Only ten days into September and it is proving it could be one we will remember with the U.S. markets down 5 of the last 6 days.

Market Statistics

The U.S. indexes have been down 19 of the last 24 sessions and that is not something we see every year. The Dow had triple digit moves in those 19 sessions. Sentiment was definitely negative on Friday but you have to remember, just like last Friday, there is significant European event risk over the weekend as well as terror risk. With Greece one headline away from an official default there was no reason to be long the market over the weekend. I wrote last week that the assumed default of Greece was to some extent already priced in but every new headline is being treated as a new chapter in the story.

This is like one of those Saturday afternoon movie serials from the 1950s. Every week was a new cliffhanger but the hero always found a way out at the beginning of the next installment. Today we are seeing a new cliffhanger headline every Friday and then the market rebounds the following week when Greece does not disappear beneath the ocean like mythical Atlantis. Lately we have had a new cast of villains every week. Last week it was Italy and strikes against austerity along with pending votes in Germany on the constitutionality of the bail outs and bond purchases. Eventually investors are going to tire of the European shell game and focus on the U.S. fundamentals. Unfortunately that carries an entirely different set of risks.

Friday had no major economic reports to roil the market but it was already roiled from the events in Europe. The Wholesale Trade report showed inventories rose +0.8% in July compared to +0.6% in June. This is a lagging report and it was ignored.

Next week's calendar increases in intensity with both CPI and PPI as well as the Philly Fed Manufacturing Survey and NY Empire Manufacturing Survey. The most important of those is the Philly Fed Survey, which is expected to improve to -15 from -30.7 in August. Even a -15 would still be ugly since anything under zero means a contraction in business activity.

In the August report back orders were -21 and had been negative for four months. New orders fell from slightly positive to -26.8. This was a very negative report and it killed the rebound off the August 10th lows and knocked the S&P back to those lows at 1120. It has been a month now and the indexes have been range bound and we could easily revisit those lows if the Philly Fed does not show a dramatic improvement. The Philly Fed has a high correlation to the national ISM that comes out the first week in October. That makes the Philly Fed a predictor of the ISM and a sentiment indicator for the rest of September. A decent rebound in the report could go a long way towards rebuilding investor confidence.

Consumer Sentiment for September is released on Friday and we really need to see a strong rebound in sentiment. The debt limit debacle is now well behind us so that should fade as a concern for consumers. However, the Europe mess is another faceless monster under the bed. Most consumers don't understand it but they know it is killing our markets and that makes it bad. If Greece eventually defaults I believe they would understand that and the crisis of confidence would fade. You fear what you don't understand but once that fear has a face it becomes far less of a problem.

Economic Calendar

The challenge in Europe is still the future default of Greece. Everyone in Europe says it won't happen but the bond markets are giving it a 91% chance. The 10-year Greek bond has a yield of 20%. The 2-year is 65% and the 1-yr is over 80%. That represents an extreme lack of confidence in Greece and their ability to work through the problem.

As I have described before the problem is not with Greece itself but with the European banking system that owns billions in Greek debt. Now that Greece is expected to default the European banks are imploding. German banks are down -36% since early July. Italian banks are down -38% and French banks -43%. Credit default swaps are now higher than they were during the 2008 financial crisis. Nobody really knows which banks have what kind of exposure to Greece.

Secondly, if Greece defaults and life continues without the crushing debt burden and forced austerity then Italy, Ireland and Portugal might consider hitting the panic button and taking the easy way out as well. That means even more problem for European banks and it is the main reason why the IMF, ECB and the EU finance ministers can't let Greece default but they may not have the will to keep it from happening.

Despite many claims to the contrary the potential for a Greek default had Germany preparing a bailout plan for banks in case a default occurs. The emergency plan "B" involves measures to help banks and insurers recover from a possible 50% loss on their bonds if the next tranche of Greece bailout funds are withheld. That is a strong possibility after the EU team tasked with auditing the Greek compliance with agreed austerity measures went home in disgust last week after being denied access to documents. The Greek failure to adhere to the agreed upon austerity measures could result in the bailout funds being withheld and pushing Greece into default. The team is supposed to return on Monday and documents will have to be made available or "else" according to a German official.

German Chancellor Merkel said last week, "The EU won't be able to avoid treaty change" and policy makers "shouldn't be afraid of tackling the challenge." Also, euro countries will "only preserve the common currency if there is more integration in the European Union."

Nearly every speech by anybody important last week carried the implied threat of critical and formative change coming to the European Union in the months ahead. Treasury Secretary Geithner said in a interview at the G7 conference in France, "policy makers are moving but I think they are going to have to demonstrate to the world they have enough political will." In other words talk is cheap. Nobody wants the EU to fracture and have members leave but they are currently unwilling to take the steps necessary to keep it from happening. The EFSF was engineered with a face value of €440 billion ($620 billion) and analysts believe it needs to be raised to €1.0 trillion in order to head off problems with Italy and Spain. That many zeros is producing a severe case of sticker shock for most of the EU nations.

On Friday the big news that threw the markets into a tailspin was the unexpected resignation of the top German official on the board of the European Central Bank. Jurgen Stark resigned for "personal reasons" but he was strongly opposed to the bank buying €50 billion to purchase Spanish and Italian sovereign bonds last month. He still had three years remaining on his term on the board. Another board member, Axel Weber, the assumed successor to Jean-Claude Trichet whose term expires next month, abruptly resigned in April in protest over the purchase of Greek, Irish and Portuguese bonds. Several other board members also oppose the bond purchases so the sudden resignation of Stark suggested the ECB's resolve was also weakening.

Analysts are worried that continued buying of weak sovereign debt could put the ECB in jeopardy of needing a bailout or recapitalization. Who rescues the rescuer?

The ECB is also under fire for not cutting rates last week. They are currently at 1.5% but the real rate in Europe is more like .75% and analysts thought the ECB should relax policy to head off a recession after all the major players slashed GDP forecasts for the euro zone earlier in the week. Analysts were astonished by the lack of action. Personally I am afraid the same lack of action by the Federal Reserve on the 20th could cause a serious market upset in the USA.

The deadline for the Private Sector Involvement (PSI) in rolling over the existing Greek debt into new bonds at a different value was Friday Sept 9th. However there was some confusion over the Asian roadshow promoting the conversion so we really don't know if the Friday deadline was real or has been pushed back. This should be clear on Monday. The plan requires 90% participation in the soft restructuring scheme in order to make it happen. The latest numbers only show about a 70% acceptance of the proposal. If the PSI fails then the second bailout for Greece fails and given the rapidly worsening mood in Europe towards Greece the odds of further funds for Greece appear very slim.

That means Monday in Europe could be a very event filled day and that is precisely one reason why U.S. traders wanted to go home flat or short.

What they did not short was treasuries. The flight to safety pushed the 10-year note yields to new 60-year lows at 1.896% intraday. I was sitting next to a table of retirees at lunch on Friday and they were complaining about not making enough interest off their retirement funds to live on. One elderly gentlemen claimed he had $550,000 spread across several accounts and he was only getting 0.7% in interest. He was openly hostile and I was quietly listening in to their conversation (research) until the gentleman started off a loud sentence with "Obama has got to fix this. He is going to force me to go back and live with my kids!" I think somebody noticed the expression on my face and they promptly lowered their voices. Later the discussion heated up again but I quit listening after the topic changed to how Exxon and Chevron were cutting production on purpose to keep the price of gasoline high so they could pocket big profits. I guess the evil oil company message is also finding a home in the social consciousness.

I find that level of political and economic comprehension fairly standard for the majority of consumers. Unfortunately they are the ones who are being hurt the worst by the current economic environment.

Ten year note yield chart

The Euro fell off a cliff last week with a -5% drop from highs of the prior week. This is a monumental move in a currency. It suggests there is a high degree of expectation for a crisis event in the euro nations. The dollar soared to a five month high in a flight to quality response.

Euro Trust Chart

Dollar Index Chart

The spike in the dollar kept gold from retesting its highs despite the high drama in Europe. Gold closed slightly positive at $1861 but relatively tame for the day. There were rumors of a possible margin hike but nobody really took them seriously or there would have been a big sell off. Those rumors could have been a secondary reason for the decline on Thursday to $1793.

Gold Chart

The rising dollar and GDP cuts in Europe did weigh on crude prices. U.S. WTI crude declined -$2 to $87 on fears an austerity fueled European recession would spread to other regions and depress demand. With oil holding at $90 on Thursday and very near a breakout on hurricane worries it was time to take profits when tropical storm Nate turned west for an apparent landfall in southern Mexico. Producers and explorers in the Gulf breathed a big sigh of relief and went back to work. Conditions could still change but the threat has eased.

Tropical storm Maria now appears it will turn north and miss the east coast completely as it blows by Bermuda. Both storms declined in intensity.

Tropical Storm Maria

Crude Oil Chart - Daily

Research firm Wood Mackenzie issued a report on Libya and the anticipated return to production. While they said it was possible to boost production to 600,000 bpd in 3-6 months "once hostilities cease" the speed of the recovery would depend on the National Transitional Council and help by the international community with infrastructure repair. Wood Mackenzie estimated it would take 36 months to resume full production of 1.6 mbpd once the conflict ended, all the governmental problems were resolved, removal of international sanctions, return of tens of thousands of international workers and available funds for the repairs. The longer production is offline the longer it will take to recover because of deterioration in fields, equipment and infrastructure. Until Gaddafi is captured there is always the potential for sabotage and the delay of returning workers. Don't expect any sudden drop in the price of Brent crude as a result of Libyan production resuming.

You know it was a slow news Friday when the big story was a possible merger between AOL and Yahoo. Reportedly AOL CEO Tim Armstrong approached private equity firms to gauge interest in a deal with Yahoo that would put Armstrong in as head of the combined company. Tim, back away from the bar and get a grip on reality.

Yahoo is many things but I certainly hope they are not that stupid. AOL is in terminal decline as dialup Internet goes the way of 8-track tape. Yahoo is having enough trouble staying afloat in the Google sea without taking on an anchor the size of AOL. Shares of AOL declined -5% after CNBC reported a Yahoo source said they had no interest in AOL. One reporter headlined his piece, "Two dogs don't make a right." Armstrong probably thought the leadership vacuum at Yahoo was an opportunity to improve his fortunes rather than go down with the AOL catastrophe as the last position on his resume.

AOL Chart

YHOO Chart

Despite issuing an earnings warning on Thursday night Texas Instruments posted a gain on Friday with the Dow down -300 points. If you want logic don't look in the stock market. The reason for the gain? Analysts said the warning was not as bad as they expected. I guess the key here remains to under promise and over deliver. Unofficially you talk down expectations and then only lower them slightly in the official release.

SanDisk (SNDK) and Micron (MU) were also up fractionally on Friday on positive comments from analysts. Baird Research predicted SanDisk would gain market share as it gears up to produce more chips for Apple's iPhone. The analyst believes inventories of flash chips have fallen more in line with current demand and that should strengthen pricing for the rest of the year.

If your retirement account is not doing so well this year don't feel like the Lone Ranger. A study last week reported more than 47% of fund managers are underperforming the market. Since the S&P is down more than 8% for the year that means 47% of funds are down more than 8%. Volatility has been so high over the last month many funds have increased their trading in order to capture 2-3% moves and go back to cash. This will eventually bite them when a real rally appears. They will get caught in cash on the sidelines with a 2% gain from the last move and end up chasing stocks higher. Unfortunately once you develop a trading mentality every 2-3% gain looks like a selling point and you end up jumping in and out on the long rallies and never capturing the real move. I believe we will see a real rally by year end, only 3.5 months left, and it could be strong because all these fund managers will be chasing it.

Obviously that assumes we don't fall back into recession. Yes, I know what "assume" means. I keep hearing all these analysts claiming a 50:50, 55:45, 51:49% chance of falling back into a recession. That is an exercise in political correctness. We don't really know so we are going to pick some neutral ground so we can be correct regardless of the outcome. Come back to the microphone when you actually have an opinion!

At present I don't think we are going into recession. Profits are still strong. Consumer spending is holding up even with the high unemployment. The Fed will add some form of stimulus at the meeting on the 20th. Some provisions of the jobs proposal will become law. Every minor improvement in overall conditions is microscopic today but in the end the economy is still growing. The debt limit debacle is behind us and interest rates will be near zero for the next 18 months. As long as we are not struck by a meteor while we wait those factors will eventually produce growth. Greece may default but the European economy will not self destruct. Unemployment will remain high for the foreseeable future but it is priced into the market. There is plenty of bad news if you want to focus on the negative.

When I sat down to write this commentary I was negative for next week. After about eight hours of research and writing my outlook has improved. I believe Friday's decline was yet another fear of the weekend darkness trade. Nobody wanted to be long if there was a possibility of a Greek default and terrorist attack. Volume was higher than I would have liked at 8.9 billion shares but it was the Friday before option expiration. This is when volatility should be its highest as institutions roll positions forward or exit completely. There was no urgency to exit and no panic selling. We gapped down -200 points to 11,100 on the Jurgen Stark news and held that level for 90-minutes. At 11:AM a new sell program hit to knock us temporarily below support at 11,000 by noon but that is where the selling ended. We traded sideways the rest of the day on steady volume. There was no plunge into the close and support at 11,000 held. That support dates back to November.

Can we go lower? Absolutely! We could easily test 10,700 again on some event in Europe or a worsening of the Philly Fed Survey. S&P 1120 is calling our name and with the right set of circumstances we could see 1100. This is September and the economic and political storms are swirling.

I believe the markets are scared. They are scared about Greece. We have found that Greece is the new Freddie Kruger and the crisis that can't be killed. Eventually the crisis will pass into oblivion just like Freddie Kruger but until then there is a default behind every door and a recession under every bed. The bears are coming out in force and while they could be right in the short term they will eventually be proven wrong. We just need to bide our time and watch for signs of relative strength returning.

The S&P chart has built a nice bear flag that is in danger of breaking to the downside to confirm but it still has to break below 1120 to cause any real damage. That has been strong support since early August. Technically 1101 was the August low so any dip to that level is just a retest. A dip below 1101 would be a confirming breakdown. It would take a strong move over 1225 to attract reluctant buyers. That gives us a huge range to play in while we wait for Greece to cut their lifeline to the EU.

S&P Chart

The Dow is a weaker chart than the S&P. The Dow broke important uptrend support from early August and the top on Thursday is a lower high. It would appear the Dow is setting up for a critical test of 10,800. That is a critical level and a break there could cause a breakdown in sentiment that leads to a retest of Dow 10,000. We don't want to go there so next week is very important. I believe fund managers will buy 10,800 because they don't believe we are entering a bear market.

Dow Chart

The Nasdaq traded in line with the broader market and ended the week right in the middle of its recent range. The lower high from Thursday gives it a negative bias but I think the additional circumstances have to be taken into consideration. Support at 2400 should be decent followed by 2335.

Nasdaq Chart

Russell Chart

Fundamentals used to matter. In the current market environment every move is based on a macro event like the Greek crisis, debt debacle or the terror warnings. The fundamentals based on corporate earnings are still strong. S&P earnings for 2011 are expected to be in the range of $100 and 2012 around $107. Apply a PE of 15 and you get an S&P at 1500 and 1605. The case for a rising market can easily be made using those numbers.

However, if the country falls back into recession those estimates decline to $75-$85 for forward earnings and the market is closer to fully valued at 1125-1275. Guess what? That low range is exactly where we are today. The market is already pricing in the potential for another recession or at least a few more months of very slow growth.

Whether we get that growth or not is the $64 question. Even if we did see a dip in GDP it does not mean we are in a crisis. The impact of the great recession of 2008 is still with us. The rebound faded because of the high unemployment and this could be a lasting problem that takes years to solve. That does not mean the economy can't muddle through even with the high unemployment. Time will tell.

What was the difference between Thursday and Friday? Why were they so dramatically different? I believe it boils down to only a couple of points. It was the Friday before expiration and volatility is normally higher as institutions close and roll positions forward. There were repeated rumors Greece would default over the weekend. I seriously doubt anyone really believes Greece will not default. According to John Mauldin and others it is mathematically impossible to avoid a Greek default simply because their debt is so high.

The key is how that default occurs and how the euro zone, ECB and IMF deal with it. The news of a default will create volatility but if you check the history books countries default all the time. What makes this different is because Greece is part of the euro zone and their default will damage banks all across Europe. Finance ministers know this and they will have to solve the problem or we will have another Lehman type event only on a sovereign level. Unlike Lehman and Bear Stearns we have had two years to prepare for Greece to fail and only two weeks for the Lehman events to transpire. A Greek default is priced into the market. There will still be volatility but it will be manageable.

I believe the decline on Friday was due in part to Greece, Germany's plan B, Stark's resignation from the ECB and a lowering of economic projections for Europe and Japan. However, all those events were just cloud cover for the real problem. On Thursday night the government announced there was credible evidence of another Al-Qaeda plot to attack Washington and New York on the anniversary of 9/11. Since it is a proven fact Al-Qaeda likes to attack on anniversaries and the government was mobilizing tens of thousands of police and security forces most traders saw the perfect storm of all those factors above as an excuse to exit the market. After all would anybody actually want to be long the market on the anniversary with the government reporting credible threats?

Whatever the reasons for the downdraft, Monday will be a new day. On Saturday Greek prime minister George Papandreou delivered his annual keynote speech on the Greek economy. He promised Greece will meet the ambitious targets for austerity despite the deepening recession in Greece. He said it was necessary to secure the continued flow of international rescue loans keeping the country from a catastrophic bankruptcy. "We will push through all the major changes our country has needed for years and we will take whatever other decisions are needed and we will do whatever is necessary to keep the country on its feet." The speech appeared to calm nerves in Europe but we all know talk is cheap.

If we make it to Monday without any attack and without a Greek default I believe the markets will breathe a sigh of relief and the selling will ease if not disappear. I would be a buyer at S&P 1120 because traders should buy stocks in anticipation of additional Fed action on the 20th. I see the current events as a buying opportunity unless conditions in the U.S. worsen. The Philly Fed this week will be critical for market direction although bad news would make it more likely the Fed will act more aggressively.

Jim Brown

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