Fears that the Federal Reserve might taper its $85 billion a month QE program sooner than expected continued to haunt the U.S. market all week long. A string of better than expected economic reports drummed up anxiety that Friday's non-farm payrolls number might be too high and push the Fed to taper in December. When the jobs number came out at +204,000 those fears vanished and stocks rebounded on Friday, nearly erasing the prior five-day decline. Speaking of declines, the S&P 500 did fall five days in a row, which hasn't happened since the year 1996. Yet in spite of the drop the S&P only lost -1.2% for that entire five days compared to the +9% rally in the prior eight weeks.

Economic Data

U.S. economic data continues to be uneven but most of last week's reports came in better than expected. Investors are still worried about this year's holiday shopping season and news from the National Retail Federation that the Black Friday weekend retail sales were down -3.0% from last year didn't help. The homebuilder stocks didn't react much to news that new home sales in October soared +25.4%. Home sales could face pressure from rising rates. Last week saw mortgage rates hit a 10-week high. Mortgage applications to purchase a home were down -4.1% while refinance applications plunged -17.5%.

The national ISM index came in better than expected with a reading of 57.3. This is the highest level since April 2011 and marked six months of growth. Economists were expecting the ISM services number to hit 55.0 but November's reading slipped to 53.9. One positive surprise last week was the University of Michigan consumer sentiment survey. December's survey reading soared from 75.1 to 82.5. That's quickly approaching July's high of 85.1. Analysts were actually expecting a small decline to 74.2.

Another big surprise last week was the U.S. Q3 GDP estimate. The latest estimate exploded from +2.85% growth to +3.6% growth. Economists had been expecting a rise to +3.1%. This new growth estimate is the strong reading since Q2 2010. Unfortunately investors should be worried about why the GDP rose so much. The reason was rising inventories. Bloomberg news probably said it best, (U.S. GDP) "...expanded more in the third quarter than initially estimated as unsold merchandise piled up at the fastest rate since 1998, setting the stage for a possible slowdown in the final three months of the year." Looking beneath the headline number of +3.6% growth we see that 1.68% of that move was due to rising inventories. At the same time inventories were rising consumer spending in the third quarter only rose +1.4%, which according to Bloomberg, is "the smallest gain since the fourth quarter of 2009." This combination of unsold merchandise and slowing consumer spending does not bode well for Q4's GDP growth.

Of course the biggest economic report for the week was the jobs report. The ADP Employment change report came out on Wednesday. Analysts were only expecting the ADP report to show +170,000 in job growth but November's number hit +215,000. This upside surprise only inflamed worries that the nonfarm payroll number would be too hot and spark the Fed to taper in December. Economists were estimating that November would see +185,000 new jobs but there were whisper numbers of +250K to +300K. When November's report only came in at +204,000 there was a sigh of relief and the news sparked some short covering in stocks. Another surprise was the unemployment rate that ticked down from 7.3% to 7.0% but that was blamed on government employees going back to work after the partial government shutdown in October. One positive data point below the headlines was a small increase in the average workweek. If we see a continued rise in the average workweek it could precede a stronger increase in actual hiring.

Overseas Data

There was plenty of economic data overseas. The European Central Bank left interest rates unchanged at 0.25%. Eurozone GDP inched higher with +0.1% growth over last quarter. Wholesale inflation (PPI) slipped -0.5% month to month, which was lower than expected. Retail sales in the Eurozone fell -0.2%. Germany said their factory orders declined -2.2% last month while German services PMI rose from 54.5 to 55.7, which was above estimates. Numbers above 50.0 indicate growth. Bundesbank increased their 2013 growth forecast for Germany from +0.3% to +0.5% and adjusted their 2014 GDP forecast from +1.5% to +1.7%.

The United Kingdom raised their 2013 GDP growth forecast from +0.6% to +1.4%. Last week saw the Bank of England left their interest rate unchanged at 0.5%. The U.K.'s construction PMI rose from 59.4 to 62.6. In the not so good news category France said their unemployment rate ticked higher from 10.8% to 10.9%. In Asia we saw China's HSBC PMI data hit 50.8. Numbers above 50.0 suggest growth. The Chinese HSBC services PMI ticked down from 52.6 to 52.5.

In other news the hedge fund industry is having a rough year. Hedge funds are underperforming the S&P 500 for the fifth year in a row. This year has been exceptionally bad with the average hedge fund trailing behind the broader market with its worst performance since 2005. The S&P 500 index is up 26% year to date while the hedge fund industry (through November) was only up +7.1%.

Major Indices:

The S&P 500 posted a five-day decline, a feat we haven't seen in 17 years. Yet Friday's bounce (+1.12%) was strong enough to almost completely erase the five-day loss. The S&P 500 closed less than one point from last Friday's close. Just a little bit higher and it would have been nine up weeks in a row.

The shallow pullback is not a surprise since fund managers are likely chasing performance between now and year end. Thus they're buying every dip. The 1780 level held up as support. If the S&P 500 can breakout past its recent highs near 1810 then we could witness a rally into the 1840 area before the year is out. Keep in mind that we only have 15 trading days left for 2013.

chart of the S&P 500 index:

The NASDAQ composite displayed relative strength last week with a +0.6% gain. The index found short-term support near the 4,000 level and its rising 10-dma. Friday left the index at a new 13-year closing high.

The next level of resistance is probably the 4100 level and then 4150 beyond that. Potential support levels are 4,000, 3950, and 3900 (near its 50-dma). Year to date the NASDAQ is up +34.5%.

chart of the NASDAQ Composite index:



The small cap Russell 2000 index had a rougher week. At Wednesday's intraday low the $RUT was down -2.7% from last Friday's close. It pared those losses with a two-day bounce to just -1.0% for the week.

If this bounce continues the $RUT could find resistance near 1150 and its new trend line of higher highs (see chart). If the $RUT were to reverse I'd watch for support near 1100 and its 50-dma.

chart of the Russell 2000 index



Economic Data & Event Calendar

It is a relatively quiet week for economic data. We will hear from multiple Federal Reserve members this week. The market will be listening for any hints on when the Fed might taper its QE program. We're only two weeks away from the next FOMC meeting. It is possible that Wall Street's attention might turn toward Washington again. Congress is supposed to agree to a new budget deal by Friday, December 13th.

Economic and Event Calendar

- Monday, December 09 -
multiple Federal Reserve governors speak

- Tuesday, December 10 -
wholesale inventory data
Eurozone industrial production

- Wednesday, December 11 -
weekly MBA mortgage application data

- Thursday, December 12 -
Weekly Initial Jobless Claims
U.S. retail sales data for November
business inventory data

- Friday, December 13 -
Producer Price Index (PPI)
U.S. budget deadline for congressional committee

Additional Events to be aware of:

Dec. 17th - FOMC meeting & economic forecasts update
Dec. 17th - post-FOMC meeting Ben Bernanke press conference
Dec. 24th - U.S. stock market closes early
Dec. 25th - U.S. stock market closed for Christmas




Looking Ahead:

As we look ahead there are a couple of events that could influence stocks. This Tuesday, December 10th, multiple government regulating bodies will vote on the Volcker Rule. This is part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was signed into law back in 2010. It's named after former Federal Reserve Chairman Paul Volcker. The rule is supposed to limit the sort of investments that banks can make and prohibit any proprietary trading by the banks. It's taken this long for regulators and lawmakers to flesh out the rule and what form it would take. Tuesday is the final vote on the current version of the regulation. This news could influence financial stocks so don't be surprised if the sector sees a bit of volatility midweek.

The biggest event for the week is probably the Friday, December 13th deadline for the U.S. budget. It's being called a "soft" deadline because back in October, during the shutdown, lawmakers agreed to a deal to fund the government through January 15th, 2014. The bipartisan committee working on this issue says there is no deal yet. It will likely come down to the wire again. I suspect that December 13th will come and go and we'll be dealing with the budget issue when Congress returns back in January. Negative rhetoric out of Washington could dampen investor enthusiasm for stocks.

All the talk about whether or not we are in a stock market bubble seems to have subsided a bit. There are still a number of concerns the bears continue to growl about. It is true that market breadth is narrowing. The major U.S. indices are at new all-time or multi-year highs. Yet the number of stocks trading above their simple 200-dma is declining. That means the rally is getting more narrow with fewer stocks participating.

Another warning signal is Citigroup's panic/euphoria model. It's a contrarian warning signal. When stocks sell off and the model falls into "panic" levels then it's supposed to be a buy signal suggesting stocks are near a bottom. When the model rises into euphoria levels then it's suggesting the market is near a top. Currently Citigroup's model is nearing the euphoria levels at its highest reading since 2008.

Additional warning signals are the record high margin debt we discussed last week. More and more investors are buying stocks on borrowed money. When the market eventually turns this high level of debt could exacerbate the decline. There are concerns that stocks are expensive relative to their 10-year average earnings growth. Another concern are record high corporate profit margins that are due to contract. There is some worry that U.S. stocks look expensive compared to the rest of the world. There is another model suggesting that U.S. stocks are expensive when compared to U.S. GDP. Of course the stock market does not have to be in a "bubble" to actually peak. The market cycles up and down on a regular basis and the current bull market is pretty long in the tooth.

One concern that is getting a lot of play is investor sentiment. The Investors Intelligence bull/bear survey has seen the number of bullish investors rise to 57.1% and the number of bearish investors has fallen to 14.3%. These are extreme numbers. Today's low level of bearish investors is below the market peaks from the year 2000 and the year 2007. As a matter of fact we are seeing the lowest level of bearish investors since 1987. There have been a number of high-profile bears that have thrown in the towel and some have turned into outright bulls. If you put it altogether, the lack of bearish sentiment is a huge contrarian warning signal that sentiment is too positive.

Now all of these warning signals does not mean the market is going to immediately crash next week. It does suggest that sooner, not later, we could see the market top. It's been a long time since the U.S. market has produced a normal -5% to -10% correction. We could easily see the U.S. market continue to climb into January. It's January that worries me. The budget deadline on January 15th and the U.S. debt ceiling deadline in February could actually throw the U.S. government back into another shutdown if democrats and republicans refuse to work together.

In summary the path of least resistance is still up but we do see storm clouds on the horizon. The trend remains our friend (until it doesn't) but investors may want to scale back their position size to limit risk and keep some capital in reserve so we can take advantage of any market pullback that is likely to appear in the first quarter of 2014.

James