Fears over a sharply declining U.S. economy, increasing worries over the European credit crisis and global growth combined to crush the markets and produce some serious technical failures.

Market Statistics

Apparently the declines for the last week were not just related to the worries over the debt limit but increasing worries over the direction of the economy. The ISM and GDP reports provided a real shock to the system and investors are very worried about the ADP payroll report on Wednesday and Nonfarm Payrolls on Friday.

The only material economic report due out today was the Personal Income and Spending for June. This is a lagging report but it was negative for the markets. Consumer spending declined -0.2% in June to continue its five month decline. It was the lowest number since Sept 2009. Wage income was unchanged and the lowest reading in seven months. Consumers were hoarding cash ahead of the debt limit deadline with the savings rate rising +0.7% to 5.4% and the highest level in nine months.

Inflation, a real key of how demand is slowing, fell by -0.2% and the fourth consecutive month of lower readings. That was the biggest decline since June 2010. Continued high employment and worries about the economy could keep the consumer on the sidelines for the rest of the year.

Auto sales improved slightly for July at an annualized pace of 12.23 million units. This is still well below the 13.0 million unit average for the first four months of the year. The decline is still related to the Japan earthquake BUT the GM CEO said there was a solid hit to sales from the debt limit worries. Buyers were looking but many saying they did not want to buy ahead of the potential debt default. GM thinks this created a lot of pent up demand that will come back to showrooms this fall when the new models arrive.

GM sales were still up +7.8%, Ford +8.9% and Chrysler the big gainer at +20%. Toyota sales declined -22.7% due to continued supply problems but they did raise full year sales and profit guidance. GM reports earnings on Thursday.

The economic calendar for the rest of the week is full and Wednesday has some critical reports. The ADP payroll report is expected to show job gains of 100,000 but you have to wonder if those analysts are on hallucinogenic drugs. The same goes for the Nonfarm Payrolls on Friday with estimates of 90,000 jobs. The sentiment has turned so bearish that both reports could show job losses and nobody would be surprised.

You may remember the race to upgrade estimates for the Nonfarm Payrolls last month after the ADP report showed a gain of +157,000 jobs. Analysts were falling all over themselves to put out numbers over 100K for Nonfarm. When the actual number on Friday showed a gain of only 18,000 jobs there were a lot of embarrassed people. I think that is why the official estimates on both ADP and nonfarm are holding in the 90K range. Everyone wants to be in the middle of the pack and not make a call for job losses and then look like an idiot if they don't appear. There is something to be said for safety in numbers when you are paid to come up with estimates. "Everybody else got it wrong too!"

After the five point miss on the ISM Manufacturing on Monday I would not be surprised to see a decline on the services ISM on Wednesday. Supposedly the services sector is in better health than manufacturing but that remains to be seen.

Economic Calendar

There is some real evidence the debt debacle caused some real concern on Main Street. Aon Hewitt tracks the 401K accounts of 4.7 million workers. The company said the money moved from stocks to fixed income funds since the prior Monday was the third highest level since they began tracking in 1997. As the deadline neared last Thursday nearly $1 billion was moved into bond funds compared to recent averages of $300-$400 million. There was another $862 million on Monday. More than 95% of the money went from stocks into "stable value funds" and fixed income investments. Workers who were burned in 2008 have a very low tolerance for risk today. Most 401K accounts lost a third of their value in 2008. Average stock exposure declined from 70% to 50% as investors moved out of stocks. Only about 1% of those assets returned to stocks after the crash so the majority of 401K accounts missed out on the market rebound.

The U.S. may have ended the debt limit crisis but the European crisis appears to be getting worse. The positive sentiment over the grand plan to bailout Greece and others two weeks ago has evaporated and the bond wolves are howling again. Italy and Spain, the third and fourth largest economies in the 17-nation Eurozone saw their borrowing costs explode higher and analysts are worried the countries will run out of money to pay their debts in a matter of months. Once a country is unable to borrow from the international debt market their options are limited and they will have to resort to the European Financial Defense Fund for a bailout. Unfortunately that fund is not large enough to handle countries like Italy and Spain.

Greece, Ireland and Portugal have already applied for bailouts and they are some of the smallest countries in the zone. Italy's benchmark 10-year bond hit a 14-year high at 6.21% on Tuesday. With their debt already at 119% of GDP they will have a very hard time staying current with payments in a rising interest rate environment. The Spanish 10-year bond rose to 6.45% today. Spain needs to raise €3.5 billion ($5.0 billion) in an auction on Thursday so rates could go even higher depending on what buyers are willing to take for increasing risk. Europe's 90 largest banks hold more than €326 billion in Italian debt compared to the €90 billion in Greek debt. Those same banks also hold €278 billion in Spanish debt.

JP Morgan said Italy will run out of cash in September and Spain in February if they are unsuccessful in borrowing from the public markets at a reasonable rate. This would result in a "self-fulfilling negative spiral" according to JP Morgan.

The resurgence of even more serious problem in Europe along with the possible return to recession in the U.S. helped push U.S. bond yields to the lows for the year and gold prices to new record highs. Gold rose +$41 today to close at $1662.50 and silver at $41. Never say never! How many people have you heard saying gold prices have peaked or forecasting a significant drop? I know quite a few people have been shorting gold over the last few weeks even though I have been warning against it.

You may remember this paragraph I have posted more than once.

Standard Chartered PLC, a major international bank with a 150-year history and 1,700 offices, is predicting gold prices could rise to $5,000 an ounce over the next five years. Read the full report here: In Gold We Trust

The Silver Institute recently released a report titled The Future of Silver Industrial Demand and predicted demand for industrial use would increase to 665.9 million ounces by 2015 for a 36% increase from the 487 million used in 2010. Mine production only rose +2.5% in 2010 to 735.9 million ounces. Silver investments like the SLV ETF saw a +40% increase in the amount of silver owned by 279.3 million ounces in 2010 to 582.6 million. Coins and metal demand rose +28% to 101.3 million and there were 55.6 million ounces of bullion produced. The SLV ETF increased its holdings by 1,428.6 tons in 2010 and has already added another 280 tonnes in 2011.

Another factor squeezing the shorts was news South Korea spent more than $1.24 billion in gold in recent weeks as uncretanity about global growth and sovereign debt pushed central banks to add to gold positions. The Bank of Korea said it bought 25 tonnes of gold over the past two months to raise its total holdings to 39.4 tonnes. That was their first gold purchase since 1998. China and India have also been actively buying gold. China has the sixth largest holding at 1,054.1 tonnes at the end of May, Japan in ninth place at 765.2 tonnes and India, 11th place at 557.7 tonnes. The U.S. is the largest holder of gold at 8,133.5 tonnes. That makes up 74.7% of the U.S. foreign reserves. Germany is second at 3,401 tonnes and 71.7% of its currency reserves.

The reason all these central banks are buying gold is the decline in other reserve currencies like the dollar (-10%) and the Euro (-6%) in the last two years. As global economies weaken these same countries will likely increase their holdings in order to get away from the dollar.

Gold Chart

Silver Chart

If you have not refinanced your mortgage you might want to reconsider it again now. The 30-year treasury yield fell to an 8-month low at $3.92% after being well over 4% for the last eight months. Mortgage interest is not going to get much cheaper because free is never going to be an option.

Ten-year Yield Chart

Thirty-year Yield Chart

Not all commodities were rising. Oil prices collapsed from a post deal spike to $98.60 to close at $93.26. The problem with oil is the worry over future demand. If the economy is falling back into a recession analysts fear demand for crude will decline sharply as it did in 2008. Basically the price of crude is a referendum on economic expectations for the USA.

The MasterCard Spending Pulse report for last week showed gasoline demand declined -3% for the week. Since there were no major storms and prices were muted at $3.69 per gallon nationally there is nothing to account for the decline other than a conscious effort to save money by driving less and continued high unemployment. A slowdown in economic activity ahead of the debt default deadline was also to blame.

Brent crude declined slightly but continues to hold near resistance at $118 because there is no real drop in demand overseas thanks to the boom in Asia. The spread between WTI and Brent widened to $22.58 and near record levels.

Crude Oil Chart

Brent Crude Chart

Fitch Ratings announced today it upheld its AAA rating on the U.S. thanks to the agreement on spending cuts but they would not finish their review until the end of August. They still have the U.S. on the potential for a downgrade. David Riley, the chief analyst said he would not rule out keeping a negative outlook on the U.S. rating when the review concludes. He said the agreement was only the start of a very long process that would require some very hard decisions. Those decisions would be even harder against the currently negative economic backdrop. He said the downward revision to the Q1 GDP to barely over recession levels was far bigger than anyone expected and a serious source of concern. Fitch noted that "U.S. federal, state and local debt as a percentage of GDP will reach 100% in 2012 and will continue to rise over the medium term and that is not a profile that is consistent with the U.S. retaining a AAA rating."

S&P had said they wanted a $4 trillion spending cut in order to maintain the U.S. AAA rating. They backed off that claim slightly in recent comments but they are still a worry over a possible downgrade. Several analysts have said that there is better than a 50:50 chance S&P will cut the rating given the backend loading of the announced spending cuts, which don't really kick in until 2013-2014.

Emerson Electric (EMR) posted profits that rose +17% to 90-cents but missed expectations by a penny. The company makes electric motors, power tools, appliances, factory automation and process management systems. The earnings were not the big news since the company had already guided lower a couple weeks ago.

The Emerson CEO, David Farr, lashed out at government saying the U.S. and European governments are "dysfunctional." And, "I do not see the catalyst that would say the economy will be fundamentally different in the second half than it was in the first half. We are looking at slower growth." He said he told his managers to cut spending because these were "extremely uncertain and difficult times." He said the way I see it "Washington is arranging the deck chairs on the Titanic" with corporate confidence declining sharply. "Instead of reforming corporate taxes to boost investment and hiring the government is introducing new restrictions like forced health care costs and higher fuel efficiency requirements for automobiles."

He said governments are not addressing the real issues. "The U.S. has enormous regulations coming right at us right now. The incentive to invest in the U.S. right now is negative." Emerson employs 140,000 workers.

Come on Mr. Farr, how do you really feel? Unfortunately I believe quite a few businesses feel that way today and it is depressing the economy.

Emerson Electric Chart

I am not going to list a lot of earnings tonight because they had no real impact on today's market. The problems with the market today shifted from fundamental to technical. Fundamentally the corporate earnings were good with 70% of companies beating on earnings and 65% on revenue. Corporate cash levels are very high so there is money available for expansion and hiring if the conditions were right.

The economic fundamentals are declining rapidly and fears of a double dip were forcing asset allocation trades out of equities and into bonds. The massive and accelerating decline in the major indexes show exactly how fast that exiting is progressing. Economic fears are rising and that broke the fundamental picture driving the market higher. The "it will be better in the second half" scenario has run off the tracks and by all accounts now it would be worse in the second half.

The failure of the economic scenario caused a failure in the technicals. The S&P broke through critical support at the 200-day (1285) and the lows from June at 1265. I believe it would have punched through the one remaining thread of support at 1250 but it ran out of time.

I am sure the risk is clear to everyone on the chart below. The S&P is now in breakdown mode and to pin our hopes on 1250 holding would be foolish. There are too many negative tail winds and any rally from here would be begging to be shorted. However, rebounds always come when they are least expected and I think this situation would qualify as "least expected."

I am afraid we will see a break of 1250 and a continued decline to 1175 or even lower unless the jobs reports are suddenly bullish and the economics do a stunning about face in record time. Investors have locked in on "double dip recession" and it will take a major change in factors to break them out of that mindset. Sell stops are getting hit and volume is increasing. Volume the last five days has been the highest in months and that is not a good sign.

The S&P closed at the low for the year although it did dip to 1249 intraday back in March. The seventh consecutive loss on the S&P created the biggest losing streak for the S&P in more than three years.

S&P-500 Chart

The Dow did not just break support at 12,000 it was crushed with the Dow closing at 11,866. That was the lowest close since March. There is no way to spin this chart positively. Granted an opening rebound on Wednesday would create additional support at the current level but I think it could be quickly broken. There is simply nothing positive to say about the charts. Until the fundamentals improve I expect rallies to be sold.

Dow Chart - Daily

The Nasdaq has not declined as much as the other indexes thanks to the relative strength in Apple. However, if the S&P and Dow continue lower it will drag the Nasdaq lower as well. In a falling tide all boats move lower. I would expect the Nasdaq to try and hold support at 2615 but that depends on how badly the other indexes are declining.

Nasdaq Chart

Russell = Ugly! The Russell has completely broken below strong support at 775 with a close at 767. In theory the Russell should go into freefall with support broken and money managers trying to raise cash. Margin selling on the small caps should be particularly bad.

Russell Chart

The NYSE Composite is even more ugly than the Russell. The NYSE closed at a new low for the year and there is absolutely nothing to prevent it from retreating to 7400.

NYSE Chart

The flush at the close was probably had a lot to do with margin selling and fund managers raising cash to cover redemptions as investors moved money away from equities and into money markets. When market collapses occur they don't normally happen all at once but on that rare occasion when the perfect storm arrives they can be ugly.

We could have a dead cat bounce at any time but unless the ADP report or something else is suddenly bullish I think we are looking at a breakdown in the market. With the Dow, S&P, NYSE and Russell already in full breakdown mode I don't see a meaningful recovery. Despite the high volume today the technicals were not yet at capitulation levels. Without any positive news events there is no reason to rush into the market.

Fund managers know August and September are normally down months and with economics imploding there is no reason to put money at risk. As I said earlier, the "it will get better in the second half" scenario has crashed and burned. Until we actually see something getting better I think investors will avoid equities.

Now for the qualification. The expectations for the Nonfarm Payroll report have fallen so low so quickly the risk is not for a negative surprise but for a positive surprise. Will that be enough to power a rebound? I seriously doubt it. We could see some short covering but unless the upside surprise was massive I think it would be only a brief relief from the selling. We are however VERY oversold already thanks to eight days down on the Dow and seven on the S&P. A short squeeze could be powerful but again I believe it would be sold just as quickly.

The bond market is sending a message. You don't get that big a drop in yields without massive buying and investors don't normally buy bonds for a week or two. That money moving from equities to bonds is probably there for months rather than days. It is not coming back next week.

Don't forget the FOMC meets next Tuesday. August is the anniversary of the Bernanke speech in Jackson Hole that started the QE2 rally. I would not be surprised if there was some action out of the FOMC or something leaked at Jackson Hole about a new QE3 program. If employment really did take a dive in July then the Fed is going to be pressured to take action. Stimulus may be a dirty word in Washington today but Fed stimulus does not come out of the U.S. budget. It is funded by the Fed and not all Fed stimulus requires funds. They can change rates and/or rules and they are not restrained by lawmakers. Bernanke may have to go to Congress and explain himself later but I would view that as "take action and ask forgiveness later."

The next week is going to be pivotal for the markets and I believe volatility will increase.

Jim Brown

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