Stocks failed to crumble over fears of a significant downgrade for Europe. Overall it was another relatively quiet week for stocks. The U.S. market continued to drift higher and even with Friday's widespread decline the S&P posted another weekly gain. Thus far for 2012 the S&P 500 is up +2.5%. The major indices like the S&P 500, Russell 2000, Dow Industrials and the Transportation average all managed to hit new five-month highs late in the week. A good question to ask is where are the traders? Is everyone still on vacation? Volume continues to be very light. I suspect that market participants might be waiting for earnings season to kick into high gear before volume picks up.

The big event for the week just happened after the closing bell on Friday with Standard & Poor's downgrading several European nations. We'll cover that in a minute. Let's look at some of the major headlines from the week. Europe remained in the spotlight. Last Monday there was another meeting between France and Germany but it failed to inspire any major market moves. On Tuesday the Fitch credit rating agency expressed their opinion that France and Germany would probably keep their AAA credit ratings throughout 2012.

Thursday was a busy day with several headlines and economic data. It looks like European banks are using the cheap three-year 1% money they got from the ECB to buy sovereign debt. This was expected but it's still encouraging to see Italian and Spanish bond yields falling. Both countries held successful bond auction this past week. One down and several more to go as Italy needs to sell a significant amount of new debt in the first quarter. Speaking of the European Central Bank (ECB), it left interest rates unchanged at 1.0% but comments from its new chief Draghi reminded investors that the region faces economic risk. Across the channel the Bank of England left rates unchanged at 0.5%.

Economic data last week was mixed. The Federal Reserve's Beige Book was a non-event. Its anecdotal evidence continues to suggest moderate improvement. The December retail sales data was a disappointment with sales up +0.1% and core sales, without autos, dropped -0.2%. The weekly initial jobless claims rose unexpectedly from 375,000 to 399,000. On a positive note the University of Michigan Consumer Sentiment Survey surged to an eight-month high with an improvement from 69.9 in December to a 74.0 for January's preliminary reading.

As I mentioned earlier the biggest event for the week just occurred after the closing bell on Friday night with S&P downgrading several European countries. You may recall that S&P warned us back on December 5th when they put all 17 Eurozone nations on creditwatch negative and warned there could be downgrades. I have been cautioning readers that this was looming over the markets and would happen in the first quarter. The good news is that stocks really didn't react that much - at least not yet.

Rumors were circling Friday morning of a major downgrade and the U.S. market plunged to a -1% decline but slowly fought back to trim its losses by the closing bell on Friday. That's pretty encouraging considering that we're looking at a three-day weekend. Investors could have easily chosen to hit the "sell" button and wait for the dust to clear on Tuesday or Wednesday next week. The euro currency did drop to new 17-month lows on Friday but even the euro was bouncing off its worst levels of the day.

Overall there were nine EU countries that were downgraded by S&P. Italy, Portugal, Spain, and Cyprus all saw their credit ratings cut by two notches. France, Austria, Malta, Slovakia and Slovenia were downgraded by one notch. S&P reaffirmed their ratings on Germany, Ireland, Finland, Belgium, Estonia, Luxembourg and the Netherlands. While S&P removed all countries from their creditwatch negative list they kept their long-term outlook negative and suggested there could be more downgrades to come over the next couple of years.

The key point in that downgrade was France (sorry, Fitch). The markets have fretted over France losing its AAA rating for weeks. France and Germany are the two major tent poles holding up the EU. Now that France has been downgraded it affects the EFSF rescue fund, which will lose its own AAA rating. This means the EFSF will have to pay higher prices when it sells debt to raise cash for its bailout fund. Furthermore it puts a lot of pressure on French president Sarkozy. His party is facing re-elections in April and the opposition will surely use this downgrade as a hammer. Any big changes in French government could make it less cooperative with Germany as the two negotiate how to manage the EU crisis.

It's entirely possible that this downgrade news has been priced into the market, which is probably why the U.S. indices held up reasonably well on Friday. Yet I would not be surprised to see a knee-jerk reaction spike lower on Tuesday morning. Fortunately with our markets closed on Monday it might soften the blow giving investors more time to adjust their expectations and we'll get to see how Asia and European markets react to the news first. We do need to bear in mind that this massive downgrade will cause a reshuffling of risk. There are some hedge funds and mutual funds that might be forced to sell based on the lowered credit rating of the country they own debt on. Plus the downgrade will force a review and likely downgrade for all the related government entities, banks, insurance company, and more that all depend on these countries for financing and income (i.e. the EFSF).

Major Indices:

The S&P 500 index rallied to new five-month highs but it struggled with new resistance in the 1296-1297 area all week long. Traders bought the dip near its rising 10-dma and prior resistance near the 1280 level on Friday morning. If investors buy this intraday bounce then we could see the S&P 500 challenge round-number resistance at 1300. A breakout past 1300 sets up for a run toward heavy resistance at 1350 (eventually). The inverse head-and-shoulders pattern is suggesting a bullish target of 1362. If stocks do sell off on this S&P downgrade news then look for support at 1280 and at 1260.

Daily chart of the S&P 500 index:

The NASDAQ composite is now up +4.0% for 2012 but has yet to breakout past its October 2011 highs. The 2750 level is overhead resistance. If stocks pull back then we can watch for possible support at the 10-dma near 2677 or the simple 200-dma near 2660. A real sell-off could push the NASDAQ toward the trendline of higher lows (see chart).

Daily chart of the NASDAQ Composite index:

The small cap Russell 2000 index is normally more volatile than its larger-cap peers. Friday's pull back wasn't that bad. The -0.8% drop on Friday pared the $RUT's 2012 gains to +3.1%. Broken resistance near 760 and the simple 200-dma held up as short-term support. If this level breaks then look for support near 740 instead. Should the market rally then the $RUT's next obstacle is potential resistance in the 770-775 zone, essentially the June 2011 lows.

Daily chart of the Russell 2000 index

The U.S. markets are closed on Monday for the Martin Luther King holiday. The major events to watch are the NY Empire index, PPI, CPI, and Philly Fed survey. Yet the biggest event may end up being bond auctions in both Spain and France on Thursday. Given the new downgrades these auctions should see higher yields. If they're too high it could accelerate fears for Europe.

- Monday, January 16 -
U.S. markets are closed for holiday

- Tuesday, January 17 -
New York Empire State manufacturing index

- Wednesday, January 18 -
national Producer Price Index (PPI)
Industrial Production and Capacity Utilization

- Thursday, January 19 -
Weekly Initial Jobless Claims
national Consumer Price Index (CPI)
Housing Starts & Building Permits
Philadelphia Fed survey
Spain and France debt auctions

- Friday, January 20 -
Existing home sales data

The Week Ahead:

The beginning of the week is going to be dominated by reaction to the S&P downgrade that just occurred. Fortunately it seems that investors were in a sell the rumor, buy the news mood. Stocks were already bouncing after hours on Friday. This might be a relief rally that France was only downgraded by one notch and not two. If you can look past the EU downgrade news then the major headlines for the week will probably be corporate earnings.

Dow-component Alcoa (AA) and J.P.Morgan Chase (JPM) both reported this past week. AA's strong revenues were overshadowed by its earnings miss. JPM also reported a disappointing quarter. Many believe JPM to be the best-in-breed when it comes to banks so if JPM struggled then the rest of the financial sector may have had a rough quarter. JPM's CEO Jamie Dimon did offer some positive comments on improving loan demand and strong credit quality. He also expressed some concerns over Europe (there's a shock!). We are going to get a lot more commentary this week with the Q4 earnings season kicking into high gear. There will be dozens of high-profile companies announcing across the financial and technology sectors.

Outside of stocks we want to keep an eye on Iran and Greece. Iran has been a major story the last couple of weeks with the country's threats to shut down the Strait of Hormuz, which would cripple oil transport and delivery from the major middle east producers. There was a story on Friday that Iranian gunboats were harassing U.S. ships in the area. Plus there were headlines last week with a fourth high-profile assassination in Iran, this time a nuclear scientist. The topic this week will be the EU's discussion over an Iran oil embargo with a meeting scheduled for January 23rd. Odds are the EU will postpone any oil embargo for six months while they try to make other arrangements on where to buy oil.

The bigger challenge for the markets is Greece. The country has been negotiating with creditors over the details of its 50% haircut for its outstanding sovereign debt. Germany wants a 4% yield on any remaining Greek debt it owns. Banks want 8%. There is a group of hedge funds that are choosing to not play this game anymore and they want to collect on their CDS spreads and receive full value for their assets. This past week the negotiations failed. If Greece cannot lock down the details for this 50% haircut deal then the country will not qualify for its next bailout loan. Greece has a 14.4 billion euro bond it has to repay or rollover on March 20th and they don't have the money. They will be in default if they can't solve this problem in time to get everything approved and qualify for the next handout from the EU/ECB/IMF. There seems to be growing speculation that Greece may not remain in the EU at their current rate of progress.

It will be interesting to see how the markets digest all of these competing headlines. Looking at the calendar and the first full week of Q4 earnings I would bet this is the week we could see stocks reverse lower. Don't get me wrong. I'd rather see the S&P 500 breakout past 1300 and the current trend is up and the market's reaction to the downgrade rumors was pretty mild on Friday. I am hopeful that the bullish trend continues. However, the combination of the S&P downgrade and what could be a week full of disappointing earnings guidance could be too much for investors and stocks might break their bullish trend. Until it happens though the path of least resistance is up. Just remember that the U.S. market might see a knee-jerk reaction lower on Tuesday morning. Plus, this coming Friday marks January options expiration.

- James