Stocks were in rally mode across the globe last week. The bullish reversal the prior Friday, October 2nd, when markets shrugged off the disappointing September jobs number, carried over into Monday. Bearish traders panicked and stocks soared to their best one-week performance in years. Commodities saw their best week since 2012.

Market pundits called it a "junk" rally. The third quarter's worst performers saw the biggest gains. Stocks and sectors that traders hated last quarter were suddenly screaming higher. All of the major U.S. indices posted big gains. Transportation stocks rallied +4.8%. Semiconductor stocks gained +3.4%. Banks were only up +2%. Housing stocks added +3.0%. Biotechs stuck out like a sore thumb with a -2.5% decline for the week. The group has essentially erased its gains for the year.

Energy stocks were some of the best performers thanks to a surge in crude oil. Russia's new involvement in the Syrian conflict boosted the fear premium in oil. Tensions are rising in the region with Russia's new influx of arms, men, and fighter jets. Crude oil rallied to new two-month highs and flirted with a breakout past resistance at $50.00 a barrel. For the week oil was up +8.5% in spite of news that U.S. inventories rose three million barrels on Wednesday.

Oil's big bounce lifted energy stocks up +9% and oil service stocks surged +12.4% for the week. Meanwhile the rig count continues to sink. Baker Hughes publishes a weekly count of active rigs. The latest poll saw rigs drop another -14 to 795 active rigs. That's a 10-year low.

Goldman Sachs said this rally in oil is not going to last. The fundamentals behind oil production have not changed. U.S. production may have dipped from multi-decade highs but the market is still oversupplied and now the oversupply is coming from outside the U.S. OPEC is not helping. The oil cartel is having their own little price war with each other. They keep cutting their prices to try and gain market share.

Economic Data

It was a quiet week for U.S. economic data. The ISM services (non-manufacturing) index fell from 59.0 in August down to 56.9 in September. Estimates were for no change (readers above 50.0 suggest growth). On Friday the Commerce Department reported that wholesale inventories for July were revised down from -0.1% to -0.3% and August inventories only rose +0.1%. That was actually higher than expected. However the inventory to sales ratio rose to 1.31. That means it would take 1.31 months to clear the shelves and it marks the highest level since May 2009. High inventory to sales ratios suggest an unwanted inventory build up, which is negative for the economy.

The biggest economic report for the week was probably the minutes from the September FOMC meeting. All but one member believed that a rate hike this year would still be appropriate. However, many committee participants felt it would still be "prudent" to wait for more data to confirm economic growth. Worries over the tumultuous stock market movement and economic weakness overseas were pivotal in the decision to postpone raising rates for the first time in years. The stock market interpreted the FOMC minutes to mean the Fed is actually unlikely to raise rates this year, especially following the huge miss in the September jobs number, and this view helped fuel additional gains for equities last week.

Overseas Economic Data

Europe

Economic data out of Europe was somewhat bearish. German factory orders for August fell -1.8%. Economists had been expecting a rise of +0.5%. It was the second monthly drop in a row following July's -2.2% decline. Germany's industrial production was also a disappointing -1.2% for the month.

European markets got a boost from dovish comments in the minutes from the last ECB meeting. Members of the European Central Bank suggested the region still has a lot of stimulus that needs to work its way through the system. The ECB has been buying 60 billion euros worth of QE every month since March. Now there are analysts suggesting the ECB may need to boost their stimulus.

Comments from ECB President Mario Draghi support the idea that additional stimulus could be coming. According to Draghi, "In light of renewed risks that have emerged on the bank of recent developments in global and in financial and commodity markets, we are closely monitoring all relevant incoming information." The ECB is "ready to use all the instruments available within our mandate to act, if warranted, in particular by adjusting the size, composition and duration of the asset-purchase program." The next ECB meeting is October 22nd.

While we are on the subject of central bank moves the Bank of England decided to leave their interest rate unchanged at 0.5% and their asset purchase program unchanged at 375 billion pounds. The BoE is worried that inflation is too weak to remove their easy money policy.

Asia

Economic data out of Japan was not very good either. The Leading Economic Index in Japan saw a -1.5% drop in August. That follows a -1.7% decline in July. Japan's core machinery orders for August plunged -5.7% for the month. That was significantly worse than the +3.2% estimate. Core machinery orders are down -3.5% year over year and marked their third monthly decline in a row.

The Bank of Japan met last week and decided to leave policy unchanged. There was growing expectations for Japan to boost their stimulus but the BoJ left their main interest at 0.1%. BoJ Governor Haruhiko Kuroda warned that the slowdown in emerging markets is a headwind for Japanese exports but he still believes that inflation will rise toward his 2% target is energy prices can stabilize.

China remains a huge warning signal for the market and the global economy. The International Monetary Fund (IMF) downgraded their growth estimates on China to +6.2% in 2016. Meanwhile China's slowdown seems to be having a very negative impact on U.S. corporate earnings. Alcoa (AA) warned that auto production and building construction in China was worse than expected Yum Brands (the company that runs Taco Bell, KFC, and Pizza Hut) said they experienced a huge slowdown late in the third quarter. Check out this article from Marketwatch.com on "China is becoming a red flag for U.S. stocks" China story .

It is important to note that the S&P 500 companies only generate 10% of sales from the Asia Pacific region. Most of that 10% is from China and Japan. While that may seem like a low number the region represents one of the biggest growth opportunities. Wall Street is keenly focused on China and its economic health. Later this week we'll hear China's trade data and inflation numbers. The next estimate on Chinese GDP should be October 19th.




Major Indices:

The rebound off the market's late September low has been impressive. The S&P 500 index came within four points of its late August correction low and reversed sharply. Traders are calling it a bullish double bottom. This index is up +7% in the last nine days and definitely looks short-term overbought.

Last week the S&P 500 added more than 63 points or +3.25%. This has narrowed its 2015 loss to -2.1%. The breakout past potential resistance at the 2,000 mark and past the simple 50-dma is encouraging. However, a few market pundits have called this big rally a trap with disappointing Q3 earnings as a potential catalyst to spark the next sell-off.

The S&P 500 has a ton of resistance in the 2,020-2,060 region. That does not mean the rally is over but it does mean the rally could struggle. Keep an eye on the simple 200-dma near 2,060.

5-day chart of the S&P 500 index:

Daily chart of the S&P 500 index:

The NASDAQ composite surged +2.6% for the week. This lifted the index back into positive territory for the year (with a 2015 gain of +2.0%). The rally past 4,800 is encouraging. However, as you can see on the daily chart below, the NASDAQ has stopped right at significant resistance near the declining 50-dma and its trend line of lower highs.

After a +330 point rally from its late September low I would expect a pullback and I'm probably not the only one. That probably means a breakout past this resistance could spark some serious short covering.

The 4,900 and 5,000 area still represents significant resistance.

chart of the NASDAQ Composite index:

The small cap Russell 2000 index ($RUT) added +51 points or +4.6% last week. That boosts the rally from its late September-early October low to +7.8%. That's a pretty big move in just six trading days. I would expect some profit taking.

Optimistically the 1,140-1,150 area might be short-term support but I wouldn't bet on it. The 1,160-to-1,220 area still represents a lot of overhead resistance.

Year to date the $RUT is down -3.3%.

chart of the Russell 2000 index



Economic Data & Event Calendar

The week starts with Columbus Day. The U.S. bond market and most banks will be closed. That could mean light volume for the equity markets. Overall it is a relatively quiet week for data. We'll get both the PPI (wholesale) and CPI (retail) look at inflation in the U.S. The market will also digest the New York and Philly regional Fed surveys. The Beige book will provide a regional look at the U.S. economy. There are four voting members of the Federal Open Market Committee speaking this week. Any one of them could say something that might move the markets.

The biggest "event" is probably the first full week of Q3 earnings season. There are 35 S&P 500 companies reporting earnings this week.

- Monday, October 12 -
Q3 earnings season picks up speed.
Bond market (and most banks) closed for Columbus Day

- Tuesday, October 13 -
Germany ZEW index
Chinese inflation data
Chinese trade data

- Wednesday, October 14 -
Producer Price Index (PPI)
U.S. retail sales (September)
Business inventory data
Federal Reserve Beige Book report

- Thursday, October 15 -
Consumer Price Index (CPI)
New York Empire State manufacturing survey
Philadelphia Fed manufacturing survey

- Friday, October 16 -
Eurozone CPI data
Industrial Production
University of Michigan Consumer Sentiment

Additional dates to be aware of:

Oct. 19th - Chinese GDP estimate
Oct. 22nd - ECB meeting
Oct. 28th - FOMC meeting
Nov. 5th - U.S. debt ceiling deadline
Nov. 18th - $14 billion in U.S. social security payments due
Nov. 26th - Thanksgiving holiday (markets closed)
Dec. 16th - FOMC meeting, new forecast Dec. 16th - Fed Chairman Yellen's press conference
Dec. 24th - Christmas Eve (market closes early)
Dec. 25th - Christmas (market closed)

Looking Ahead:

Rising Geopolitical Risk

Looking ahead we could see the return of geopolitical risk influencing the market. I mentioned earlier that Russia has jumped into the Syrian conflict with both feet. Russia has been a long-time supporter for Syrian President Bashar al-Assad. Russia entered Syria under the pretext of fighting ISIS but most of their targets have been anti-Assad rebels. Russian jets violated Turkish airspace and Turkey warned Russia don't do it again.

How would the markets react if Turkey, a member of NATO, shoots down a Russian military jet? In the mean time France just bombed ISIS targets in Syria and the U.S. is still there (although we don't seem to be accomplishing much). That is a lot of countries flying fighter jets through Syrian airspace. I hope there aren't any mishaps that kick off a larger conflict. We could hear more about Turkey. The just had a horrific terrorist bombing at a peace rally. Turkish officials are blaming ISIS but no confirmation yet on who did it.

On the other side of the world China and U.S. seem to be on a collision course in the Pacific. The U.S. and most of the world has criticized China for months over China's artificial islands. China claims most of the South China Sea as their territorial waters regardless of other countries' claims to the region. To defend these claims China has built up several islands into small military bases with airplane runways.

The United States does not acknowledge China's claims for these international waters and said they will continue to operate wherever international law allows. This has sparked an outrage from Chinese officials who claim they will not allow any country to violate their territorial waters or airspace (within 12 nautical miles of these man-made islands).

An Earnings Recession

The U.S. is poised for +2.5% GDP growth in 2015 and does not seem to be in jeopardy of a recession (two consecutive quarters of negative growth). However, we could see an earnings recession.

At the end of June this year Wall Street was expecting Q3 earnings to be -1.0%. Today analysts are expecting a -5.5% drop in Q3 earnings, which would be the worst quarter in six years. 2015 Q2 earnings for the S&P 500 came in at -0.7%, which was better than the estimated -1.6%. If Q3 earnings are negative it would be the first back-to-back quarterly earnings decline since Q2-Q3 of 2009. Currently Q4 earnings estimates have fallen from +12% to -1%.

The research team at FactSet has outlined which sectors could see the biggest Q3 earnings declines.

Financials earnings estimates have fallen from +10.1% to +4.3%.

Earnings in the materials sector have fallen from -1.5% to -18.5%.

Industrials Q3 earnings have been revised down from +0.1% to -5.7%. Meanwhile energy company earnings have been downgraded from -58.9% to -64.3% (from a year ago).

Revenues are also expected to fall -3.3% from a year ago. This would be the third consecutive quarter in a row of year over year declines, which hasn't happened since 2009. FactSet has a lot of great information on their Q3 earnings outlook. Check it out here (.pdf file).

Investor Sentiment

Investor sentiment has seen some crazy swings lately. Last weekend we noted how bullish and neutral sentiment dropped and bearish sentiment surged +11.2%. It was the biggest one week surge in bearish sentiment since July.

Sentiment has reversed again. Last week's AAII survey showed bearish sentiment falling -11.7% to 28.2%. Neutral sentiment rose +2.3% (to 34.3%) and bullish sentiment surged +9.4% to 37.5%. Even with the big bounce in bullish sentiment it is the 28th week in a row that bulls have been under the long-term average of 38.7%. It has been a record 32 weeks since bulls were above 40%.

Investor Sentiment Survey (AAII)

Source: AAII

Unfortunately there are other signals hinting that investors are losing confidence in the market. NYSE margin debt is plunging. Some have argued that margin debt is falling too fast and suggests it represents a lack of demand for stocks. Another analyst noted that investors dumped money into money market accounts as a temporary safe haven to avoid stocks.

Bloomberg noted that bond investors, typically seen as "smart money", are losing faith, especially in central banks. The International Monetary Fund is also warning that central banks around the world need to be careful. IMF chief Christine Lagarde said that globally central banks have spent $7 trillion in quantitative easing since the 2008-2009 financial crisis and yet the global economy is stuck in a "mediocre" growth pattern.

Central banks are desperate to avoid deflation but after $7 trillion they still can't seem to generate any serious inflation. Last week Lagarde reiterated her request to the Federal Reserve to postpone raising rates for fear of squashing an already fragile global economy. Chicago Federal Reserve Bank President Charles Evans seems to agree. Evans is worried that inflation is still too low and that the Fed should be extra patient before removing stimulus from the system.

Seasonal Weakness

Wow! What happened to the "worst three weeks" of the year? The last two weeks have been up with last week up big. The normal seasonal trend of stocks sinking in the first half of October did not show up. It's possible the big plunge in late August pulled the correction forward.

I would still be cautious. The next few weeks will be flooded with Q3 earnings results but it's the next two weeks that will set the tone for earnings season. I still expect a Q4 rally. Ideally we see a dip in the next two weeks. This would alleviate the short-term overbought conditions and hopefully set a new higher low.

We are quickly approaching the best six months of the year for stocks (November through April). According to the Stock Trader's Almanac, the period from Halloween to Christmas is one of the most consistent winning trades for bulls. This time period has posted gains for the S&P 500 index in 25 of the last 33 years with an average gain of +4.2%. The Dow Industrials do even better with an average gain of +12% over the last twenty years. That could boost the DJIA back above the 18,000 mark by year end.

Another seasonal trend to be aware of is the fiscal year end for mutual funds. October 31st is the end of the fiscal year for most fund managers. The vast majority have underperformed the market this year. There could be a lot of window dressing and performance chasing between now and the end of October. This would suggest that declines going forward might be shallower than normal as active money managers jump in to buy the dip.

~ James