The day after the Greek crisis appeared to take an important step towards a resolution Moody's put 16 Italian banks on credit watch for a downgrade based on contagion concerns from Greece.

Market Statistics

Just when it appeared investors were starting to get excited about buying Thursday's dip the rating agency trashed not only those 16 Italian banks but also several Italian government related bond issuers for possible credit downgrades. Shares in Unicredit, the country's largest bank, were down -8% to lead the sector lower. Moody's had already put Italy's public debt on review due to low growth and high public debt around 120% of GDP and one of the largest in Europe.

Nobody should have been surprised at the downgrades since Moody's, Fitch and S&P have been taking turns beating up the weaker Eurozone countries and their financial systems for more than a year. After these firms were smacked around for their lack of accuracy and action prior to the 2008 financial crisis they are trying to find new targets as often as they can.

What surprises me is the U.S. market reaction to this downgrade parade every time a new warning is issued. It was Moody's and Italy on Friday. It may be S&P and Ireland next week and then Fitch and Portugal the following week. It makes you wonder if they collaborated on a calendar so they can each get their weekly 15 min of fame and not bump up against a downgrade from the other firms. Everyone in the U.S. markets should understand those weaker European countries are going to get smacked around about once a month for the next couple years so what is the big deal? We know the finances are terrible and nobody in their right mind should be investing there so why the big market drop every time a new downgrade appears?

I think investors (or newscasters) are just looking for an excuse to sell OR an excuse to pin on the selling. The downgrades are a perfect opportunity.

Here in the U.S. the third GDP revision for Q1 rose to +1.9% growth from +1.84%. That was a little better than the consensus estimates for a decline to 1.7%. This compares to a +3.1% growth rate in Q4. This was a ho-hum report because everyone already knew it held no surprises. The worry is what the Q2 report will look like when it is released at the end of July. There are widely differing views on the Q2 growth rate from less than +1.0% to as high as +2.9%. Considering the sharp declines in the economic reports over the last six weeks I would lean toward the lower numbers.

GDP Chart

The first sign of good news was the Durable Goods report for May. Orders rose +1.9% in May compared to a previously reported -3.6% decline in April. That decline was revised higher to -2.7%. However, the headline number contained a significant amount of orders related to defense. Without those defense related orders the headline number would have shown a -1.9% decline. An order is an order to me since U.S. workers still have to manufacture the products.

Next week is economic week. This is the week we get all the major ISM reports along with the Kansas, Richmond and Texas manufacturing surveys. This is the week we have been waiting for to see if the economic dip in May was a one-time deal or the start of something bigger.

The biggest report for the week is the national ISM on Friday. After a 53.5 reading last month we want it to stay above 50 and in expansion territory. A drop under 50 would mean manufacturing contracted in June.

There are a few more anecdotal reports every day that suggest the impact of the Japanese quake and resulting supply chain break is fading and activity is back to 100% in some places. We want to hear more of that in the official reports. This could give the market some reason for optimism.

Economic Calendar

The market needs some reason for optimism after last week. The market did not like the collapse of the debt ceiling talks in Washington. It did not like the Greek Prime Minister making comments that sounded like they would give up and not even vote on the austerity package. That worry was erased when Greece won new concessions on Thursday. Now the big problem is the vote in parliament on Tuesday. Some of the ruling party members have said they will not vote for austerity even though that means an almost certain default in the weeks ahead. That vote is on Tuesday and is probably the most important event of the week.

The market did not like the plunging PMI in Europe and China on Thursday. However, on Friday China's Premier said the efforts to halt inflation had worked and suggesting the government could ease up on its restrictions soon. He said the falling oil prices would relieve inflation pressures. China's National Business Daily said government agencies are preparing to remove limits on automobile purchases. That will be a big boost for sentiment in China and add to China's rapidly rising demand for oil. China's oil demand has risen almost one million barrels per day over the last year and is on track for an even bigger increase in 2012.

The constant chatter about releasing the IEA oil reserves failed to push U.S. oil prices any lower and they closed with a slight gain just over $91 per barrel. The Shell CEO pointed out that the U.S. Energy Information Agency expects Gulf of Mexico oil production to decline by 330,000 bpd in 2012 because of the halt in drilling permits and nine rigs leaving the Gulf thanks to the administration's permit moratorium. That equates to lost production of 120 million barrels of light sweet crude in 2012. I seriously doubt the president will release another 120 million barrels from the Strategic Petroleum Reserve to make up for that lost production so expect fuel prices to rise again. Enjoy that cheap gasoline whiles it lasts. The national average dropped to $3.60 per gallon. It is $3.39 at Costco in Denver tonight so I am not complaining!

FYI, Senator Obama criticized President Bush on July 7th 2005 for releasing oil from the SPR after the hurricanes saying, "The oil in the Strategic Petroleum Reserve should only be used for real emergencies not for price manipulation." I guess he had a change of heart.

U.S. Crude Oil Chart

The equity markets sold off ahead of the weekend on fears of further events in Europe but the bond markets were finding plenty of buyers. Interest rates (yields) fell to a seven-month low and well under 3% on the ten-year note. This flight to quality has got to be choking Bill Gross at Pimco after he dumped all his U.S. debt a couple months ago.

Ten Year Note Yield Chart

Obviously for bonds to be soaring and yields falling there has to be stress somewhere else. That stress was being felt in equities and commodities. The dollar rose again and gold fell sharply for the second day. There were rumors some large funds were selling gold in order to raise cash to buy the dip in equities. They may also have been raising cash to prevent margin calls on other positions like oil futures and energy stocks. Gold hit $1559 on Wednesday and the highest level since the May 2nd record high but closed at $1502 on Friday for a major two-day loss. This is also a function of the rising dollar and falling euro since gold is priced in dollars.

Gold Chart

Tech stocks reversed their gains from Thursday thanks to earnings problems at Oracle and Micron on Thursday night. Oracle lost -4% and Micron -14% and they poisoned the tech sector with worries about future earnings problems in other companies.

The Q2 soft patch may have caused a detour in the road to $100 in S&P earnings for 2011. Those estimates are already starting to come down despite a lack of any big name warnings. Traders are worried those warnings are just around the corner.

The Q2 earnings cycle officially begins on July 11th when Alcoa reports. The next two weeks could be full of warnings now that the quarter is nearly over and that has pushed analysts to lower estimates now rather than be caught flat-footed with an unexpected surprise.

The bright side to this is the possibility of some upside surprises based on those lowered estimates. Obviously that would be sheer speculation since nobody of importance has guided higher recently. The trend is in the other direction with guidance being lowered. Time will tell but the next two weeks could have some potholes in the yellow brick road if major companies start to confess.

Google (GOOG) hit a new 10-month low after it acknowledged it received a subpoena in what is likely to be a broad antitrust investigation and review of business practices. The FTC has asked for access to information on search and advertising and Google said it was cooperating with the probe. European investigators are also stepping up their scrutiny of Google and questioning whether its dominance in search blocks the competition and harms consumers.

There are no positives here. Google only has downside from the probe and it could take years and billions of dollars before it is over. This will also act as a distraction to management and likely hinder acquisitions during that period. Google performed 66% of the searches in the U.S. in May with Yahoo at 16% and Microsoft 14%. Google had over an 80% of the searches in Germany, France, Italy and Spain in May according to ComScore.

An FTC official said they would be looking at things like how Google modifies their search results to "raise the cost for Google's rivals, raise their advertising costs and raise their development or operating costs." The FTC will also focus on whether Google ever tried to limit clicks to competitor websites by how it listed the search results. Obviously putting a Yahoo or Bing article on page two of the search results rather than page one would decrease the number of clicks through to that website. In addition to the FTC the states of New York, California, Texas and Ohio are in the early stages of their own antitrust investigations.

Google Chart

The airlines can't win. A day after spiking to multi-week highs on falling oil prices the sector was hit with investor concerns after United Continental (UAL) warned that second quarter revenue would be well below street estimates. UAL said in a regulatory filing that Q2 revenue would rise by 8.3% to 9.3%. Analysts were expecting more in the range of 11% to 12%. United blamed the revenue miss on a transatlantic revenue sharing agreement but then also said demand was consistent with a slow economic recovery. Consensus earnings estimates are $1.54 and UBS analysts believe that could be 30-cents too high.

AMR, parent of American Airlines said its revenue would only rise between 4.5% and 5.5%. Shares of AMR fell -5.6%. Earlier this month the International Air Transport Association industry group slashed their earnings estimates for the sector by more than half citing high oil prices, slow recovery and the turmoil in Japan.

Personally I believe any bounce in the airline is an opportunity for a long term short. Over the next two years oil prices are going to turn any airline profits into rivers of red ink. By 2015 only the very rich will be able to fly and there may only be 2-3 airlines left and those could be nationalized. Check back in 2015 and see if I was right.

United Continental Chart

Friday was the annual Russell index reconstitution event. Once a year on the Friday after option expiration the Russell takes a snapshot of all the stocks in their universe and reconstitutes their indexes. They sort all the stocks by market cap that meet their criteria. That is companies incorporated in the U.S. or a BDI country. They are over $1.00 per share and are not on the pink sheets or a bulletin board stock and have a market cap over $30 million. They must have traded on a U.S. exchange on the last business day in May. They cannot be a closed-end mutual fund, limited partnership, royalty trust, foreign stock or American Depository Receipts (ADRs), etc. After removing all the excluded stocks they sort by market cap. The top 3,000 become the Russell 3000 Index ($RUA). The top 1000 of those 3,000 stocks become the Russell 1000 ($RUI), the bottom 2,000 of those 3,000 stocks become the Russell 2000 ($RUT).

The Russell changes spiked the volume over the Friday to 8.5 billion shares and that was actually light for a normal Russell change day. Volume on Thursday's whiplash trading was 8.1 billion shares. Volume for the rest of the week averaged 6.1 billion shares. There will be some carryover into Monday but most of the funds tracking the Russell indexes are non discretionary so changes are as close to the modification date as possible. Russell claims there are $3.9 trillion dollars in investments tied to the Russell indexes.

Russell 3000 Chart

There was a lot of chatter on Friday about the debt ceiling discussion being kicked upstairs after the talks with VP Biden collapsed. President Obama has scheduled discussions with the leaders of each party for Monday and rumors are starting to slip out on what an eventual deal may look like. Treasury Secretary Geithner was interviewed on Friday and he alluded to a potential $2 trillion deal with no tax increases or a $4 trillion deal with some increases for people earning over $500,000 and elimination of come corporate deductions for things like corporate jets. Obviously they are a long way from a real deal but those rumors are probably trial balloons to see how their constituents will react. They are under the gun to get something done sooner rather than later in order to remove the cloud over the markets and prevent a credit rating downgrade due to the uncertainty. It will take a hike of about $2.5 trillion to get past the 2012 elections before this topic arises again.

If a deal was done next week I believe the market would celebrate. When the administration is doing politically questionable things like releasing oil from the SPR and announcing highly controversial events a year in advance like troops coming home from Afghanistan, a debt ceiling compromise would be a really positive accomplishment both parties could capitalize on before the July 4th holiday.

The S&P closed near the low for the day at 1268 but still over the critical support of the 200-day average at 1263. The rebound from Thursday was almost completely erased and internals were lousy despite the Russell changes adding volume. The reason for the swoon was blamed on the warning on Italian banks but I think the real reason we closed on the lows was worry over Greece. That is a very unstable situation and with only a five-seat majority in parliament it would not take but a few defections for the austerity vote to fail. There have been a lot of protests and nationwide strikes have been called starting on Monday. The GSEE union with more than 500,000 workers called the austerity requirement to get the loan a "mafia-style rescue." There could be news at any time over the weekend that could cause a triple digit drop at Monday's market open. Traders ran to the sidelines rather than face that risk.

Greece will definitely be an event risk over the next several days. However, on Friday EU leaders basically gave Greece a blank check and pledged not to abandon Greece or allow the nation to default. German Chancellor Angela Merkel said, "This is an important decision that says once again we will do everything to stabilize the euro over all." The leaders at the meeting said once Greece approves the new austerity plan they would immediately give Greece the $17 billion tranche of emergency funds and then immediately put together a second rescue plan estimated to be another 120 billion euros to be announced on July 3rd in Brussels. (On a side note, how do you help a country that has five times more debt than they could ever pay by giving them another loan that is twice again more than they can pay? Trying to cure too much debt with even more debt is irrational.)

President Sarkozy of France also said, "Greece is supported." Basically everyone is going out of their way to let the world know they will not let Greece default. They would like to have the Greek vote pass but based on the number of "support" comments it appears they are ready to bite the bullet to save the euro regardless of the Greek vote.

These comments did not come out until late Friday so the market already had its weekend event risk mindset going into the close. Depending on what Greek officials say over the weekend the fix appears to be in place unless there is an outright revolt in parliament.

To recap last week's comments the European banks have so much sovereign debt on their books from countries like Greece, Italy, Ireland, etc that they are essentially insolvent if they ever have to mark this debt to market. U.S. money market funds are in a panic. According to some analysts they have 50% of more than $3 trillion in cash invested in these banks. They are not rolling over their commercial paper to these banks so there is a liquidity squeeze coming. These banks will have a tough time selling new paper to replace those maturing loans. The Eurozone can't afford to let Greece default or those banks would also default, fail or be nationalized. Europe is hoping they can kick the can far enough down the road to give them time to work the banks out of this problem. I don't see this happening but they may be able to drag out the problem for 2-3 years by extending new loans and pretending there is not a bigger problem.

Eventually as the Eurozone begins to unwind and countries pull out of the grand experiment there will be a period where multiple countries default on their debt. The ECB has over $100 billion in Greek and Irish debt already. U.S. banks have nearly $100 billion in credit default swaps, that is known, on Greek, Irish and Portuguese banks and no telling how much in additional swaps that is unknown. As these foreign banks fail and the dominoes begin to fall around the world we could be headed back to a 2008 style credit crisis where banks won't lend to other banks because they don't trust their balance sheets. Let's hope the EU finance ministers can work a miracle and none of this comes to pass.

Assuming no major upsets in Greece over the weekend I still believe the support on the S&P will hold. That does not mean we are going to rocket higher but I would be very surprised if we moved substantially lower. Based on historical trends I was expecting a quarter end window dressing rally but I saw no evidence on Friday of any dip buying. I am withholding judgment until we get past the weekend and see what happens. This is definitely an inflection point for the market.

To be blunt the S&P chart looks bearish. Chartists always claim the chart tells the whole story and you don't need to factor in things like Greece, quarter end, debt ceilings, earnings, etc. I agree to some extent but I think we have seen over recent weeks that news events clearly over power chart trends.

While many analysts are focusing on 1263 and the 200-day as the critical support level I would also call 1250 and the March low a critical level. While a dip below 1263 would be critical, a dip below 1250 would be a disaster. We have tested the 200-day twice now with instant rebounds but Friday's close was nearly a third test. In theory a third test usually fails but theory does not take into account the calendar and the news.

S&P resistance is now a good distance above at 1300 and support is 1263 followed by 1250.

S&P Chart

The Dow lost its grip on 12,000 again but is still a long way from critical support at 11,600 and the March lows. The Dow is not very reactive to moving averages since fluctuations in individual stocks have such a dramatic impact on the Dow. Therefore the 200-day on the Dow is not that material as a support level.

The Dow is lagging on the current downtrend with the S&P and Nasdaq already lower on the charts relative to the Dow. We should watch the S&P for guidance and ignore the Dow as anything other than a sentiment indicator.

The Dow has not posted a gain in June since 2004.

Dow Chart

The Nasdaq has been extremely volatile over the last week thanks to big moves in several key large cap tech stocks. The earnings guidance from Oracle and earnings miss by Micron did not help tech sentiment but the Nasdaq still managed to close over the 200-day average for the fourth consecutive day.

May and June are not typically good for tech stocks. Earnings ease because of the end of school PC shopping and the lull before the back to school buying and then the holiday rush. Techs normally pick up again later in the summer. The technical problems with shares in Apple and Google are a very heavy weight for the rest of the Nasdaq issues to drag around. We saw how strong the Nasdaq rallied when Apple had an $8 day. On Friday Apple, Google and Priceline lost a combined $18. That is a significant anchor but the damage was not that bad relative to support.

Resistance is just below 2700 and a move over that level would be a breakout. Critical support is 2615.

The Semiconductor Index is relatively weaker and that is producing extra drag on the Nasdaq. Critical support on the SOX s about 390.

Nasdaq Chart

Semiconductor Index Chart

The Russell 2000 index is not relative for Monday because of the reconstitution. There will be dozens of new stocks in the index on Monday and dozens of old stocks will be gone. Russell balances the index weighting to roughly correspond to the closing price on Friday but it will remain slightly more volatile for the next several days as fund managers complete their adjustments.

I like that the Russell is holding well over support but we don't know how much of that is related to the index rebalance. This is a sentiment indicator only for next week.

Russell Chart

There is event risk this weekend from ruling party defections in the Greek Parliament. Only six of the 155 members of Prime Minister Papandreou's ruling party have to vote against the austerity plan for it to fail. At least one high-ranking deputy, Alexandros Athanasiades, said he would vote against it because of provisions in the plan. With protests all over Greece and nationwide strikes planned it would not be surprising to see five more lawmakers switch sides.

While this would cause a major news event and market disruption the comments from the EU officials late Friday suggest they would find someway to work around it. While the event risk is great for market disruptions the final result will most likely be a dispersal of the funds and a new bailout of some sort. We just have to put up with this slow moving train wreck a few days longer. Who knows, maybe the U.S. will come up with a debt ceiling deal to overshadow the European political theater currently in progress.

I am still leaning towards a bout of quarter end window dressing but I could easily see the Greek news over powering any thoughts of buying by fund managers. Uncertainty is a market killer and we will definitely have uncertainty next week.

I would continue to be very cautious. Enter passively, exit aggressively.

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Jim Brown

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