other indexes were not so lucky. The S&P lost -2%, Nasdaq -3.6%, Transports -4.9% and the Russell -6.9%. I suggest you take special interest in the Russell decline. You know I favor the Russell as the fund manager sentiment indicator and that is some ugly sentiment. The Russell gave back -6.3% last week alone. An entire month of losses in only one week.

The Russell closed September at 604 and rallied to 624 at the peak of earnings for a +3.3% gain. That means the Russell actually declined -10% from its October highs and I don't think the damage is over. I wrote on Tuesday that 580 was the initial support target and a break of 580 could test 550. The Russell closed at 563 on Friday. We need to pray that support at 550 holds or we are in serious trouble since the next material support is 500. The October closing high was 623.64 making a 10% correction a drop to 561.28. The intraday low on Friday was 560.19 or almost exactly -10%. A further dip to 550 would be a solid correction of about 12% and an excellent test of bullish support. I would be a buyer of that 550 level if tested. However, a break under 550 would mean the markets are probably not going much higher by year-end. I believe it would signify a willingness to wait in cash to see how the recovery plays out.

Russell-2000 Chart

The S&P imploded on Friday losing -2.8% to close at 1035. The talking heads on stock TV were all a twitter over the support break at 1042. Personally I did not see the relevance with 1035 and 1023 much more critical levels. The S&P did not even slow down when it hit the uptrend support at 1050 and that trend is now broken. 1097 was the October closing high making a dip to 987 a 10% correction. That just happens to be a strong support level and I would love to see it happen. Fund managers could check off the correction box from their due diligence list and start buying stocks again.

S&P-500 Chart

The Dow is holding up much better than the other indexes despite all 30 stocks being negative on Friday. The Dow only lost -2.6% for the week and was exactly flat for the month at 9712. The October high close was 10090 making a 10% correction a distant 9081. Considering the Russell has already corrected 10% and the S&P has fallen -5.6% the Dow is the hero by far. This is because the Dow has the monster blue chips that do the best in hard times. These high liquidity stocks are exactly the stocks that fund managers were using for cash banks as their year came to a close. Small caps imploded and megacaps were flat. That should be all the explanation anyone needs to understand our current situation.

The next material Dow support is 9410 and the 38% Fib retracement level. I would be shocked if the Dow fully corrected but it would not be the first time that has happened. If those funds decide to go back to cash next week we could see some serious Dow weakness but there is still a crowd that sees every dip as a buying opportunity so I am not making a prediction here.

Dow Chart

Dow Table

The Nasdaq gave up -5% for the week and came to rest right on decent support at 2040. I would be surprised if it held but there is a huge range of converging support from 1950-2010. If 2040 breaks I really expect that broad range of support just below to hold. It could still mean a maximum 100-point drop for the Nasdaq with something around the 2000 level a likely price magnet.

The Nasdaq has had its share of bad luck in recent days. BIDU took a 50-point dive. First Solar gave back 35 points and AMGN lost almost 10 points over the last two days. Add in -20 points for Apple and -23 points for Google and I am surprised it only lost 5% for the week. I believe funds are still holding Apple and Google and any post October restructuring next week could see selling in those names. Other than that I believe support from 1950-2010 will hold.

Nasdaq Chart

October is over but the portfolio restructuring games are not. Any fund manager with the normal Oct-31st fiscal year-end probably tuned his holdings to put forth the best picture possible for the year-end tax statements and marketing brochures. Starting Monday that slate is wiped clean and he has another 12 months before he has to do it again. Anything he picked up recently to appear in the list of year-end holdings can now be dumped and turned back into cash. Given the events of the last week a larger cash position is probably looking pretty desirable today.

Any post October portfolio adjustments should only take a couple days. They will know what they want to dump/buy and it should happen quickly. The next challenge for the market is the FOMC statement on Wednesday and the Payroll report on Friday. I would be surprised to see any major rebound until after the payroll report. I can't envision anything the Fed could say that would be very positive for the market. They have to be worrying about a strong statement to keep the dollar in check. They have exhausted their $300 billion buy of securities and that was keeping a short-term top on real interest rates. Unless they announce a new round of purchases I think real rates are going to tick back up and they may not be ready for that. I think the Fed will err on the side of a stronger statement rather than continue to be conciliatory to the markets. If the "considerable time" sentence disappears the markets might not react favorably.

As you might expect the internals were terrible on Friday. There were nearly 12 billion shares traded and nearly 11 billion were down volume with only 1.16 billion in up volume. Decliners were 5:1 over advancers. Thursday's short squeeze volume was decent at 9.8 billion shares compared to the nearly 12 billion on Wednesday's decline. Down volume on Wednesday was 8:1 over advancing. Larger volume on down days remains the trend as well as increasing volume as we enter a period of economic instability. The earnings cycle is basically over and all eyes will be on the Fed and Jobs next week. This should be an interesting exercise in Fed watching and I will be glad when this week is over. The following week is devoid of any material economics so the markets will be left to roam alone. Let's hope the direction is not down.

Don't forget to turn your clocks back on Sunday when daylight savings time ends.

Jim Brown