Blame it on Washington. Stocks suffered one of their worst weeks all year long as market participants began to grow increasingly worried that we would not see a debt ceiling deal before the August 2nd deadline. The ongoing Q2 earnings season continues to produce better than expected results but guidance has been lackluster at best. Sprinkle in some disappointing economic data like the Q2 GDP estimate and it fueled fears of another recession. The S&P 500 index lost -3.9% for the week. The Dow Industrials fell -4.2%. the NASDAQ composite dropped -3.5%. The small cap Russell 2000 index plunged -5.3%. While the volatility index (VIX) surged +44% to new four-month highs.

The economic data this past week was definitely mixed. Initial jobless claims came in at under 400,000 for the first time in a long time but the news was ignored. The New York ISM continues to climb to new relative highs but it too was ignored. Pending home sales came in better than expected. The final reading for the July consumer confidence was virtually unchanged at 63.7 but it's the lowest level since March 2009.

The Chicago ISM (previously the purchasing managers index) dropped from 61.1 in June to 58.5 in July. Readings above 50 indicate growth but it's moving the wrong direction. While the big report this past week was the advance Q2 GDP estimate. Economists were hoping for growth of +1.8%. I mentioned last week that Goldman Sachs had been predicting +2.0%. The government's estimate came in at +1.28%. Making matters worse was a very sharp revision for the Q1 GDP from +1.9% down to +0.4%. Ouch! If we see a similar revision for Q2 down the road it could be in negative territory. This prompted several analysts to start slashing their Q3 and Q4 estimates. For months now we've heard the Federal Reserve and plenty of corporate CEOs talk about how things will be better in the second half of this year. Now suddenly the second half doesn't look so hot. Folks are starting to worry about another recession again. Having the U.S. on the verge of insolvency does not help matters but more on the debt issue in a bit.

Two weeks ago the S&P 500 saw a +3.8% surge from its intraday lows on Monday, July 18th to that Friday's close. We completely reversed that bounce with a -3.9% plunge this week. The sell-off accelerated on Wednesday the 27th. Friday saw the S&P 500 dip toward technical support at its simple 200-dma and bounce but the rebound was fading lower into the closing bell. Technically a bounce from the 200-dma would look like a bullish entry point. It's an easy spot to place a bet because you can limit your losses with a tight stop loss. Unfortunately, this time, if we do not see a debt deal by Monday morning the market could gap open lower under this support. If the 200-dma fails then we're probably looking at drop to the 1250 level. If the 1250 level doesn't hold then the next levels to watch are the 1225-1220 zone and then 1200. On the other hand if we do see a debt deal come Monday morning then the S&P 500 could challenging 1350 before the week is over. I do have to point out that further declines will start to look like the right shoulder to a bearish head-and-shoulders pattern on the S&P 500 chart. This pattern would forecast a drop from 1250 toward 1140ish.

Daily chart of the S&P 500 index:

Weekly chart of the S&P 500 index:

Better than expected earnings were not enough to keep the NASDAQ at its highs. The big cap tech stocks were holding up pretty well until Wednesday. Then the NASDAQ-100 (NDX) index reversed sharply from ten-year highs. Thus far the NDX still looks relatively healthy but a close under the 2320-2300 zone would be worrisome.

Meanwhile the NASDAQ composite has plunged back under its 100-dma and flirted with a breakdown under its 50-dma this Friday. You can see on the weekly chart that it too is facing the prospect of a big head-and-shoulders pattern although it's a lot farther away from a breakdown.

Weekly chart of the NASDAQ Composite index:

Daily chart of the NASDAQ-100 index:

The small cap stocks were underperformers this past week. The Russell 2000 index flirted with a breakdown under technical support at its simple and exponential 200-dma on Friday. The weekly chart for the $RUT does not show the same H&S pattern seen on the S&P 500 but it still looks vulnerable. A close under the June lows would look very bearish.

Daily chart of the Russell 2000

Weekly chart of the Russell 2000

The SOX semiconductor index is still sinking under a bearish trendline of lower highs. The index is also on the verge of breaking down below its long-term trendline of higher lows.

Weekly chart of the SOX semiconductor index:

Dow Theory practitioners like to follow the transports. The Dow Jones Transportation index appears to be breaking down below its trendline of higher lows. This also follows the bearish reversal from all-time highs in early July. On the daily chart (not shown) the $TRAN traded below its simple 200-dma on Friday before bouncing back. There is potential support near 4900 but a close under the June lows would look pretty ominous.

Weekly chart of the Transportation index:

We have a very busy week of economic reports ahead of us. The major events will be the ISM on Monday, the ISM services and ADP employment report on Wednesday and the jobs report on Friday. Of course the BIGGEST event of the week will be the August 2nd debt ceiling extension deadline. Currently economists are expecting +80,000 new jobs in the nonfarm payroll report. That's up from last month's +18K jobs. You may recall that last month analysts were expecting +125K new jobs. If you consider the recent run of negative economic reports there is a rising chance that Friday's jobs number could actually come in negative! Q2 earnings results will continue to flow but we're past the biggest wave of earnings and their importance will subside.

- Monday, August 1 -
ISM index for July

- Tuesday, August 2 -
DEBT CEILING EXTENSION DEADLINE
personal income and spending
auto and truck sales

- Wednesday, August 3 -
ADP employment report for July
ISM Services for July
Factory Orders for June
mass layoffs report

- Thursday, August 4 -
Weekly Initial Jobless Claims

- Friday, August 5 -
Non-farm payrolls (jobs) report for July
consumer credit for June

All right, let's talk about the debt ceiling issue. This was THE headline all of last week and it will remain front and center until the ceiling is extended. The U.S. has been consistently raising its debt ceiling for decades. Unfortunately, our liabilities are so grossly above and beyond our income that it's become a major wedge for politicians. I am going to try and avoid being political here. I don't care if you're republican or a democrat. As of today the U.S. needs to extend its debt ceiling to keep operating. Now some will argue that a default would be good for us because it will force us to get our house in order. I'm not going to go there because the unforeseen consequences of such an event would be monstrous.

Eventually we do need to massively cut spending and we will need to balance the budget. The question is how we do this and when we do this. The obvious argument is that we don't want to cut spending too much with the economy already on fragile footing. Yes there are opponents who will disagree. Right now all eyes are on Washington to get a deal done and it better not be just a short-term extension to kick the can down the road. Even if lawmakers come together in compromise and actually pass a debt extension bill by the deadline the U.S. could still see a credit downgrade.

I mentioned a couple of weeks ago that I do not see the U.S. failing to make its interest payments to bond holders. If the August 2nd deadline is not met the country would still pay its bond holders and just not pay someone else. While we would technically avoid a default it's still a default and we would see a credit downgrade. If politicians do pass a debt extension but it doesn't have enough spending cuts in it then the ratings agencies could still downgrade the U.S. to a double A rating.

There are plenty of analysts who will argue that the market has already factored in a downgrade to a double-A rating. If there is a downgrade there might be a temporary knee-jerk reaction but overall it's already baked into the stock market. Yet a downgrade has not been baked into the economy. If the U.S. loses the triple-A rating it will cause interest rates to rise across the country. Everyone from consumers to corporations to local and state governments would all see their interest rates rise. We could also see a wave of credit downgrades for any institutions that depend on the U.S. government. Rising interest rates could slow spending, slow investment, and slow hiring.

Believe it or not this past week saw U.S. bonds rally with the yield falling to 2.8%. Yes, the very debt that is in jeopardy of getting downgraded is in rally mode because in a sea of bad debts (think Europe) the U.S. with a double-A rating is still a "safe haven" trade. Money managers both here in the U.S. and overseas have to put their money somewhere. Many of these fund managers cannot just sit there in cash. If they are pulling it out of equities the U.S. bond market is still the safest spot for it. Granted that's an opinion being expressed by market pundits on Wall Street but it helps explain the rally in bonds.

Let's pretend that lawmakers in Washington actually come together with a deal before Monday and the market believes it could actually get passed by the deadline. This would be seen as short-term bullish and stocks will likely gap open higher on Monday morning. We could see a rally back toward the summer highs. If there is no deal by Monday morning then stocks will most likely gap open lower and we could see a repeat of the TARP sell-off. You may remember that the first time congress tried to pass the TARP program the vote failed and the Dow Industrials plunged -800 points on the news. I'm not saying we'll see a drop that big but I'm not saying it can't happen either.

There have been a few estimates of what happens if the U.S. actually defaults (a.k.a. no debt deal by Aug. 2nd). Some have predicted a -30% drop in stocks. There are also predictions of what happens if there is a deal but we still get a debt downgrade. These predictions are for a -5% to -10% correction in stocks.

What really concerns me, assuming we do get a debt ceiling extension passed, is that the market still faces a storm of uncertainty. The U.S. economy seems to be slowing drastically and the situation in Europe is not improving in spite of all the bailout attempts. It seems like every week another EU country gets downgraded. Italy recently moved heaven and earth to pass their austerity package to assuage investor fears but when Italy held a bond auction this past week they paid the highest interest in almost three years. Spain is also a major problem for the EU. They just sold debt with yields at three-year highs. Both of these countries have to sell more debt this week. If Spain finally falters and forces a bailout from the EU it's going to rock the boat for the entire region and you can bet U.S. investors will see the volatility in our stock market.

On a positive note Spain doesn't seem to be in immediate peril but we could be facing a torture of a thousand cuts all over again. How many months have we been talking about Greece's debt struggles and they're still in jeopardy. The problem is that Spain is significantly larger than Greece. You can bet that EU's sovereign debt problems are going to remain a thorn for the market for a long time to come.

One investment that has been rising on all of this uncertainty in the U.S. and abroad is gold. The precious metal surged to a new all-time high above $1,630 an ounce this past week. I hate to say it but we sold our gold GLD calls a little too early. There are analysts now predicting that gold will rally into the $1,750-2,000 zone in 2012. At the current rate it could be at $1,750 before the end of this year. Although I will warn you that some have predicted a -$100 drop in gold if a debt ceiling deal gets done on time but the pull back will only be temporary.

The last couple of weeks I have ended my wrap with a market neutral outlook. As of Saturday night there is no deal in Washington, which would force a bearish outlook for the coming week. Even if a deal does get done the positive effects are likely to be short-lived. Our time frame for our LEAPS trades are normally six to twelve months. I am concerned that the stock market could be significantly lower four to six weeks from now and that means we need to be patient when it comes to launching new positions.

- James