Expectations for window dressing to power the market to another high were disappointed. The mid September QE announcement by the Fed pushed the S&P 500 to new multi-year highs. The index closed at 1465, which marked a +7.5% gain for the third quarter and a +16.5% gain for the year. In the last two weeks concerns over Europe and a parade of disappointing economic data have fueled profit taking in the U.S. markets. Headlines out of Spain regarding new austerity measures and speculation that China would soon add additional stimulus helped spark a bounce on Thursday. This ended a five-day losing streak for the U.S. market but there was no follow through on Friday.

We had a very week for economic data. The latest consumer confidence reading was an unexpected surprise with a rise to 70.3 compared to estimate of 63.0. Another positive surprise was the Case-Shiller 20-city home price index, which saw its July reading rise +1.2%, up from a +0.5% gain the month before. The initial weekly jobless claims dipped to 359,000 versus estimates of 379,000. Unfortunately, that was about it for improving economic data.

Disappointing investors was the latest estimate on Q2 GDP growth, which fell to +1.25%, down from the prior estimate of +1.73%. The Chicago ISM (previously PMI) dropped from 53.0 to 49.7, which is the lowest reading since September 2009. Readings under 50.0 indicate contraction and foreshadow a potential recession. The Kansas Fed manufacturing survey dropped from 8.0 in August to 2.0 in September, a new low for the year. The Durable Goods report for August plunged from a +3.3% gain in July to a -13.2% drop.

Spain and Greece remain major worries for Europe and the markets. The small country of Greece announced further budget cuts spread out over the next two years. This was most likely an effort to satisfy EU regulators so Greece would qualify for the next round of bailout payments. Greece has yet to meet its prior budget cuts so why the EU would believe them this time is a good question. Meanwhile Spain helped fuel a market bounce on Thursday when they announced strict austerity measures in their 2013 budget. It was suggested that Spain's proposal were stricter than what the EU might have proposed. The deal also focused on cutting spending instead of raising taxes. That also may have been a nod to the Spanish public since Spain will hold its regional elections on October 21st. There is a growing expectation that Spain will ask for a bailout from the EU/IMF/ECB this year. Two years ago that would have been unthinkable. Spain is the fourth largest economy in the EU with a $1.8 trillion GDP.

Major Indices:

Last week I cautioned readers that technically the S&P 500 was due for a pullback but I was expecting more window dressing. Well, the window dressing by fund managers for their third quarter statements failed to do much. The S&P 500 dipped to 1430 at its lows on Wednesday before bouncing. The index remains inside its five-month bullish channel after a -2.3% pullback from its high. The question now is will it remain in the channel or will it breakdown?

On a short-term basis the 1430 and 1420 levels should offer some support. If the S&P 500 were to breakdown from this channel (see chart below) I would expect a decline toward the 1400 level. That's almost a 38.2% Fibonacci retracement of the June-September rally.

chart of the S&P 500 index:

It was a rough week for the tech-heavy NASDAQ with a -2.0% decline. The index failed at resistance near 3200 the prior Friday and then fell the first three days this past week, slicing through the 3100 level on Wednesday. The correction may not be over yet.

I would look for support near 3040 and its simple 50-dma. If trader sentiment really sours we could see the NASDAQ drop toward the 3000 level over the next couple of weeks. That would be a -6% pullback from its September highs.

It would appear that the 3140-3150 area is now new short-term resistance.

chart of the NASDAQ Composite index:

The Russell 2000 index tried to hold support near the 840 level and failed. The short-term oversold bounce on Thursday ended a three-day losing streak but there was no follow through higher on Friday. Odds are growing that we will see the $RUT dip toward support near 820 or its simple 50-dma. Look for overhead resistance at 850 and 870.

Daily chart of the Russell 2000 index

We have a very busy week of economic events and reports. Stocks could move on Monday based on PMI data from around the world. China releases its latest PMI reading on September 30th. The Eurozone, Spain and India all release their PMI readings on Monday. Speaking of China, the Chinese markets will be closed all week for the semiannual "Golden Week" holiday.

There will be plenty of central bank headlines. The Bank of England, Bank of Japan, and the ECB all report on their latest interest rate decisions this week. ECB president Draghi will hold a press conference following the ECB rate decision on Thursday. Fed President Bernanke will speak on October 1st. Plus, the FOMC minutes from the last meeting will be released on Wednesday.

The major reports to watch in the U.S. are the ISM report on Monday, the ADP report on Wednesday and the Nonfarm payrolls (jobs) report on Friday. Right now economists are expecting the jobs report to show a gain of +120,000 new jobs for September compared to +96K new jobs in August. Considering all the negative economic data in recent weeks there is a good chance the September jobs report will disappoint.

The U.S. presidential election is less than 40 days away and the first debate is this coming Wednesday evening.

Economic and Event Calendar

- Monday, October 1 -
ISM Index (for September)
Construction spending
Eurozone PMI

- Tuesday, October 2 -
auto and truck sales for September
Eurozone inflation data

- Wednesday, October 3 -
ADP employment change report for September
ISM Services index
FOMC minutes
U.S. Presidential Debate (in Denver)

- Thursday, October 4 -
Weekly Initial Jobless Claims
European Central Bank interest rate decision

- Friday, October 5 -
Nonfarm payrolls (jobs) report for September
Unemployment rate (Sept)

The Week Ahead:

The week ahead could be quiet. I would expect stocks to churn sideways up until the jobs report on Friday. Of course we could see headlines out of Europe create waves. There are always multiple cross currents at play in the market. Right now the U.S. dollar is bouncing and that could create pressure to push commodities lower. The third quarter is over but many mutual funds have their fiscal year end on October 31st. That gives them one month to make changes and shuffle their portfolio around. Will they be buying winners? Selling losers? Trying to lock in gains?

Another obstacle approaching the market is the Q3 earnings season, which will begin in a couple of weeks. Right now expectations are very low. Analysts are expecting earnings to fall by -2% or more compared to a year ago. Has a negative earnings quarter already priced in? It's possible but then the market is only a couple of percentage points off multi-year highs. I suspect the odds for additional profit taking loom large.

Adding to this worry that stocks could see profit taking on a disappointing earnings season is the upcoming fiscal cliff and the barrage of new taxes all set to begin in 2013. One of those taxes is an increase in capital gains. It is possible that the stock market could see additional selling as investors choose to take money off the table and lock in a lower tax rate now instead of selling in 2013. This pressure may be postponed until after the election as investors wait to see who wins the White House.

Short-term the market trend is down but that's inside a larger up trend. I suspect the correction will continue with either a sideways move or another drop to the next level of support. Patient investors can wait for the market to dip to and test support before launching new positions.

James