The markets had their worst week since June and for the second day the Dow gave back a +75 point opening gain on afternoon weakness.

Market Statistics

The S&P and Nasdaq closed negative for the sixth consecutive day but the Dow managed to close with a +2 point gain thanks to IBM and Boeing. The major indexes gave back -2% for the week with the Nasdaq losing -3%. With some economics turning positive you would have thought the markets would find some support but even commodities declined.

This market decline should not be a surprise to anyone. This is the seasonal pattern I have written about several times as a result of fund managers restructuring their portfolios ahead of their fiscal year end on Oct 31st.

Were it not for the fiscal cliff and the uncertainty surrounding the election we would likely see a rebound in the last ten trading days of the month as those funds currently selling stocks would add new positions going into year end. So far there is no indication of any change in the seasonal patterns but we need another week and the presidential debate on Tuesday to remove some of the uncertainty.

Helping to push the markets higher at the open was a better than expected reading on Consumer Sentiment. The headline number for October rose sharply from 78.3 to 83.1. That is the highest level since late 2007. The breakout astounded analysts that were expecting a decline. Moody's was looking for a drop to 77.3.

This was the third consecutive monthly gain from the cycle low of 72.3 in July. The expectations component was the biggest driver with a spike from 73.5 to 79.5. The present conditions component rose slightly less from 85.7 to 88.6. These numbers were even more startling since sentiment normally falls in October. Sentiment has fallen in five of the last seven years in October.

The only two positive drivers seem to be the positive surprise in the payroll report last week and the first presidential debate. The headline about falling unemployment to 7.8% would have been about all the general public would have seen or understood. The vast majority of consumers don't pay attention to economic news but that headline attracted attention since it was the focal point of the election campaign over the last week.

The markets rallied after the first presidential debate because of the good showing by Romney. The polls jumped significantly after it appeared he had a plan for moving the economy forward and might actually beat Obama (No emails please, I am just reporting). If that same positive sentiment that moved the market the day after the debate was translated into consumer sentiment then that may be why we saw such a big bounce in the expectations component. People are expecting the economy to get better over the next six months despite the fiscal cliff.

The improving housing market is also a plus. Hardly a day goes by that some reporter is not on the news talking about the improvement. Since the majority of consumer wealth is tied up in their homes this is always a plus.

Consumer Sentiment Chart

For the second week in a row the government produced an employment report that seems too good to be true. Weekly jobless claims fell to 339,000, a decline of -30,000 from the prior week. Analysts were also grasping at straws as to why the claims dropped so suddenly. Why would companies stop laying off people all at once? This points back to the reasons for the improving sentiment I mentioned above. If companies suddenly saw an injection of hope they may have decided to hold off on making changes until after the election.

However, the jobless claims was another report with an asterisk attached as commentators immediately cried foul and said the abnormally low report was suspect. An analyst at the Dept of Labor fielded questions and said it was probably due to a large state not turning in all their claims because of understaffing. California was the state the analyst suggested had not completed the claims process. She said the unprocessed claims would probably be included in next week's report. The comments made the rounds on the news desks and the problem was solved. Some whispered that the shortage of claims from California was on purpose so the report would drop significantly and be another talking point in the Obama campaign since California is strongly democratic.

Later in the day the Director of California Employment issued a statement saying "California has reported all UI claims data and submitted the data on time." He offered another explanation saying the unseasonable warm weather had delayed some typical seasonal patterns in employment. He demanded a retraction by the news agencies of the statement by the Dept of Labor analyst. Sorry, but that horse has already left the barn. Or to put it another way, "You can't un-ring that bell."

Next week's jobless claims will be interesting to watch since prior claims are revised every week.

MarketWatch Jobless Claims Chart

On the negative side of the economic ledger was the Producer Price Index. The PPI for September came in at +1.1% and almost double expectations. This is the second month with a major spike in prices. August saw a spike of +1.7%. This is an index that normally moves in 1-2 tenths of a point not 1% or higher each month. This is bad news for QE3 if it continues. However, nearly all the gains were in the food and energy categories that the Fed ignores. Prices for energy goods rose +4.7%. The core rate, excluding food and energy, were flat after a +0.2% gain in August. If you don't eat or drive you are not seeing any inflation.

Moody's Producer Price Index Chart

The Treasury Dept released the final figures on the budget deficit for the 2012 fiscal year. The deficit was $1.089 trillion and down $207 billion from 2011. It was still the fourth largest in history. Future deficits are still expected to be over a trillion dollars a year with our total deficit hitting more than $25 trillion by 2022. Whichever candidate wins this election is going to have a huge task ahead to change the course of this ship. Budget cutting over the last several years has been the equivalent of rearranging the deck chairs on the Titanic. Unless major reforms are undertaken the bond market will eventually be our economic iceberg and the U.S. will suffer the same fate as the titanic.

The economic calendar for next week is headlined by the beginning of the October manufacturing reports in the Empire and Philly Fed reports. The monthly housing reports are also on tap. However, the biggest event could be the China GDP on Thursday.

China's GDP is hotly debated and there is always a chance of a negative surprise. The official consensus estimate is for +7.4% growth. However, there is a wide range of estimates and there is always the debate on whether the government numbers are even close to reality. Quite a few people believe the number is closer to +7.0% growth and the government is allowing the official numbers to decline a tenth of a point every quarter in order to manage the results. If the number was to come in 2-3 tenths higher the street would suddenly believe the bottom was in on the weakening China economy and the rebound would be huge.

Conversely if there were a sudden decline by 2-3 tenths of a point there would be analysts pounding the table on the impending crash.

Ray Dalio, head of the $130 billion Bridgewater fund, thinks the real number is several points lower not several tenths of a point. For him a 6% GDP in China would be a recession.

The CEO of International Paper, John Faraci, said in an interview on Wednesday that China's growth feels more like 2-3% not 7%. He said based on their historical business in China they are not running at a 7% rate but much lower. A company like IP that sells paper products into all the global economies knows when sales implode. If a company was selling $500 million a year into China and growing $50 million a year and purchases suddenly declined to $200 million with no growth you would know the government numbers were not correct. Paper is a commodity and although there are other paper companies IP does have products and scale that others can't match. If China's sales were cut in half there is no other explanation but a severe decline in the economy.

Faraci also quoted the statistic on electricity usage. He said China's usage had been flat for the last year. However, I reported several times over the last year that Chinese regulators have forbidden electricity providers from reporting negative numbers. If usage goes down they have to say it was flat with the month before. Since usage is a clear sign of economic activity and it is easily tracked by analysts the government prevented those actual numbers from being reported.

Also, I have reported several times about the mountains of coal being formed around the electrical plants in China. Plants order coal months or years in advance. When electrical usage drops so does the consumption of coal. The coal yards surrounding the plants are full to overflowing and there are new mountains being created in the fields nearby to store the coal that is not being used.

I know this is a long winded explanation of why China's GDP report is important BUT it is also a reason why it should show very little change. The numbers are managed to prevent market reactions.

Economic Calendar

While I am on the topic of China there was some good news last week. China's exports grew at roughly twice the rate expected for September. Exports rose +9.9% compared to estimates of +5.0%. That was almost four times the +2.7% gain in August. The "reported" trade surplus for September was $27.7 billion and well over the $20.7 billion estimate. Readers should also realize that exports in September are headed to stores for the holidays. There is a reason the exports bounced.

Everyone always points to the Chinese economy as important for global growth. Actually the Chinese economy is the measure of global demand. If the world is not buying Chinese products then China is going to post lousy numbers. If global consumer sentiment suddenly improved and consumers were going to the malls we would see China's numbers jump as a result. China is the thermometer of global growth, not the driver of global growth.

Moody's has a weekly global survey of business confidence. The sentiment level fell to a 52-week low last week at 12.9 on a four-week moving average basis. They use the average to smooth out the week to week volatility. It has not been this low since the Debt Ceiling debate in August 2011. The current decline in business sentiment is directly related to the fiscal cliff and fears are rising. This is a business survey not a consumer survey and business owners are far more in tune with the economic times. Does the chart below look like the global economy is improving?


The real calendar controlling our destiny next week is the earnings calendar. IBM, INTC, MSFT, EBAY and GOOG will determine the direction of tech stocks and C, GS, USB, AXP, BAC, MS and COF will determine the direction of financials. Tuesday is the critical day with IBM and Intel. The banks are already heading lower after the JPM and WFC earnings on Friday. Maybe Citi and Goldman Sachs can resurrect the sector but it will take some strong earnings and I don't expect that.

Intel has already warned but IBM has been quiet. A big beat or miss by IBM will be a major market mover.

Earnings Calendar

Wells Fargo (WFC) reported earnings of 88 cents that beat estimates by a penny. Unfortunately revenue was light at $21.21 billion. Analysts were expecting $21.47 billion. WFC said it originated $139 billion in mortgages in Q3 compared to $131 billion in Q2. Mortgage banking non-interest income rose +53% to $2.81 billion. Credit loss provisions declined from $1.8 billion to $1.59 billion. Total profits rose from $4.06 billion to $4.94 billion for the quarter.

WFC declined -2.6% after the report because the "net interest margin" (NIM) or spread declined from 3.84% to 3.66%. That is the difference between its interest earned and its cost of money. Part of the decline in that margin was the stock market. Cautions about the equity market caused an increase of $23 billion in cash on deposit and that required an increase in short term investments that earn less interest. When questioned by analysts on the drop in the NIM the CFO, Tim Sloan said, "We could have easily increased our NIM by making some bad short term decisions." He meant the bank chose less risk and lower margins instead of more risk and higher returns.

WFC shares were at a 52-week high last week so they were due for some post earnings profit taking.

WFC Chart

JP Morgan (JPM) reported earnings that rebounded from the bad trade quarter and beat the street. JPM reported earnings of $1.40 a +37% rise over the year ago quarter. Analysts were expecting $1.24. Total revenue rose +6% to $25.86 billion. Loan loss reserves declined by $900 million. Investment banking revenue declined by -1% to $6.3 billion.

Jamie Dimon said trading losses related closing the whale trades were $449 million in Q3 and less than the worst case scenario of up to $1.6 billion in the estimate he gave last quarter. The bank has lost $6.2 billion on those trades in total. Dimon said revenue from mortgage production rose +36% to $1.8 billion. He also said "housing has turned the corner."

Fixed income trading came in at $3.7 billion, a gain of +33% over the year ago quarter. A KBW analyst said that was a good sign for Goldman Sachs and Morgan Stanley, both of which report earnings next week.

JPM and WFC reported a strong improvement in credit quality. That translates into improvements for Bank of America and KBW expects them to beat earnings next week.

JPM Chart

AMD warned on Thursday that sales in Q3 would decline 10% or more from the prior period. That was a bigger drop than previously expected. Barrons is quoting multiple sources this weekend saying the company may be preparing to announce a cut of up to 20% of its workforce. That would amount to 2,340 jobs out of the total staff of 11,700. CNET is reporting expected cuts of 30% of the workforce. All Things Digital said the cuts were going to be primarily in engineering and sales.

Gartner Inc said global PC sales declined -8.3% in Q3 to 87.5 million units. Applied Materials (AMAT) warned last week it was going to cut -9% of its workforce. Disk drive makers Western Digital and Seagate have both warned that demand has declined significantly. This makes the outlook for Intel pretty grim.

AMD Chart

Intel Chart

Infosys (INFY) reported earnings of 75 cents that were 2 cents below analyst estimates. Revenue was $1.8 billion and below the $1.9 billion estimate. The company cut full year forecasts through March 2013 to $2.97 due to currency conversion issues. Analysts were expecting $3.04. The Indian consulting firm provides services to clients in more than 30 countries but 66% comes from the USA. More than 98% comes from outside India.

The CEO said "global uncertainties" were impacting the industry. The company only added 39 new clients in Q3 and that was the lowest number since Q1-2011. An analyst from William Blair said Infosys was seeing a slowdown in spending from large corporations due to the uncertain environment.

Shares of INFY declined -7.6% on the news.

INFY Chart

One of the worst upgrades ever was handed out by Wells Fargo to Dollar Tree (DLTR) on Wednesday. The analyst cited solid valuations and expectations for solid same store sales to continue. They raised the price target from $53 to $57. That was Wednesday. Shares of DLTR rallied to $47.50 on the news.

On Thursday morning DLTR warned that Q3 sales would be at the lower end of the prior forecast because of "cautious" consumer spending and higher gasoline prices. Shares of DLTR fell -11% to $42.51 but the pain continued on Friday with a close at $41.11. This stock has self destructed since its highs back in June at $57.

Think this through for a minute. How bad is the real economy when consumers can't afford items for $1 or less at the dollar store? These stores normally do well in rough economic times because of their low price point. What does this say about the sales expectations for Wal-Mart and Target?

DLTR Chart

Amazon (AMZN) shares declined -$18 over the last four days after Target, Wal-Mart and Ebay announced they were planning same day delivery services. Wal-Mart is testing Wal-Mart to Go in three cities and expects to add more later this month. Ebay announced it was testing an app for same day delivery for a couple months now in San Francisco with more cities to follow soon. Ebay said deliveries can arrive in as little as an hour.

Amazon announced a couple weeks ago it was going to offer the same day delivery service. Suddenly the field is full of competitors with several of them clearly well into the process. Amazon had sales of $49 billion last year compared to Wal-Mart's $419 billion. Wal-Mart has a much bigger footprint than Amazon so this battle is far from over. Wal-Mart is charging $10 for instant delivery. With stores every ten miles in the major metropolitan areas Wal-Mart has a definite edge.

Amazon also disclosed it was selling the Kindle Fire at cost in order to get customers that would buy merchandise from Amazon using their Fire for years to come. I don't think that was any big secret. Everyone has thought that to be the case ever since the Fire was announced.

I can vouch for the model because I have bought more than 60 books on my Kindle in the last six months.

Amazon Chart

Apple (AAPL) finally released a date for the iPad Mini announcement. They did not actually say iPad mini but it has been rumored for many weeks. The date is Oct 23rd and "coincidentally" only two days before Microsoft is going to release its Surface tablet with Windows 8. You did not really think Apple was going to let Microsoft steal their thunder did you?

The 7-inch iPad mini is expected to come with a lower resolution screen and slower processor to enable Apple to market it at the same price as the Kindle Fire and Nexus 7. Both of those sell for $199. The Nexus 7 sold out right after it was launched thanks to high demand. Google's Nexus 7 is also being sold at cost. The 7-inch tablets are popular because they can be carried in the vest pocket of a sport coat or suit.

Apple Chart

Apple's nemesis Google (GOOG) is in trouble. Federal regulators are moving closer to suing Google over allegations the company is monopolizing its advantage in search technology. Reportedly Google is using its monopoly to drive up online advertising rates. Several news outlets reported late Friday that FTC staffers were urging the agency to file a suit. Three of the five FTC commissioners would have to agree before a suit could be filed. Bloomberg and Reuters both claimed to have talked to people familiar with the FTC investigation. The investigators are circulating a more than 100-page memo recommending the suit. Secondly, the FTC is considering another suit against Google for misusing patent protections to block rival smartphones from coming to market. Google has sought court orders to prevent Microsoft and Apple from using video compression technology in competing phones. Before Google acquired Motorola the phone maker had sued Microsoft and Apple over the xBox, iPhone and iPad in an effort to block sales. Google has continued those suits.

Google Chart

Crude prices declined on Friday after the IEA cut demand estimates once again. The International Energy Agency said demand growth in 2012 would now be only +700,000 bpd. That is a cut of -100,000 barrels from the same report issued just last month. For 2013 the IEA affirmed its estimates for another increase in demand of +800,000 bpd. If it were not for the tensions in the Middle East the price of oil would be a lot lower. However, the Iran/Israel worries and the shooting between Syria and Turkey is providing support. If Turkey gets dragged into the Syrian civil way the oil pipelines could come under attack.

The IEA said Iranian production declined to 2.63 mbpd and exports fell to a new low of 860,000 bpd. Analysts were expecting the sanctions to weaken in September as Iran resorted to several schemes to get around the sanctions but the cancellation of insurance appeared to have overcome those schemes. One scheme saw Iran shipping oil in its own tankers and offloading to other tankers in remote harbors in other countries in the dead of night to try and disguise where the oil was going.

September output was lower from Saudi Arabia, Nigeria and Angola and higher from Iraq. Even with the decline in Iranian exports, production continued to run about 1.0 mbpd more than global demand.

The sudden spike in consumer sentiment and the unexpected rise in industrial production in Greece also provided support on Friday.

Gasoline prices fell -3% intraday on Friday but rebounded slightly to end down only -2%. The crisis at the various refineries appears to be either over or under control.

WTI Crude Chart

The earnings cycle is just getting started but already the outlook has soured. The expectations for earnings for Q3 are nearing a decline of -3% and the first negative quarter since the recession. That has declined from a -2.1% estimate on Oct-1st. S&P reports that 11 S&P-500 companies have already warned for Q4 and there have been zero companies raising estimates. Earnings warnings for Q3 are running 4:1 over positive guidance. Of the companies that have announced Q3 earning only 59% have beaten the estimates compared to the long term average of 62%. That is not a big discrepancy but very few have reported. Only 50% have beaten on revenue compared to the average of 62%.

Europe has been used as the excuse more often than any other reason according to Reuters. Q4 earnings estimates have fallen to +9.6%. That is down from +14.1% just two months ago.

The deteriorating earnings picture is weighing on the markets. We are seeing daily warnings from multiple companies and we have not even gotten to the real earnings yet. There is always the potential for a pessimistic warning turning into a positive surprise because companies normally estimate low when they warn and then report slightly higher if the pessimistic expectations fail to come to pass.

The S&P closed just below support at 1430 after declining -42 points from its high at 1471 on October 5th. The decline has been direct but it has also been peaceful. There have been no crashes or major declines. The pace has been slow, steady and calm. So far it has been a somewhat casual portfolio restructure cycle compared to a normal October.

We could be on the verge of a new leg down if that support at 1430 breaks. That would suggest a retest of 1400, which is strong support. Below 1400 it begins to get ugly with 1330 the next material support.

Without a worsening of the headline flow I would expect support at 1400 to hold. However, if the earnings estimates for Q3 and Q4 continue to decline there is a point where investors will throw in the towel.

Over the last week open interest on VIX calls has been at record levels. That means traders are expecting the VIX to rise and the market decline. Since the herd is normally wrong, any positive surprises could produce a major short squeeze. We have not had a material short squeeze since September 13th and the QE3 announcement. There have been several openings where the market gapped higher but in all but one case the selling started almost immediately.

I believe the normal cycle of a late October rebound would prevail but the election and fiscal cliff have put that in jeopardy. The calm nature of the restructure process means managers are not too worked up over it but you never know what headline will break the market's back.

S&P Chart

Like the S&P the Dow has returned to the support of the 50-day average and a breakdown here targets a -300 point return to Dow 13,000. With multiple Dow components reporting earnings next week anything is possible. INTC, JNJ, KO, VZ, UNH, TRV, MSFT, MCD, IBM, GE, BAC and AXP all report earnings. If the early trend of miss estimates and warn on Q4 continues then the Dow could be in trouble.

On the positive side the pessimism may already be priced into the market and even minor earnings beats could trigger a short squeeze in the stocks. I am not betting on that scenario.

Dow Chart

With the major tech heavyweights reporting next week, INTC, MSFT, IBM, GOOG and EBAY, the odds of a retest of support at 3,000 are very strong. The index is in free fall and it was only thanks to a rare positive day by Apple that kept it from collapsing on Friday. The tech outlook is very cloudy.

Nasdaq Chart

The Russell 2000 did not decline any more than the big cap indexes. The loss for the week was -2.3% and it remains above decent support at 820. The lack of panic in the small caps is somewhat bullish. Fund managers are not running for cover. The decline is orderly for an October portfolio restructure. It is as if everyone is waiting for that magic moment when a headline breaks that starts the end of month buying binge.

The Russell does not have any clearly defined support under 820 other than the 200-day average at 802. The support patterns start to become choppy but we are going to depend on headlines not chart lines.

Russell Chart

The AAII Sentiment Survey for last week showed that bullishness fell to a 10-week low. Bearishness rose to the highest level since July. Bullish sentiment fell -3.3 points to 30.6% and the lowest level in more than two months. This was the 27th out of 28 weeks that bullish sentiment was below its historical average of 39%. Neutral sentiment fell -2.3 points to 30.6%.

Bearish sentiment spiked +5.6 points to 38.8% and an 11-week high. This is considerably over the historical level of 30%. Clearly the herd is rapidly accelerating into bearish mode.

There are really good reasons for this with the fiscal cliff, earnings deterioration, election uncertainty and still no solution in Europe for Greece and Spain. While those reasons exist they can also be a wall of worry for the bulls to rebound over. Eventually fundamentals will matter again and when that time comes I hope the fundamentals are significantly better than they are today or we are in some serious trouble. There are analysts calling for a 20% to as much as 40% decline in the markets because of those reasons above. Fortunately the herd is stampeding into a bearish posture and the herd is almost always wrong. Until they are proven wrong we have to go with the trend and that trend is pointing lower.

The market is at a critical support point. A break here is not disastrous but would setup a major test of support at Dow 13,000 and S&P 1400. I believe that would be a buying opportunity.

I still believe we will find a bottom in the next week or so and rebound into October's close but that depends on how the presidential polls look over the next couple of weeks.

Enter passively, exit aggressively!

Jim Brown

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"It's tough to make predictions, especially about the future."
Yogi Berra