I have heard many times it does not matter how something happens, only the results count. For last week I believe the "why" matters more than the results.

Market Statistics

If you only saw the score of a football game at 27 to 28 you would assume the teams were evenly matched. Would it change your opinion if you found out the winner came back from being behind 27 to zero with ten minutes to play to win the game? Would your opinion of the winning team change if you found out the losing team threw two interceptions for touchdowns, fumbled the ball in the end zone that was recovered by the other team and kicked a punt into a defender that rolled into the end zone where it was recovered by the defender for a touchdown? In those circumstances did the winning team win the game or did the losing team lose the game?

Last week the bears lost the market but not because of anything they did. The bears were setup to score on Tuesday at the 1075 level on the S&P and they could not hold their gains. The bulls intercepted a rumor of a bank bailout from Europe and knocked the bears back and gained possession of the ball. They proceeded to build on those gains as headline after headline from Europe flattened the resolve of the sellers. Add in a few unexpected plays from the economics special team and the bulls ended the week with a +2% gain instead of a -5% loss at Tuesday's lows.

We were hostage to Europe and economics and those factors have temporarily faded. In fact the number of positive surprises was unexpected. After months of saying there was no problem with the banks the Eurogroup suddenly started making plans and commenting on the necessity of bailing out their banks and supplying additional capital. After months of denial there was suddenly an acceptance and an urgency to get something done. New plans and resurrection of old ones from the 2008 crisis were suddenly popping up all over. Merkel and Sarkozy are meeting this weekend to work out some details so they can provide a united front at the special EU summit on the 17th.

France and Belgium joined together last week to support Dexia, a European bank with 32,500 employees and its main operations in Belgium, Luxembourg and Turkey. France and Belgium are meeting this weekend to finalize the breakup of Dexia, a bank with 512 billion euros of credit risk exposure. Some of its parts will be nationalized and some sold off to other banks. The market saw this news as positive but is it really? Is the government takeover of a major European bank positive?

The ECB made unlimited loans available to banks for the next year and the Bank of England announced an extension to their quantitative easing program. Greece unexpectedly found it had enough money to last until mid November. The number and complexity of the various plans and the sudden postponement of a default in Greece until mid November suggests the Eurogroup is going to prop up their banks and protect them from any sovereign debt problems and then let Greece default in November with no material impact to the European banking system. It is a good trick if they can do it.

In the U.S. the economics steadily improved and there was no sign of recession. Everyone worrying about the U.S. falling off the economic cliff the week before were being forced to reconsider their positions. The extremely bearish environment of just a week ago evaporated and the bears were wondering what happened.

On Friday the Nonfarm Payrolls came in much better than expected with a headline gain of +103,000 jobs. Not only was that better than expected but August was revised higher from zero to +57,000 and July was revised from +85,000 to +127,000. Overall that was a net gain of +202,000 jobs over what was previously reported the last 90 days.

You would think everyone would be thrilled. Personally I was shocked because I was sure the zero reading in August would be revised lower. To be revised higher by 57,000 jobs was a real surprise.

If you look under the headline number the economy actually created +137,000 new private jobs in September. Government lost 34,000 jobs to drag the headline number down. The glass half empty analysts complained that 45,000 of the gain in private jobs was due to the ending of the Verizon strike and those people going back to work. I explained this last month that they were counted as job losses in August and would be added back in September.

For an economy that appeared to be on the edge of recession in September the 137,000 new private jobs was a surprise. I did point out more than once last month the regional activity reports were showing improvements in the employment components even though the top line numbers were flat.

Health care employment rose by +44,000 and construction jobs rose by +26,000. Business and professional services rose by +48,000. Manufacturing lost another -13,000 and electronic and appliance stores lost -9,000 jobs.

In the separate Household Employment Survey the number of jobs rose by +398,000. Unfortunately the labor force grew by 200,000 and that kept the unemployment at 9.1%. The broadest measure of unemployment rose from 16.2% to 16.5% or 25.8 million people. That includes 14.0 million currently unemployed, 9.3 million working part time because they can't find full time employment and 2.5 million "discouraged workers" who have given up looking for a job.

The economy has to create a minimum of 150,000 jobs per month just to keep up with the population growth and that does nothing for those already unemployed. Last month 200,000 new people joined the labor force. That does not mean they have a job but they are looking. We would have to create 350,000 jobs or more per month to make any material dent in the 25.8 million currently unemployed and it would take a very long time.

The average length of unemployment rose to 40.5 weeks even though there are more than three million positions currently unfilled due to lack of skilled workers.

Regardless of how we report the numbers this was good news. Including the September jobs and the upward revisions to the prior two months the economy added more than 200,000 jobs. That is far from a recession but it is still very slow growth. This report moved analyst expectations away from the edge of the recessionary cliff but we can still see the cliff from here. We need to build on these numbers in the months ahead.

Nonfarm Payroll Chart

The following chart from CalculatedRiskBlog shows the time for jobs recovery back to peak employment after a major recession. Note that this time it is deeper, longer and the recovery much slower compared to prior recessions. The other long line was the 2001 recession. We have a long way to go.

Calculated Risk Job Loss Chart

The Monster Employment Index, also released on Friday, rose one point to 148 and the second monthly increase. It was 144 in July. The index showed broad gains across multiple industries and multiple regions of the country. Analysts believe it projects continued job gains over the next 2-3 months.

The index measures help wanted ads placed online by U.S. employers. The gain pushed the index to its highest level since October 2008. An increase in job ads should result in an increase in hiring. Jobless claims are slowly declining and could be under 400,000 per week by the end of October.

The pace of job growth and the different data points relating to hiring is excruciatingly slow but it is growth. The debt ceiling debacle in August had a definite impact on hiring, production and capital expenditures. I only hope we don't see a repeat when the super committee presents their recommendations around Thanksgiving.

Moody's Monster Index Chart

The economic calendar for next week is light with the FOMC minutes the only real pothole. The risk to the market is the European events. Merkel and Sarkozy are meeting over the weekend to talk about bank recapitalization with an announcement expected on Monday. The following weekend the EU meets in Brussels to discuss the EFSF and anything is possible. Now that the bank recap talks are underway we are at risk every day of somebody in Europe saying something they shouldn't and tanking the market.

After last week traders are upping their doses of "hope-ium" with visions of a Q4 rally quickly overcoming reality. European officials can end that hopium induced state of euphoria with a single sentence.

Economic Calendar

The earnings cycle kicks off next week with Alcoa on Tuesday but the big reports for the week are JP Morgan and Google on Thursday. The banking sector has been in the tank since July as global traders shorted U.S. banks as a hedge against Europe when the European exchanges halted bank shorting overseas. Many of those shorts were quickly erased last week but the sector lost -4% on Friday on profit taking and fears of a weekend news event. The JPM earnings on Thursday could go a long way towards reassuring U.S. investors the banking system is solid or it could knock the sector back to the lows if they miss earnings, warn or say something stupid.

Bank Index Chart

JP Morgan (JPM) is trading at $30 and it is an outstanding bank. Yes, it has problems left over from the financial crisis but we will look back at JPM at $30 and kick ourselves for not loading up. I believe we need to get past the JPM earnings, listen to the guidance, make a judgment call on Europe and then decide how we want to play the rest of the banking earnings. There could be some decent trades there. Dow component JPM was down -5% on Friday. Earnings are expected to decline to 96-cents from $1.01.

JP Morgan Chart

Google (GOOG) has a really rocky history of reacting to earnings reports. The spike back in early July was earnings related as was the spike last October. Earnings at Google are rising sharply but so are expenses. Google has been hiring thousands of people every quarter and they tend to spend a lot of unnecessary money. Google at $475 was my suggested buy point the last time I wrote about Google but I would not ever recommend holding a Google position over earnings. The risk of $30 moves is simply too great. Those moves make great entry points when they occur to the downside. Google earnings are expected to increase from $7.64 to $8.74.

Google Chart

In stock news on Friday Sprint (S) was a big mover after comments made at an investor conference. Earlier in the week Sprint said it was going to buy $20 billion of iPhones from Apple. They will lose $400 or more on each one because of the initial subsidy to encourage retail sales. They will make money on the backend of the user contract and on data plans. On Friday they told analysts they were going to abandon the Clearwire network and build out their own 4G system. That was good news except they will have to go to the capital markets to raise the $7 billion needed to create the network by the end of 2013. They claim it will save them $10-$11 billion once completed but they will have negative cash flow over the next several years.

By abandoning their Clearwire effort they are admitting the WiMax plan had failed. They will quit selling phones using the WiMax network by the end of 2012. Sprint owns 54% of Clearwire so that leaves the company without a major customer and in serious need of a new network to compete with the other majors.

When asked about the future of Clearwire the CEO, Eric Prusch, was evasive. He said he was optimistic the company could raise the $1 billion necessary to continue to upgrade and operate the network through 2012 and that Sprint was still dependent on them until the end of 2012. Analysts grew hostile at Prusch and continued to ask increasingly pointed questions.

Joan Lappin of Gramercy Capital Management angrily asked the Sprint CEO, Dan Hesse, why Sprint was spending so much to upgrade its own network while Clearwire, which has more spectrum than Sprint, still lacked needed funding. The question was greeted by loud clapping and cheering among analysts and investors. Can you say "hostile room?" Hesse declined to comment on whether they would provide more funding for Clearwire. He was then asked directly if Sprint would let Clearwire file bankruptcy. He responded, "if there was a bankruptcy he would expect it to be constructive." Looks like a divorce in progress to me. Rarely does an analyst meeting decline into a mob scene but it came close on Friday and the stock was hammered. After opening up more than 10% it was crushed for a -20% loss after the meeting turned hostile.

Sprint Chart

Clearwire Chart

Another company making headlines was genetic analysis tool maker Illumina (ILMN). The company said it was slashing revenue and earnings estimates because of concerns that research funding will be reduced. Illumina said customers were delaying orders for equipment because of uncertainty surrounding research funding in the U.S. and Europe. Illumina cut revenue estimates to $235 million and well below analyst estimates of $278 million. The company said the U.S. government was looking to curtail spending and could reduce the research budgets for agencies including the National Institute of Health. "It is a pretty safe assumption because of the events in Washington that NIH budgets are not going up." ILMN fell -32%, PKI -8%, BRKR -4.4% and AFFX -5%.

Illumina Chart

The markets were doing ok after the jobs report on Friday until news broke that Fitch had downgraded Spain and Italy. Fitch downgraded Italy from AA- to A+ citing high public debt, low growth and "politically complex" solutions necessary to fix the financial conditions and earn back the trust of investors. Moody's downgraded Italy on Tuesday.

Fitch cut Spain to AA- from AA+ citing increased risks from the eurozone financial crisis as well as high debt levels and weakening growth prospects. Fitch kept a negative outlook on both countries suggesting there could be further downgrades ahead.

After the close on Friday Moody's put Belgium's Aa1 rating on downgrade review. Moody's said it was due to "The uncertainty around the impact on the already pressured balance sheet of the government and the additional bank support that will likely be needed." France and Belgium have jointly agreed to bailout Dexia for the second time in three years. Unfortunately Belgium is not that far away from needing a bailout on their own.

All three ratings agencies are now considering further downgrades of the weaker European countries because of the likelihood they will have to put up billions of euros they don't have to shore up the banks before Greece can default.

This is one of the problems facing the markets next week. As the bank bailout conversations increase in intensity the number of euros required will rise. Without a coordinated effort by all of Europe there are several countries that may not be able to follow through on a meaningful support program. Secondly, anything the EFSF does could increase the capital requirements on the member nations. It is a tricky situation where they are d***ed if they do and d***ed if they don't provide support.

Analysts are expecting a high profile announcement from Merkel and Sarkozy on Monday as an expression of solidarity meant to bring all the other nations in line on the coordinated bailout. Conversely, a weak statement or a failure to come to an agreement could be devastating to the market rebound.

Last week all the bad news was priced into the market. The number of bearish analysts counted in the investor's intelligence poll was the highest since early 2009. Today some of those bearish factors have faded and expectations are improving. I would hate to go back to last week's lows but it depends completely on comments out of Europe.

The Q3 earnings cycle has produced no real surprises so far. The number of negative pre-announcements has been minimal. Earnings estimate revisions have been mild. We should know by the open on Wednesday the 19th how the quarter will turn out. IBM reports on the 17th and Apple/Intel on the 18th. If companies are not missing estimates and slashing guidance we should be ok and the markets will continue digesting the news from Europe as it moves slowly higher in anticipation of an eventual resolution.

The bad news is priced into the market until it isn't. Once investors begin expecting higher earnings and better news out of Europe the market will be in danger again. We need low expectations so we can better handle the bad news. There will be bad news, you can count on it. The key is how the market reacts. When the Q2 earnings were released and guidance given the country was heading into the August 1st debt debacle. Most companies probably downplayed expectations given that negative news cycle. Hopefully they will over deliver now that the initial debt crisis is behind us.

I believe most investors are tired of selling. Even the ones who make a business out of it are losing interest because the easy money has been made. Pushing lower from here could be a challenge. Buying the dip may be the easiest way to ring the cash register in the days ahead but I think we need a little more positive news to light the fire.

Despite the strong rebound the markets are still oversold long term. That is the strongest factor on the side of investors.

I know a lot of people were disappointed the S&P gave back -14 points at the close. Come on guys, after a +95 point gain in slightly over two days you should expect some profit taking. With traders facing extreme weekend event risk I am surprised it was not -25 points.

Merkel and Sarkozy meeting over the weekend to discuss bank bailouts. What could possibly go wrong? Also, China's stock market was closed all last week for the National Day holiday. Given the events of the past week in Europe you would expect China's market to open higher BUT I have no clue if there were any events in China/Asia last week that would weigh more heavily. We just have to wait and see. The point is still the weekend event risk and it was a strong reason to take profits before the close.

I was actually fairly impressed the markets held up as well as they did on Friday. The Nasdaq was down thanks to the biotech sector and a decent decline in Apple. Apparently some investors may be rethinking the post Jobs environment or just taking some chips off the table.

Good thoughts and hopeful expectations aside, we still have a confirmed pattern of lower highs and lower lows on the S&P. Until that pattern actually breaks this is just a bear market rally. Also, the 50-day average at 1177 is waiting to be tested. Even if events in Europe work out to our advantage over the weekend, the road ahead is going to be bumpy.

Initial support should be 1150 followed by1120 and 1080. Let's hope we don't go to 1080 again. Resistance is 1177, 1200 and 1220.

S&P Chart

The Dow traded in a 180 point range but only gave back 20 points at the close. That was an amazing performance after better than an 800 point rebound from Tuesday's lows. Traders were still buying the dip at 3:PM on Friday. Maybe it was just shorts covering after the drop on the downgrade of Spain and Italy at noon failed to hold but then again maybe not. We could be seeing the first indications the dip buyers are coming back. Time will tell.

Resistance if 11,200 and 11,400. Support is 11,000 and 10,600.

Dow Chart

The Nasdaq was the weakest of the big cap indexes on Friday thanks in part to the biotech weakness led by ILMN. However, there was plenty of weakness to go around. Chinese stocks and solar stocks returned to their losing ways.

The Nasdaq failed at the 50-day average resistance, which was also the round number resistance at 2500. This would be the perfect place to start another decline and tech buyers may not want to be in the market over the Google earnings event. Until the Nasdaq moves over 2600 it will not get any real respect.

Nasdaq Stocks Top 10 Winners-Losers

Nasdaq Chart

The Russell is our canary in the coal mine for the stock market. The Russell 2000 lost -2.6% on Friday and several times more than the Dow (-0.2%) and S&P (-0.8%). The Russell even lost more than twice the -1.1% decline in the Nasdaq. This was NOT a bullish showing and it is a clear warning for next week.

The Russell failed at short term downtrend resistance and it was a major sell off of -17 points. The Russell is screaming caution for next week. There is major overhead resistance at multiple levels and the Russell is well below the relative position of the other indexes. The Russell outperformed the other indexes on Tue-Thr because it was the most heavily shorted and then most heavily squeezed. It appears those shorts came back on Friday when the Russell severely underperformed the bigger indexes.

Another decline below prior support at 650 could mean another retest of the lows or even a lower low. Small cap buyers better appear quickly or the Russell is going to poison investor sentiment.

Russell vs Dow Chart

Russell Chart

When I sat down to write this commentary on Friday afternoon I was mildly bullish and in the buy the dip camp. However, by late Saturday afternoon I have a lot more concerns about what we may see next week. The Russell is telegraphing weak sentiment on the part of fund managers and it could be telling us the market is going to retest the lows. The dip to 1075 last week may not have been sharp enough or long lasting enough to really get a washout of weak holders despite the positive signals from the internals and the 90% volume imbalance days.

Secondly, and probably third, fourth, fifth, etc, is the mess in Europe. Comments out on Saturday suggest Merkel and Sarkozy have a huge gap between them on how to prop up the European banks. There may not be a united front on Monday and a divided front at this stage could be a disaster.

In John Mauldin's weekend newsletter he relates some conversations with Irish officials who claim they have a side agreement with the ECB/IMF that whatever deal Greece gets in the form of a debt haircut Ireland will get also. When Ireland was on the bubble several months ago and the EU provided them a bailout it was only a token amount compared to their real debt. Ireland has guaranteed bank debt from failing banks equivalent to trillions of dollars in the American banking sector. There is no way Ireland can ever pay back all of its debt but in return for not blowing up the euro many months ago before there was a consensus inside the Eurogroup, they agreed to take the handout and wait until the Greece haircut was announced and then accept the same terms.

Obviously if Ireland has a side agreement then Italy, Portugal and Spain probably have some side agreements as well. When Greece debt holders finally see their principal cut by 50% to 75% there are a lot of other sovereign debt holders going to be flushed as well.

This weekend the IMF mission chief said Greece much implement "much stricter structural reforms." It is not going to happen. Greece has already said they won't implement any further austerity. Greece is already in default. It can't pay its bills today or at any point in the future without continued payments from countries willing to write checks for money they will never see again. I believe the Eurogroup is preparing their banks for the Greek default in November. Greece has not even received all of the funds from the first bailout and there is another 109 billion already in the pipeline. Why keep pouring money into Greece when it is mathematically impossible to get it back? Why not put that same money into your own banks to protect them from the default event and then allow Greece to default?

The prospect of restructuring deals already in the pipeline for countries other than Greece means the bailout for the European banks is going to have to be bigger, a lot bigger. The current 440 billion euro EFSF is a drop in the bucket. Stratfor and others have said it will take a minimum of 2 trillion euros. The Boston Consulting Group put out a report claiming it will take 6 trillion euros. They are already talking about leveraging up the EFSF to between 2-3 trillion euros. Since the EFSF debt is based on promises to pay by the 17 member countries and five of them are incapable of paying their own bills much less the bills of others, exactly how are they going to leverage up the fund? Doesn't it take either equity or good credit to sell additional debt to the public?

Fitch, Moody's and S&P are already lowering country credit ratings almost weekly. When the ratings agencies look at Europe and realize they are about to take on 2-3 trillion in additional obligations based on the credit ratings of only a few countries it has to give these agencies a serious cause for alarm.

The impending breakup and nationalism of the European bank Dexia this weekend is just the tip of the iceberg. There are dozens of much lower profile banks that are going to be in serious trouble when multiple Eurogroup countries are allowed to default on their debt simultaneously. The safety net has to be fully deployed before the big bang event and it will be a big bang. One analyst said once the net is in place Merkel will call up Papandreou and tell him everything is ready, pull the plug. He will hold a press conference and tell the world Greece has taken the only possible way out and will restructure its debt at 25-cents on the dollar (euro). Portugal and Ireland will exercise their option to slash their debt as well and the world will wait patiently to see if Italy and Spain are going to join the party. In theory the Eurogroup will be better off in the long run. The banking bailout will essentially end up nationalizing all the banks that are insolvent and Europe will survive.

The next problem is more difficult but the Eurogroup is already moving in that direction. That is a common government of some sort to prevent this type of situation from happening again ten years from now. The lesson has been learned that you can't have a common currency with individual socialist governments. The urge to grow government as a means of keeping the population happy is too strong. Somebody or some group has to be in control. Some group has to say no to Greek transportation workers making 70,000 euros a year. Some group has to say no to teachers and hairdressers in Greece being able to retire at 50 on full pensions of 50,000 euros a year plus full health care. In Ireland families on welfare are receiving 90,000 euros a year without working.

Socialism does not work when the country providing the benefits has to pay for those benefits with its own money. It only works when they can finance that deficit spending by selling the debt to others. A common Eurogroup government or finance agency responsible for overseeing the finances of each nation would have to deal with those problems. In the end this is why the Eurogroup will eventually self destruct. Very few countries are going to allow an overseeing group to control their finances. The next step is that group assessing taxes to cover the budget shortfalls and that will never work. The rich countries are not going to accept taxes to pay for welfare in Ireland or hairdresser pensions in Greece. Countries are not going to give up their sovereignty to a 17 member agency. The lifestyles and heritages of each individual country will not permit them to voluntarily submit to common rule by someone else.

I wandered off topic in those last paragraphs but I think everyone needs to realize that a resolution in Europe next week or next month is only temporary. We could be facing these problems for the rest of the decade or at least until the weak and fiscally irresponsible countries are kicked out or withdraw from the Eurogroup. It will happen. It is only a matter of time. Hopefully the U.S., China and other countries outside of Europe will eventually glaze over and become immune to the weekly news events. Until then we are hostage to the headlines.

Jim Brown

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