The U.S. stock market bounced hard with a five-day rally and a +5% gain for most of the major indices. The gains were fueled by a parade of bullish rumors and events concerning Europe all staged to scare shorts into covering positions. Meanwhile safe haven trades like bonds and gold retreated and the U.S. dollar saw some profit taking as the euro produced an oversold bounce.

Let's hit the rewind button and quickly hit the major events last week. Monday morning was ugly with a spike lower thanks to negative comments from some German officials suggesting the best move might be a Greece bankruptcy or expulsion from the EU zone. Chancellor Merkel scrambled to refute this idea and offered renewed support for Greece. Unfortunately for Europe, the European stock markets were down hard on Monday, especially France, thanks to worries that the major French banks might get downgraded. Yet stocks in the U.S. staged a very sharp rebound off their Monday lows thanks to rumors that China was in talks to buy Italian bonds. Italy is one of the struggling PIIGS nations in the EU and if China is willing to buy Italian bonds then maybe their support will help end worries Italy might default.

The rumors continued on Tuesday after word spread that the remaining BRIC countries might be poised to buy European debt. On Wednesday the positive "momentum" continued in Europe with an overhyped conference call between top leaders from Germany, France, and Greece. The result of the call was vocal affirmation that Greece will indeed meet its budgetary goals in spite of all the evidence to the contrary.

Thursday saw more "help" for the EU zone when the U.S. Federal Reserve, the European Central Bank, and three more central banks all presented a coordinated effort to provide short-term three-month dollar loans to struggling European banks, which might be facing liquidity issues. The fact that stocks rallied on this news is a bit of a mystery. Central banks do not coordinate in this fashion unless the situation is in serious jeopardy. Yet day after day the markets continue to rebound in the face of lackluster or negative economic data here in the U.S.

Looking at the major U.S. reports there was nothing to get excited about. The August retail sales figures were flat. The PPI for August came in flat with core prices rising +0.1%. The weekly initial jobless claims were worse than expected at 428,000. the New York Empire manufacturing survey was worse than expected with a drop from -7.7 to -8.8. Negative numbers indicate contraction. The Philly Fed survey improved from -30.7 to -17.5 but economists were expecting a bounce to -10.0. The consumer sentiment report on Friday saw a bounce from 55.7 to 57.8, which was a minor improvement. To put that into perspective, Bloomberg.com said that consumer sentiment data averaged 89 during the five years prior to the last recession. I believe readings over 90 are considered "healthy".

Major Indices:

The S&P 500 continues to trade off technical levels. Last week was a rebound from 1140 on Monday to 1220 on Friday. The actual low last Monday was 1136. The big bounce should negate the bearish head-and-shoulders pattern for the S&P 500 it does not negate the bear-flag pattern (see below). The breakout past 1200-1205 is bullish but stocks are now short-term overbought. If the S&P 500 falls back under 1200 then I'd look for support near 1180. If the S&P 500 can breakout past resistance at 1230 then it will probably see a run at the 1250 level.

Bear Flag pattern on the S&P 500 index:

Weekly chart of the S&P 500 index:

The tech-heavy NASDAQ produced some impressive gains last week with a +7.5% rebound off its Monday morning low. The close over resistance at 2600 and its 50-dma is also very bullish but you have to contrast that against its short-term overbought condition. If this rally continues then the NASDAQ composite could face resistance near 2660 and then at 2700 near its 200-dma. On a pullback I would look for support near 2550.

Daily chart of the NASDAQ Composite index:

Weekly chart of the NASDAQ Composite index:

We are seeing a very similar story in the small cap Russell 2000 index. The $RUT did see a +7.3% bounce from its Monday morning low. Plus, it closed above the prior week's high. Yet it remains at the 38.2% Fib retracement level and it remains inside the bear-flag pattern. Sometimes a bearish head-and-shoulders pattern will actually have two right shoulders and a pull back from current levels might be the second shoulder to that bearish pattern.

Daily chart of the Russell 2000 index

Weekly chart of the Russell 2000 index

We have a relatively quiet week for economic data. There will be several reports on the housing market (I'm not listing all of them). The biggest event will be the conclusion to the two-day FOMC meeting on Wednesday. The announcement is usually around 2:15 p.m. ET.

- Tuesday, September 20 -
Housing Starts & Building Permits

- Wednesday, September 21 -
exiting home sales
FOMC announcement @ 2:15 p.m.

- Thursday, September 22 -
Weekly Initial Jobless Claims
Leading Indicators

Another key event this week will be the German vote on changes to the EFSF euro zone rescue fund. The EU is trying to increase the size of this fund and change the rules so it can purchase bonds (similar to the Fed's QE programs). All the EU members need to approve it but Germany is the key vote. If they vote it down it would be very bearish for the stock market.

The market's focus this week will be the FOMC announcement on Wednesday and any new headlines from Europe. Fed chairman Ben Bernanke has already alluded to some sort of stimulus being approved at this meeting. Since the market is already expecting stimulus then he'll need to come out with a bigger than expected deal to actually lift the market. We are facing a greater risk that whatever plans the Fed offers is not enough for investors and stocks see a sell-the news reaction instead.

Assuming we get past the FOMC announcement on Wednesday without any market meltdown then investors will hopefully turn their attention toward corporate earnings. The Q3 earnings season is less than four weeks away. Of course the worry will be how good were earnings during a quarter where so many economic reports came in worse than expected?

Speaking of expectations there was a rash of analysts downgrades. The major firms were lowering their S&P 500 price targets. Goldman Sachs just dropped their 2011 yearend target to 1250 based on the current environment of uncertainty. This isn't too surprising since many firms were lowering their GDP forecasts in the last few weeks. This is going to increase the focus on corporate earnings as investors look for growth and guidance.

The big picture hasn't changed that much. Credit markets are still pricing in a Greek default sooner or later. My thoughts on Greece have not changed. Here's a repost from last week:

The problem is not just Greece. They are a tiny country in the scheme of things. The challenge is what might happen if they are allowed to default. How many tens of billions of dollars in Greek debt is owned by all the European banks? How many banks would fail if Greece defaults? Furthermore, if Greece throws up their hands in defeat and says, "We can't pay back all this money, sorry." What will stop Ireland, Italy, Portugal and Spain from doing the same thing?

...You could definitely argue that a Greek default is already priced into the market but that does not mean that stocks would not see a massive knee-jerk reaction on the news.

You already know that a week ago Germany said they were taking emergency steps to prepare their banks for a worst case scenario on a Greek default. How many other countries are trying to shore up their banking system while central banks, the EU and the IMF try to keep Greece's head above water just a little bit longer before they cut the life line and let them sink? I'm not suggesting that Greece will default this week but sometime in the next six months might be a good bet.

I warned readers a week ago that if the market does rally we could see money managers chasing performance. The end of September ends the third quarter while the end of October is the fiscal yearend for many funds. Most funds have underperformed the market this year. They don't have much time left if they're trying to catch up!

- James