The volatility index (VIX) is sinking but stocks remain volatile. The S&P 500 just saw a +3% bounce marking its first weekly gain in a month. It was the best pre-Labor day week in 20 years, but it followed the worst August in nine years. Stock market gains were powered by short covering that began on Wednesday following the U.S. ISM manufacturing data and the Chinese PMI numbers. Friday's jobs report was also better than expected and shorts scrambled to cover before the long weekend.

It was a pretty good week for economic data around the world. The country of India significantly raised some of their growth estimates with consumption surging from +3.7% to +10%, investments soared with a change from +3.7% to +7.6%, and government spending in India reversed from -0.7% to +14.2%. The Indian market rallied midweek and closed less than 1% from new two-year highs. Australia made headlines on Wednesday when they announced their GDP growth climbed to +1.2%, better than the +0.9% estimate. Australia's Bureau of Statistics said the growth was fueled by stronger consumer spending. The U.S. rally actually started on Wednesday when China released better than expected PMI numbers. Economists were looking for an increase from 51.2 to 51.5 but the official report came in at 51.7. A separate, private PMI report for China, created by HSBC, also showed improvement with a rise from 49.4 to 51.9. Readings over 50.0 indicate expansion for these surveys. Fears that the Chinese economy might be slowing down too fast were temporarily forgotten.

Investors were also surprised to see the ISM manufacturing index for the U.S. suddenly improve. On Wednesday economists were expecting the ISM to drop from 55.5 in July to 52.8 in August. Yet the Institute for Supply Management reported their manufacturing activity index rose to 56.3 in August. Again, readings over 50.0 indicate growth and this was the 13th month in a row the report was positive. This data completely overshadowed the worse than expected ADP employment number on Wednesday morning, which saw a loss of -10,000 jobs instead of the expected +15,000. The ADP report didn't bode well for Friday's jobs number and traders were expecting a disappointment, especially with weekly jobless claims on the rise.

Imagine the surprise when Friday's non-farm payroll data came in significantly better than expected. Analysts were looking for the August jobs report to show a loss of -110,000 jobs with private sector job growth falling from +71,000 to +41,000. Instead the Labor Department reported the headline number at -54,000 jobs while private sector jobs grew +67,000. The headline number was negative due to the termination of summer census workers and a drop in state jobs. Shorts were once again in a rush to cover their positions. That is two weeks in a row that Friday had a big economic event that traders were expecting to be negative but surprised to the upside (last week was the Q2 GDP revisions). Another positive read in Friday's jobs report was an increase in temporary staffing (+17,000), which normally rises ahead of permanent job growth.

Chart of the Non-Farm Payroll Report:

Big picture the economy is still struggling. Temporary hiring averaged more than +40,000 a month from Q4 2009 through Q2 2010 so we're still tracking below average and need to a significant increase before expecting any serious improvements. The U.S. needs +150,000 new jobs a month just to keep pace with population growth. With almost 15 million people out of work it's going to take years and years before we reach anything resembling "normal" employment. Speaking of the unemployed, the unemployment rate actually ticked higher to 9.6% as nearly 500,000 people renewed their search for a jobs, which technically means they have rejoined the workforce even though they're still searching for work.

The pre-market release of the jobs data set the tone for trading on Friday and investors pretty much ignored the weaker than expected ISM services data released late Friday morning. The Institute for Supply Management reported their service-sector index fell from 54.3 in July to 51.5 in August. This was the lowest reading since January 2010. While readings above 50.0 indicate growth it's moving the wrong direction. Manufacturing only accounts for 11% of the U.S. economy while services are closer to 80%. A drop in services is not a positive sign for future growth. Inside the report the new orders component fell -4 to 52.5 and the employment component actually turned negative with a drop to 48.2.

Chart of the ISM Services index:

Technically the market was already set up for an oversold bounce. Stocks had been consolidating near support after the worst August since 2001. They were oversold and some unexpected good news sparked some short covering that began to feed on itself due to the low volumes. Sadly this has all the characteristics of a bear-market rally. It was short, very sharp, and didn't see much volume. On a more positive note the major indices crashed through a few resistance levels last week. Plus, the S&P 500 appears to be building an inverse head-and-shoulders pattern (a bullish H&S). If the S&P 500 can close over resistance near 1130 the pattern would forecast a move toward the 1240 area over the next two or three months.

Daily chart of the S&P 500 index:

On a short-term basis the S&P 500 should now find support at 1080, the 50-dma, and the 1060 area (in addition to 1040). The close over 1100 on Friday is bullish and certainly looks like another breakout over resistance but the index is facing the simple 100-dma directly overhead. If the rally continues we can look for resistance at the 200-dma (near 1115) and the August highs near 1130. The market is moving so fast we've gone from oversold to overbought. From a technical perspective I would look for a dip back toward 1080 (now support) before we see further upside.

Daily chart (#2) of the S&P 500 index:

The NASDAQ has produced a similar move higher with a breakout from the 2100-2150 trading range. Short covering pushed the composite above resistance near 2200 and the 50-dma but there is still resistance at the 200-dma and at the 2300-2310 zone. Technically I would expect some profit taking with a dip back toward the 2180-2170 zone although optimistically we might see the 2200 level hold as support.

Daily chart of the NASDAQ index:

I am still somewhat optimistic with the bullish double bottom pattern in the small cap Russell 2000 index. However, the $RUT has rallied nearly +9% from its August lows so it too probably needs to see a correction before making any further progress. Look for a pull back into the 625-616 zone. If the $RUT can close over resistance near the 675 area it would be very bullish for the market.

Daily chart of the Russell 2000 index:

Looking ahead the month of September is historically the worst month of the year for stocks but there can obviously be exceptions. If stocks continue to climb then fund managers will be tempted to chase them for fear the market will run away from them. We have seen this scenario before with the big rallies in Q3 2009 and Q1 2010. Short-term the trend is up but we're now overbought and need a dip. We might see that dip on Wednesday when the Federal Reserve releases their Beige Book report. At the same time if the Beige book is stronger than expected we could witness more short covering.

Keep in mind the 2010 elections are two months away. Short-term I see this as a negative as investors would rather wait and see the election results before putting money to work. Will the democrats defend their majority in Washington or will republicans see a surge in power as frustrated Americans continue to search for anything but the status quo? Right now polls seem to be favoring the republicans but we have a long eight weeks ahead of us and a lot could change between now and then.

Uncertainty over the elections could easily keep money on the sidelines but there will be some investors that begin placing their bets ahead of the vote in anticipation of a Q4 rally higher. For the moment each economic report remains a landmine but the last couple have blown up on the bears and not the bulls. The double-dip recession remains a risk but the recent splash of better than expected economic news has pushed those fears aside - at least until the next landmine goes off. I still expect a Q4 rally but it's too early to tell if the current bounce is our entry point or if we'll see another entry point in the next six weeks.

- James