The stock market's midweek rally is losing steam. Friday's widespread decline chopped off most of the week's gains, while small caps have been underperforming. Investors seemed to be ignoring the most recent parade of disappointing economic numbers in favor of earnings news. Thus far about 120 of the S&P 500's components have reported earnings and 67% of them have beaten Wall Street's lowered estimates. Yet renewed worries about Spain sparked some profit taking in stocks and the yield on Spanish 10-year bonds closed the week at 7.2%. The euro currency closed at a new two-year low. For the week the S&P 500 is up +0.4%, the NASDAQ composite is up +0.5%, the Dow Industrials +0.3% and the small cap Russell 2000 index lost -1.1%.

Economic data continues to disappoint but the big event was Fed Chairman Bernanke's semi-annual testimony before Congress. He spoke before Senate on Tuesday and the House on Wednesday. While Bernanke didn't say anything new he did suggest that deflation remains a possibility. Many are still expecting the Fed to offer some form of new stimulus. The only problem is that if the Federal Reserve doesn't act this July it's going to be a long six weeks until the next meeting in September.

The Fed's Beige book report suggested the economy grew at a moderate pace but employment growth remains tepid. The CPI data was flat. Industrial production came higher than expected at +0.4%. The New York Empire State manufacturing survey was better than estimated. Yet everything else was a disappointment. June retail sales data, the Philly Fed, the existing home sales, weekly initial jobless claims and leading indicators all fell below estimates.

We have been fortunate that traders were focused on Q2 earnings news. Analysts estimates have been lowered so much that many companies have managed to beat the estimate. Unfortunately, they are beating the profit estimate but missing the revenue estimate. That means corporations are meeting their numbers by cost cutting, not new business. That's troubling as we look ahead with the economy slowing down. The rising U.S. dollar has been a negative impact on many of the multi-national companies as they convert profits back into dollars. The rising dollar also makes their products more expensive overseas and less competitive. Spain seems to be closer to the financial abyss than we thought. Rumors started late in the week that Spain's regional government of Valencia would soon ask the national government for a bailout. This is the second regional government that's expressed their dire need for help. Meanwhile at the same time Spain lowered their growth forecasts for 2012 and 2013 and said their country would remain in recession throughout 2013.

Compounding matters with Spain was news the European Central Bank (ECB) would no longer accept Spanish bonds as collateral for loans. This is a big deal. If banks can't use Spanish bonds as collateral then any demand for them, which was already soft, will dry up completely. The yield on Spain's 10-year bond soared past the key 7% mark and ended the week with a yield at 7.2%. Many consider the 7% level to be unsustainable and a signal that Spain will soon request a bailout before defaulting on its debts. The trouble is that Spain is considered too big to bailout. This news helped spark a -5.8% plunge in the Spanish stock market on Friday.

Adding to the distress in Europe was a news report that the IMF is about ready to give up on the Eurozone. It seems there is too much risk for problems in one country to spill over into another but not enough of a fiscal union to solve these problems. Pouring salt on this wound was another story out this weekend that the IMF has officially given up on Greece and would no longer provide any additional aid monies to the struggling country. This probably guarantees that Greece will be in default again in September unless someone else steps in to backstop Greece.

Meanwhile back in the U.S. we are suffering a serious drought. It's the worst drought in over 20 years with 42 states affected. Forecasters are expecting this drought to last into October. This is killing the corn and soybean crops. The price of corn is naturally skyrocketing. Unfortunately about 70% of the products we purchase in the supermarket are made with some form of corn. Animals eat corn as feed. Manufacturers use corn and corn syrup for thousands of items. We can expect prices in our local supermarket to rise as agricultural commodities rise in price.

Major Indices:

On Friday the 13th the S&P 500 shot higher on what looked like short covering. Stocks paused to catch their breath on Monday and then the rally continued for another three days. The S&P 500 managed to hit resistance at the 1380 level on Thursday. Friday's sharp drop has pushed it all the way back to support/resistance at 1360.

If this pullback continues then the next support level is probably 1340. Beyond that potential support at 1320 and then the simple 200-dma near 1315. I am worried that if the S&P 500 closes under the mid July low of 1325 then the July peak will look like a lower high. That would suggest we're due for a lower low, which means a test of or a drop past the June lows near 1280.

Daily chart of the S&P 500 index:

We should be worried about the NASDAQ. The index did manage to breakout past resistance near 2950 and the 100-dma but it didn't last. Now it seems the NASDAQ has created a lower high. There is potential support near 2900 and 2850. Just like the S&P 500, I am worried that a close under the NASDAQ's July low will signal a drop back toward the June lows or worse.

Daily chart of the NASDAQ Composite index:

The small cap Russell 2000 index underperformed the major indices on a weekly basis with a -1.1% decline. It too has formed a lower high. Odds are we will see the $RUT retest key support at the 780 level again. A close under 780 would be very bearish but there is a lot of congestion with possible technical support at the 50-dma and 200-dma in the 770-780 area. So we might need to wait for a close under 770 as a clearly bearish signal.

Daily chart of the Russell 2000 index

Looking ahead on the economic and event calendar it's a quiet week for economic data. The focus will remain on Q2 earnings results and then the Q2 GDP estimate out on Friday. If the GDP estimate misses estimates it could spark another market sell-off. If you consider the nearly constant parade of less than expected economic reports over the last several weeks the odds of the GDP number coming in low are probably pretty good.

Meanwhile we have a very, very busy week for earnings results. Yet there are two companies that will hog the spotlight. Apple Inc. (AAPL) and Facebook (FB). AAPL reports earnings on July 24th. Wall Street expects a profit of $10.38 a share. Facebook reports on July 26th and estimates are for 11 cents a share. If AAPL misses or issues soft (weak) guidance it could be the catalyst that sends the market a lot lower!

Economic and Event Calendar

- Monday, July 23 -
(nothing significant) but Q2 earnings season continues

- Tuesday, July 24 -
(nothing significant)

- Wednesday, July 25 -
new home sales for June

- Thursday, July 26 -
Weekly Initial Jobless Claims
Durable Goods Orders
Pending home sales

- Friday, July 27 -
Q2 GDP estimate
University of Michigan Consumer Sentiment (final estimate for July)

The Week Ahead:

Looking ahead we will have to wade through dozens and dozens of earnings news and a renewed focus on Greece and Spain. If the ECB is giving up on Spain (no more loans as collateral) and the IMF is giving up on Greece (no more aid) then the situation just got a lot worse for the Eurozone.

No wonder investor sentiment is so bearish. According to the AAII sentiment survey the number of investors who are bullish has plunged to just 22.2%. Last week it was 30%. The long-term average is 39% bullish. Bullish sentiment has been under the long-term average for 16 weeks in a row! That hasn't happened in almost 20 years. Now the contrarian will point to this and say, "Ah hah! Sentiment is so low that now is the time to buy stocks." In the past when we see extreme lows in bullish sentiment it typically signals a market bottom is near. Yet stocks just hit a new relative high on Thursday, not a new low.

The volatility index (VIX), which is the traditional fear gauge, is at 16 with the 15-14 area being multi-year lows. If investors were "fearful" the VIX would be spiking past 25 toward the 30 area. So the VIX is clearly not showing any fear - but investors obviously don't like stocks if you follow the sentiment data.

Now add the calendar to the mix. Historically the three worst months of the year are September, February, and August, in that order. So we are facing two of the worst three months of the year. If that wasn't bad enough we're also facing a presidential election in the U.S. Plus, we will soon be facing the U.S. debt ceiling issue again. You may remember last year in August when politicians were arguing about the U.S. debt ceiling and let it expire. The market saw a huge multi-week drop. Now with the elections this November the debt ceiling issue will become even more polarizing.

Overall the stock market is facing a barrage of bad news and major obstacles in our way. That doesn't mean that individual stocks can't rally. There are always exceptions. Yet the wider market, which influences 75% of a stock's move, is trying to navigate a minefield of issues that could send the market lower. Don't even get me started on the fiscal cliff scheduled for January 2013 (I've mentioned it in previous wraps).

If we see a bullish opportunity, I would be very cautious when it comes to initiating positions and start with a small position size to limit your exposure. There is the distinct possibility that stocks are a lot lower in September. I'd rather preserve cash to initiate positions this fall and ride any Q4 rebound than nurse a losing trade between now and then.

- James