The bullish short squeeze from Monday evaporated despite better than expected economic numbers and a sharp decline in small caps is a warning of potential weakness ahead.

Market Statistics

The morning started off well despite the early morning decline in the markets. The big economic news for the morning was the Factory Orders for November. The headline number rose by +0.7% and more than twice the +0.3% analysts expected. It was considerably stronger than the -0.9% decline in October. This improvement is consistent with the rebound shown in other reports over Q4 and represents an accelerating economy. Core capital goods orders rose a whopping +2.6% after a -3.2% decline in October. The accelerated depreciation portion of the recent tax cut extension program could ramp up orders of computer equipment to a fever pitch and that should start in the first quarter.

Vehicle Sales for December continued to improve at an annualized rate of 12.5 million units compared to 12.3 million in November. This is the highest level since September 2008. The rise in sales has been due to new models, decent discounts and a release of pent up demand. Analysts believe this will continue throughout 2011. The current rate of sales is far better than the 9.4 million pace in September 2009.

Sales for all manufacturers rose except for Toyota, whose sales fell -6% in December and sales for the year were flat. This is due to the falling sales of the expensive Prius and the switch back to SUVs by the consuming public. Gasoline prices had spent the year in a moderate range and now those SUV buyers are going to start paying the piper in 2011. That two percent hike in net pay by reducing the social security tax is going to be spent at the gasoline pump.

The Fed released the minutes of the Federal Open Market Committee (FOMC) meeting in December. For the time being there appears to be no likelihood of change in the QE2 program. Members were slightly more upbeat about the improving economy due in part to the tax extension bill.

The FOMC debated what it would take to change the QE2 program. They agreed that improvement of economic data alone was insufficient to alter QE2. More time and data is needed before considering a QE2 adjustment. Some thought the threshold was very high to make changes to the program. Small incremental changes in the economics and employment would not be enough to justify changing the strategy.

Some Fed members are also seeing the possibility of a more rapid recovery. The members did see the tax cut extension package as helping growth in 2011. Members believed housing, weak job growth and continued consumer deleveraging was restraining growth. The Fed said a cutback in government spending resulting in more job cuts was an additional risk to the economy and another reason to continue QE2. Europe was also seen as an economic risk.

The Fed staff saw a lowered risk of deflation and increasing risk the expansion of the Fed's balance sheet could trigger inflation but expectations were still low.

Why are rates higher when the Fed is buying up every treasury in sight? Reasons given in the minutes were market anticipation of a halt to QE2 due to better economic data, higher deficit projections, year-end positioning of portfolios and the accelerating recovery was boosting expectations for the future.

The Fed staff revised up the economic outlook and revised down the inflation expectations for 2011 and 2012. They are pretty confident they are going to avoid waking the inflation monster despite the additional risk caused by QE2. The Fed based this lower inflation outlook on the inability of businesses to pass along higher costs in consumer prices. There is still too much slack in the manufacturing sector and too little demand by the consumer for price inflation in the near future. Many of the members still felt there was still downside risk from unemployment and the weakness in housing.

The Fed members continued to see progress toward their dual mandate of stable prices and high employment as "disappointingly slow."

The FOMC is going to shift in tone as more hawkish members rotate into voting position. To avoid having a stagnant board the Fed members rotate in and out of voting positions. When this happens in January the number of dissenters will increase to three. They will be Richard Fisher, Charles Plosser and Narayana Kocherlakota. They could decide to cast one dissenting vote per meeting to show their individual dissent or all three vote at once to express a high degree of frustration. Having all three dissent at one would not be market friendly. It would damage the Fed's credibility and the market would immediately assume the worst. Members Hoenig and Lacker and to some extent Warsh are also strongly opposed to QE2 but are not voting members in 2011.

Wednesday's economic reports are not going to cause many ripples unless the ADP report suggests a much better or worse Non-Farm Payroll number for Friday. This will be the key report for the day with the ISM services more of a filler report since ISM manufacturing was a seven-month high.

Economic Calendar

In stock news Atheros Communications (ATHR) spiked +19% on news Qualcomm may be interested in buying the company to bolster its share for chips for smartphones and tablets. The sales price could be in the $3.5 billion range or roughly $45 per share. Qualcomm has about $10 billion in cash thanks in part to its popular Snapdragon processor. Atheros makes chips for Bluetooth, GPS and wireless networks and many mobile devices.

Hello Moto! Chip company Motorola (MOT) split into two companies today. Motorola Solutions (MSI) and Motorola Mobility (MMI). The solutions company (MSI) saw its stock spike +7% to $39.77 while the Mobility company rose +6% to $33.11. Apparently two companies are better than one given the strong gains after the split. MMI is the unit that makes cellphones and video equipment. Owners of MOT received eight shares of MMI for each share of MOT they owned. Then the original MOT shares underwent a 1:7 reverse split and began trading under the symbol MSI. That was to prevent the MOT shares from collapsing to one-eighth of their value. As a result the value of both shares today is actually more than the value before the split. Apparently investors liked the split, which had been in the works for nearly two years.

Motorola (MSI) Chart

After the bell Mosaic (MOS) posted earnings of $1.01 that easily beat analyst estimates of 91-cents. That compares with 24-cents in the year ago period. Mosaic earned $1.03 billion for the quarter on a strong increase in sales. Mosaic said plantings of corn, wheat and soybeans are expected to rise sharply with prices for those crops sitting at near record highs. The company said, "Everything we see on the horizon is in support of higher fertilizer prices. We are feeling very confident about the business. Demand is booming and our outlook looks good from any angle." Sales of potash rose +69% in the quarter. Mosaic is in the middle of a $5 billion campaign to boost potash capacity by more than five million tones over the next ten years. Shares of Mosaic rose +2.24 to $77.24 in after hours trading.

Mosaic Chart

We are approaching the beginning of the Q4 earnings cycle and results like we saw from Mosaic could keep investors in stocks for another couple weeks. Alcoa will be the first Dow component to report on Monday. Over 150 stocks report next week but the real deluge of earnings does not begin until the week of January 17th. The companies reporting next week will be just an appetizer ahead of the main course.

The big movers in the market on Tuesday were commodities. The dollar rebounded from a six-week low and investors took profits on metals and energy. Crude prices dropped nearly -$3.00 intraday to $88.36 before rebounding at the close to end down -$2.24 at $89.31. The decline from two-year highs was dramatic and there was no specific reason. I mentioned the rising dollar as a factor but the 50 basis point rise in the dollar index was not responsible for the decline in crude. It may have accelerated the decline but it did not cause it. Crude as well as the other commodities were simply overbought and needed an excuse to rest.

Crude Oil Chart

Silver declined about $1.50 to $29.32 intraday or about -5% before rebounding slightly. Silver has been on a rocket ride since September and the onset of QE2 buying. The Fed alluded to a new QE program on August 27th and commodities have gone vertical since the announcement. Does anyone actually believe silver is worth 65% more today than it was worth on August 27th?

Chart of Comex Silver - Daily

Copper declined -$9 on Tuesday after a $5 drop on Monday. Copper has been on a winning streak since its low in June and was impacted by the QE2 expectations but not as much as silver and gold. Copper appears to be in the correction process with strong declines on both days this week. This is clearly profit taking now that the tax year has changed. I would look to buy a dip in copper but only a big dip. Another $2-$3 is not material. A continued decline of $30 would be buyable for me. I know that is a big hit with global supplies declining and one entity holding 90% of LME inventories but should that individual decide to take profits we could see a serious decline.

Copper Chart

Gold prices have lost more than $40 so far in January. Gold is really in correction mode and is trading at $1380 overnight after hitting a high of $1424.40 on Monday. The chart on gold began to show a topping pattern in December but the gold bugs were successful in pushing it back to resistance to end the year. Now that the window dressing and tax accounting is over the selling has begun. A break below $1380 could test $1325 very quickly.

Gold Chart

The S&P-500 gave back less than two points of Monday's big gain. That left it well above that price magnet at 1258 and well above initial support at 1254. The odds are good we will test those levels before too long. If the commodities continue to sell off the profit taking disease will eventually be contagious to the broader equity market.

Everything we saw in the FOMC minutes was conducive to the market continuing higher BUT that is long-term support not short term. We are still way overbought and I suspect traders are looking for that excuse to sell. It may not appear until next week despite the Non-Farm Payrolls on Friday. That report could keep investors interested with expectations for a better than expected job gain.

The S&P has not returned to uptrend support since August. It is way over due and we know from past experience nothing goes straight up. All the positive news, except for Q4 earnings, has already been priced into the market. How much longer the market can survive on stale news is a mystery and one I am sure we will see answered in the next couple weeks.

S&P-500 Chart

The Dow managed to claw back from a decent intraday decline to post a decent gain thanks to Dow components Disney, Hewlett Packard and Verizon. Unfortunately that gain only brought the index back to uptrend resistance and very close to strong resistance at 11700 from August 2008. This was where the Dow finally failed before plunging to the March 2009 lows. This should be a difficult area to cross.

Initial support should be in the 11,550 range and well below today's close. This means the spike from Monday is very unprotected but that did not seem to matter today.

Dow Chart - Daily

Dow Chart - Weekly

The Nasdaq struggled to return to positive territory after a steep morning decline but the index could not make the trip. Large losses in stocks like PCLN -6.61, LULU -4.38, SHLD -3.61, DECK -2.53, FFIV -2.26 and GOOG -2.02 were too much for the composite index to overcome. Decliners on the Nasdaq outweighed advancers 1,691 to 779.

Fortunately the Nasdaq only gave back roughly a quarter of its gains from Monday. I am sure we would all take a four steps forward, one step back move every week for the rest of the year.

Support is 2660 and resistance a very firm 2700. That 2700 level as round number resistance could be tough to cross without a little more profit taking to build a base.

Nasdaq Chart

The Russell is the fly in the ointment for the bulls. The Russell came to a dead stop at 800 on both days and then dropped more than 2% intraday to initial support at 780. The rebound from 780 was lacking conviction and suggests the Russell bulls are losing interest. If 780 breaks the long term support at 764 would immediately become the next target.

The Russell is the canary in the coal mine and today's lack of bullishness is troubling. If the Russell declines below 780 I would be exiting any long positions. Support at 764 may only be a speed bump if wholesale profit taking begins.

Russell Chart

In summary I think we have more risk to the downside but it may not develop over the next couple days. I believe this is more of a developing weakness than something that will knock the markets down hard on Wednesday. The bulls are still alive and buying the shallow dips. Until that shallow dip money dries up we are in a mode where time will pass slowly with fits and starts that lead nowhere. I am cautious and I have exited quite a few long positions in expectation of a deeper decline before we can move higher.

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