Despite the improving economics the market seems destined to pursue a downward trend. Repeated rebounds have been sold and the pattern of lower highs is becoming disturbing.

Market Statistics

The better than expected economics were not able to push the indexes into positive territory to close the month. Good news was overshadowing the European debt crisis, Korean hostilities and China's tightening bias but that news could not resurrect our markets.

The ISM Chicago was significantly better than expected with a headline number of 62.5 for November. Estimates were for a slight gain to 60.6 from October's 60.0 reading. This is a new seven-month high for the Chicago ISM and has completely erased the August plunge.

The New Orders component rose to 67.5 and the highest level in more than three years. More importantly inventories fell more than 5 points from 54.9 to 48.6. Falling inventories means more orders in the future. The employment component rose by nearly two points to 54.6.

This was a very positive report and suggests auto sales likely improved significantly and resulted in a boost to the Chicago area manufacturing sector. This report is clear evidence of an accelerating economy and probably means the national ISM on Wednesday could also be better than expected. The national ISM is expected to decline by -1.1 points to 55.9 for November.

Chicago ISM Chart

The NY ISM rose from 477.9 to 485.7 for the biggest gain in the last five months. The current conditions component rose to 65.6 and the highest level since June. The six-month outlook rose to 71.9 and the highest level since May. The pace of recovery in the New York area appears to be improving at a faster pace then the rest of the country. The services sector is improving rapidly. New York was severely beaten down during the financial recession and it should outperform on the rebound. The housing sector in the NY area has improved significantly with sales in some areas almost doubling compared to a year ago.

Consumer Confidence also spiked higher from 50.2 to 54.1 and the highest level since June. The expectations component led the gain with a spike to 74.2 from 67.5 while the current conditions component barely budged to 24 from 23.5.

The number of consumers who thought the stock market was going higher over the next twelve months rose to the highest since January. This should be a positive point that should boost consumer spending this holiday season. Consumers who thought jobs were plentiful rose from 3.5% to 4.0%. That is actually a big jump and emphasizes the sudden improvement in outlook.

On the negative side the number of consumers planning on buying a home fell to 1.7% matching the low from last December and the prior low in September 1982. Home sales are definitely in the tank until spring.

As you can see on the chart below the confidence numbers have been moving sideways for more than a year and even though November's gains were strong they were unable to break out of that range. It may take a couple more months to see confidence move over 60 again.

Consumer Confidence Chart

Despite today's heavy schedule the calendar for the rest of the week is even busier. Key reports for Wednesday are the ADP Employment for an updated estimate of Friday's Non-Farm Payroll report, the national ISM and the Fed Beige Book.

Economic Calendar

November ended in a slump with the major averages well off their highs for the month. The markets tried to rally this afternoon but news broke late in the day that killed the rally effort. S&P warned it may cut Portugal's credit ratings on concerns the government has made little progress on boosting economic growth. This is just one more domino to drop and suggests many European countries will also be faced with further downgrades as their latest austerity plans are found lacking.

Consider how optimistic investors were coming into November with the market highs two days after the election appearing to celebrate the results and the formal announcement of QE2. That blow off spike capped two months of gains and it was all downhill from there.

The QE2 rally has stalled because of the continuing events in the Eurozone. Greece popped back up, then Ireland, now Portugal and soon Spain. Those events reversed the dollar's drop and forced those short the dollar and long equities and commodities to exit the trades. Everyone had backed up the truck in anticipation of QE2 removing support from the dollar and making equities the place to be for the winter.

Until the Portugal/Spain problem is solved the dollar is likely to hold its gains although the chart is facing some technical hurdles like the 200-day average. It remains to be seen if the technicals matter in the face of daily news events.

Dollar Index Chart

If there is any doubt the dollar and the markets are inversely correlated just look at the chart below. The blue line is the S&P and the black line the Dollar Index. As the dollar declined in September and October the S&P rallied strongly. Ben Bernanke telegraphed the coming of QE2 on August 27th. Note where the dollar began to decline and the S&P rise.

Given the strength of the dollar gains over the last three weeks I am surprised the markets have not sold off any more.

Dollar Index vs S&P-500

The markets are locked in a battle today between better economic numbers and worries about further contagion in the Eurozone. I have every confidence if the European debt crisis had not flared up again we would be much higher today. It is their problems impacting our dollar and forcing the market weakness. Unfortunately I don't see that changing over the next couple weeks. We still have the Portugal/Spain story to play out and that could take weeks or even months.

We may have a slight reprieve this week with those major reports on tap. If the ISM, Beige Book and Payrolls are much better than expected there is a possibility the European mess will find its way to the back burner. However, stronger economics means a stronger dollar so it is a catch 22 for the markets. Can we have a stronger market and a stronger dollar? It is possible and it has happened before but we may be too soon in the recovery with far too many geopolitical events in progress to see happen again this time.

The bullishness has not left the market but I think traders are growing tired of seeing every rebound stop short of the prior day's highs and every decline coming closer to piercing critical support at S&P 1175. The charts are not bullish and this is a period on the calendar when it should be bullish.

As one reader put it to me today, "we seem to be crawling along the bottom." I am going to add to that and say, "We seem to be crawling across the floor in an increasingly smoke filled room and hoping to find an exit."

The Dow has broken though support at 11,000 twice this week and each rebound was weaker than the prior rebound. Today's close on 11,000 is an ominous warning. The S&P has touched critical support at 1175 three times in the last two weeks and two of those were this week.

S&P-500 Chart

We can no longer use low volume as an excuse to discount the market moves. Volume today was 8.6 billion shares and the largest volume in two weeks. The last high volume day was the 9.5 billion share day on Nov-16th when 8.5 billion shares were down volume. That was the day that knocked the indexes down to their current range. We have fallen and we can't get up.

I would like to think that the improving economics would trump the geopolitical events but I am running out of patience. The bad news bulls have disappeared and the good news bulls can't find any traction. We need a wall of worry to climb but it needs to be U.S. worries not EU worries.

The bright spot in the market remains the Russell. The Russell gained +3.2% in November with the rest of the indexes finishing in the red for the month. The declines in the Russell this week have been muted and it is only about ten points from its recent highs. The Russell is the sentiment indicator for the market. If fund managers are buying or holding small caps they are positive about the market's future.

My question today is can they persevere? Do those managers have enough guts to wait out December in hopes of a Santa Claus rally?

December is normally kind to the markets with an average gain of +1.79% on the S&P. The S&P has risen 16 of the last 20 years in Q4. I expected that to grow to 17 of 21 but I am beginning to worry.

I expected the improving economics and QE2 program to push us significantly higher by year-end. That is looking less likely and I am afraid fund managers are also worried. Funds should have a lot of winners built up from the Feb-April rally and the Sept-Oct rally. If they thought for a minute the markets were going to fail they would be bailing in droves to protect their gains and their bonuses. They have no incentive to take one for the team and watch their profits evaporate while they are waiting for the situation in Europe to improve.

The last unknown in this puzzle is the November month end. November is not known for major month end portfolio shuffling by funds so there is really nothing to blame for the repeated declines other than event confusion. They could come roaring back on Wednesday and power us higher but I am not betting on that scenario.

I am worried critical support is about to break. I have been recommending buying the dips to 1175 and reversing to shorts under that level. It appears we may get a chance to play the short side "IF" Wednesday's economics are not strong enough to change the current declining market sentiment. Anything that can happen the rest of this week is likely to push the dollar higher unless the economics suddenly take a turn for the worst.

I am sure there are a ton of shorts tonight so there is always the potential for another short squeeze but I would probably see any failure under 1200 as an opportunity to get short at a higher level. The bullish sentiment as evidenced by multiple surveys is at the high for the year and the market is declining. That is a pretty good contrarian indicator. Until we move over S&P 1200 the market remains at risk. The more lower highs we see the higher the risk of a critical breakdown. I would be cautious in the days ahead. The tide could turn but we will have plenty of time to increase our bullish posture once the S&P moves over 1200. Until then the bears may be coming out for one more feeding frenzy before turning in for their winter nap.

On a more positive note, if I am ready to turn bearish then we are obviously at a capitulation point and there is undoubtedly a rally in our immediate future.

Dow Chart

The Nasdaq stopped right on critical support at 2500 but techs were the weakest link today. Over the last 20 years the Nasdaq has posted gains in December only 12 times compared to 16 for the S&P. On years when they do post gains they are normally strong with an average of +2.67%. On years when they decline they do that spectacularly as well. A break under 2500 targets 2470 then 2400.

Nasdaq Chart

The two most bullish charts are the Russell and the Dow Transports. These are in rally mode, or at least holding their gains because of the improving economics. Small caps typically don't receive much of their income from overseas so the dollar's strength does not really hurt them. Transports are gaining because of the rebound in the business cycle. The combination of the two charts may not be enough to rescue the broader market but it does give us a place to look for relative strength investments on any future decline.

Russell Chart

Dow Transports Chart

In summary I think we need to be concerned about a break of critical support levels and the impact on the rest of December. A break of critical support could trigger an even larger amount of selling as fund managers protect their bonuses. Very high profile economic reports this week could improve sentiment but the European mess will continue to be an overall drag. Be cautious and protect your profits.

Jim Brown

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