The better than expected European bank stress test results released on Friday setup the market for a flurry of short covering into the close.

Market Statistics

The market was expecting a much weaker result from the European banking stress test and the news provided the background for strong bout of short covering. Only seven of 91 banks failed the stress test. One German bank failed, one in Greece and five in Spain. After the results were published the surprised analysts that had expected more problems quickly complained that the tests were not tough enough.

Government bonds, sovereign debt, held by European banks were not included in the stress test. Those government bonds are held in what is called a "bank book" and are valued at full value not the current fair market value. They were considered "holding for maturity" and therefore not discounted when it came to calculating the banks capital needs. Hypothetically if a bank bought a billion euros in debt from Greece that debt would still be valued at a billion and part of the banks capital. This is true even if the market had downgraded the debt to a 50% valuation on worries that Greece will never pay it back.

Using those rules the banks were able to value it at 100% and apply it to their capital base. This gave banks an inflated picture of health. Fortunately the general public only heard the seven failed out of 91 and thought it was bullish.

The test results did not really apply any upward momentum to the market but it caused traders to rethink their short positions in a market that was not falling. At 12:30 GE announced it was raising its dividend by 20% and restarting its $15 billion stock buyback program. GE had halted the program on September 25th, 2008 to conserve capital. The GE announcement on top of the stress test news finally started a short squeeze but it was short lived. As one analyst put it, "You don't announce a 20% increase in your dividend and start buying back billions in stock if you think the economy is going to weaken again. This is a bullish move by GE." CEO Jef Immelt said the decision was due to "continued strong cash generation, the recovery at GE Capital and solid underlying performance in our industrial businesses through the first half of 2010." Dow component GE spiked +4% on the news and started a rally in the Dow ETFs. This triggered further short covering in the S&P-500 ETFs and a potential rally was born.

Another 1:PM event that spiked the ETFs even more was news that Sanofi-Aventis would be making a hostile bid for Genzyme. GENZ spiked +20% in seconds at 1:PM just as the GE news was hitting the tape. This one-two punch pushed the ETFs hard enough to trigger a short covering spree that pushed the S&P to resistance at 1100 where it eventually ran out of steam. The market had been trending lower until those announcements and the shorts got squeezed.

SPY Chart

On the economic front there were only two reports. The Monthly Mass Layoff report showed a rising pace of layoff events at 1,647 in June compared to 1,412 in May. The number of workers involved rose to 145,538 compared to 135,789 in May. Manufacturing represented 11% of all layoffs and 12% of initial claims. This report was not as bad as you would have expected given the declining economic sentiment.

The Weekly Leading Index I have been reporting about for the last few weeks appears to be leveling out despite the big drop in sentiment last week. The index was flat with last week's 120.7 reading. However the annualized growth rate declined again to -10.5% for the 11th consecutive decline. We need to continue to maintain vigilance here until the trend turns up again.

Weekly Leading Index Chart

The economic calendar was rather benign last week but next weeks schedule is full of potholes. The two biggest reports are the Fed Beige Book on Wednesday and the GDP on Friday. The Beige Book tells us the economic conditions in each of the Fed regions. This is a monthly report and we need to see that conditions are not getting worse.

The GDP report on Friday is going to be critical. The current estimate is growth of 2.5% for the second quarter. This is the first GDP report for Q2 and estimates were for 3.0% growth just a couple weeks ago. Another problem could be a revision to prior quarters. This is going to be a major stumbling block if the GDP comes in lower than expected.

Economic Calendar

Earnings took a turn higher this week after some high profile disappointments in the prior week. So far the S&P companies that have reported have produced earnings growth of +42%, +12% higher than the estimates from a month ago. More than 78% of those reported have beaten on earnings and 67% have beaten on revenues. These numbers have fluctuated a lot over the last two weeks and now that the majors have reported the trend should weaken.

Tech stocks are on fire with earnings growth of +64% for Q2 but that is likely to be the high for the year. Thomson Reuters predicts that earnings growth will slow to only 30% in Q3 and +13% in Q4. The main problem is the tougher comparisons from Q3/Q4 2009 when the economy rallied out of the recession. Unfortunately that economic rebound slowed dramatically and beating those Q3/Q4 numbers is going to be tough.

We had quite a few high profile tech stocks miss estimates or give weak guidance so tech stocks are going to have a stiff headwind in the months ahead. There are a ton of chip stocks reporting next week so we will have plenty of input for future business trends.

Disappointment was not limited to tech stocks. McDonalds (MCD) reported earnings that beat the street but posted lower than expected same store sales and the stock gave back -2% on Friday. Analysts typically look at the restaurant chains for indications of an increase in spending as consumer sentiment improves. They did not find that in the McDonalds report. Beating by a penny on slower traffic numbers is not confidence building. McDonalds did not actually show lower traffic numbers but an increase of +3.7% but that was less than analysts expected given the new menu items. The street was looking for +4.3%.

The winner for biggest post earnings rebound has to be Amazon. Amazon closed at $120 before reporting earnings. After the report the stock declined to $100 late Thursday night. It opened at $106 on Friday and rallied to close at $119. UBS lowered its price target to $165 and traders appear to be very bullish on the stock under $120.

Amazon missed earnings estimates but not because customers were not buying. The management decided to increase spending on infrastructure and marketing. They are adding 13 fulfillment centers this year and hired 2,200 during the quarter. They cut prices so their margins are going to slip to between 3% to 4% and the street was looking for 5%. Amazon has been a favorite of shorts for years and nothing has changed. They piled on after the earnings miss then saw a $20 rebound eat their lunch on Friday.

Amazon said for the quarter they were selling 143 kindle ebooks for every 100 regular books. In July that number rose to 180 kindle ebooks for every 100 regular books. The increase was due to a price cut on the Kindle reader from $259 to $189 and a 300% increase in the purchase of the Kindle readers. Your reader is worthless without downloaded Kindle ebooks so new readers were downloading away. I have a Kindle DX and I love it.

Amazon will not divulge their profit margins on a downloaded book but with most prices at $9.99 to $12.99 you have to bet they are making a lot more than on a paper book. There is no shipping to Amazon, no warehousing, no packaging expense and no shipping after the sale. A 30 second digital download has got to be more profitable than a paper book sale. I have to admit I was an Amazon skeptic for years but I have bought hundreds of items from them over the years. The site is quick, easy and you can buy almost anything.

I saw another editorial today about how Amazon is setting up for another shorting opportunity. There may be a short on a gap fill at $120 but that UBS target price of $165 could be painful for the shorts if it comes true. Depending on the number of active shorts taking the bait today it could come sooner than UBS expects it.

Amazon Chart

The analyst game plan late this week appeared to be an estimate cut on anyone who has already reported. The weak guidance is an invitation for brokers to slice and dice the future earnings estimates. For instance, Goldman lowered the earnings estimates through 2012 on Home Depot on a decline in sales now that the tax credit is dead. HD continues to cut costs but with sales declining it should be easy to predict the next chapter in their earnings. Goldman has a $34 price target with the stock at $28 today.

Barclay's started cutting estimates on the drilling companies as the moratorium drags on. They cut Diamond Offshore to neutral from overweight on expectations the moratorium is going to reduce lease rentals.

Tropical storm Bonnie turned fickle on forecasters as it picked up speed on Friday. The storm crossed over the bottom of Florida and lost strength after making landfall. When it moved back into the gulf it was moving northwest at 17 mph. That is positively flying for a major storm. However winds were only 35 mph and gusting higher. That is more wind than I would want to be facing in a small boat but as potential hurricanes go Bonnie is barely a thunderstorm.

Crude prices rallied over $79 on news that 28% of production in the gulf was shut in due to the storm. The original storm track had the storm crossing directly over the leaking BP well. However, the potential for the storm to gain strength now that it is back over the gulf, forced BP to recall the ships working on the leaking well including the ships drilling the relief wells. Ships collecting seismic and acoustic data and those operating under water robots would have been the last to leave the site. Most of the major drillships and semisubmersible rigs can easily withstand waves of 12-15 feet that could be kicked up by Bonnie. To move them out of harms way would assume much higher waves were expected. They don't want to be drilling in those waves but they can remain on station. Bonnie lost power on Saturday and sustained winds were only 25 mph when it reached the well site. All the BP ships have already been ordered back on station.

The emotion is building against the administration's moratorium. The governor of Louisiana is attending rallies and the crowds are increasing. They claim the moratorium is doing more harm than the spill ever could. The API estimates the salaries of oil workers in the gulf is $184 million per month. Filter that money through the retail ecosystem on shore and that $184 million becomes a billion in impact. Restaurants, stores, service companies, housing, service stations, etc all see that money flow through their hands and pay their employees and expenses. It left a very big hole in the gulf economy when it was cut off.

BP reports earnings on Tuesday and that should be an interesting report. BP claims its money out of pocket on the spill is now $5 billion and they don't even have the $20 billion fund up and running yet. This is a major week for oil company reports. In addition to BP there is Conoco on Wednesday, Exxon on Thursday and Chevron and Total SA on Friday along with many smaller companies.

I had a tough time finding quality companies for the earnings calendar. You won't find an Intel, Microsoft or Apple in the list. We have run out of the giants and are now into the second string batters. However, 40% of the S&P reports this week.

Earnings Calendar

The European stress test scenario may not have evolved as many analysts expected but in the end it is one more thing the market no longer has to worry about. One analyst called it a hurdle of uncertainty that no longer exists. There will be stories about how the tests were rigged by not including the sovereign debt in the calculations but the bottom line is that the EU has guaranteed that no banks will fail because of the sovereign debt crisis. That is a positive data point and now the stress exercise can fade into history while traders move on to focus on something else.

For next week we have a ton of economics and more than 400 earnings reports. However, the farther we get into the cycle the more likely investors lose interest. Remember, earnings growth prospects are going to decline sharply in Q3 and Q4. The incentive to be long into shrinking earnings is going to be low.

I have warned for several weeks that I expect the current rally to fail as we near month end. The indexes had a great week last week with the average gain around 4% but much of that was short covering. On Friday the S&P was trending lower as it approached the 1:PM mark with the 12:45 candle a two-hour low. The twin announcements for GE and GENZ triggered a burst of short covering in the ETFs and that pushed the S&P to 1103 and just barely over the psychological resistance at 1100. For two hours a battle was waged at 1100 and a final short covering spurt at the close put the final print at 1102.

This is NOT a break of resistance. It is simply a print at resistance at the close. The resistance at 1100 is still intact. There is even stronger resistance at the 200-day average at 1113 and the 50% retracement from the March 2009 lows at 1116. The S&P should struggle to move over these levels.

The stress test results were released after the markets closed in Europe. That means Monday's European market action will have a big impact on how we open on Monday. The conflicting analysts reports on the validity of the stress tests will be weighed and judged in the European markets well before the U.S. markets open. Personally I don't think the tests were worth the paper the results were printed on and I don't think real U.S. investors care either. What does matter is how the European markets react.

I mentioned last week that the S&P was heading up for a new shorting opportunity at 1100. If we do move over 1100 I don't think we will move over the 200-day at 1113 by more than a couple points as the June resistance highs are tested.

Bottom line, my weakness before month end forecast scenario is about to be tested. The bets are placed and now we have to wait for the hand to play out.

The earnings cycle is nearly over. There are plenty of companies left to report but we know how the story is going to end. 78% of companies are beating on earnings and 67% on revenue. Earnings growth was +42% through Thursday but revenue growth was +7%. These numbers will decline as the smaller companies pass through the confessional. Estimates for Q3 and Q4 are declining. In short, there is no compelling reason to be long equities over the August/September period.

I would look to short the 1113-1116 range and I would be a reluctant buyer over the 1120 level. Long-term rallies tend to breakout when you least expect them so we don't want to be caught with a firm bias that is only focused in one direction. Been there, done that, missed the opportunity more than once. I am sure any experienced investor can relate to that scenario.

S&P-500 Chart

The Dow chart is interesting even though I would rarely use it for a trade signal. The Dow closed over the 200-day of 10,395 on Friday with a close at 10,424. That is also a four-week high. In theory that should be a buy signal but I am not fond of using moving averages on the Dow for signals. The 30-stock index is too volatile and not normally moving average reactive.

Secondly the Dow has decent resistance at 10500 from June. If we do move over that 10,500 level on decent volume we could see a reluctant rally develop. I say reluctant because there are plenty of traders expecting the market to fail. A move contrary to the current market sentiment could prompt a lot of short covering. However, the next four weeks should have the lightest volume of the summer. The last four days barely broke 8 billion shares per day but that was an improvement over the 7 billion average in the prior week. This is purely because of the major earnings reports in play on companies like Ebay, AMZN, IBM and Microsoft. Those types of incentives will be absent next week.

We saw last week the Dow has strong support at 10,000 and now we are approaching strong resistance at 10,500. The trade boundaries are clearly identified and all we have to do is watch the road signs.

Dow Chart

The Nasdaq closed over the 200-day at 2259 and at a new four-week high but I am still not a fan of techs. The sharp downward revisions in Q3/Q4 earnings estimates suggests tech stocks are going to have a hard time finding investor love over the next six weeks. I don't think the Nasdaq is giving us a trading signal until it moves over the 100-day at 2325.

Nasdaq Chart

In summary I don't think there is a compelling reason to be long equities over the next 6-8 weeks. The earnings story is not over but we know how it will end. Knowing the end of the book makes it less interesting to read. We have the mud slinging election cycle ahead of us and each party will be telling consumers how bad it is and why they can fix it if elected. Unfortunately consumers will only remember the bad part because it makes better sound bites. Despite last week's rally the markets are still in a downtrend since April. Until that trend is broken investor interest will wane. I am not saying an economic recovery rally can't breakout but it would help to actually see some recovering economics before that rally begins. Recently all the economics have been declining. I am still looking for weakness as we move into August but if proven wrong I would be a reluctant buyer over SPX 1120.

Jim Brown