The Dow completed its best two week rally since July 2009 and the Nasdaq broke well above prior resistance. Where did the bears go?

Market Statistics

Good news is breaking out all over or at least that is what the bulls would have you believe. In some respects they are right. In other areas it is more wishful thinking than actual improvements.

The economic reports on Friday were mixed but buyers elected to ignore the bad news and brag about the good news. Bull markets are like that. The good news was Retail Sales for September. The headline number came in at +1.1% and the largest monthly gain since February. Autos provided a big boost but underlying strength was very broad based. Ex-autos sales still rose +0.6%. Furniture and apparel were also big winners.

In the individual components autos and parts rose +3.6%, furniture and home furnishings +1.1%, apparel +1.3%, food service +1.2% and general merchandisers +0.7%. Losers declined only slightly with building materials -0.1%, food and beverages -0.2% and sporting goods -0.3%. It was definitely a bullish report compared to the meager +0.3% rise in August and +0.4% in July.

Analysts that track these numbers on a weekly basis claim there was a strong acceleration in shopping in the last two weeks of the month. The spike in retail sales for September will be a boost for Q3 GDP in the next revision and that will also be market positive.

Several analysts downplayed the report claiming the gains were all in the seasonal adjustments. The market did not listen. All the bulls hear was strong retail sales.

You may remember that Chain Store sales for September, reported the prior week, also roared higher at +5.5%. Despite what you are hearing in the press the consumer appears to be alive and well.

That is really confusing because Consumer Sentiment for the first two weeks of October actually ticked down even with the stock market in rally mode. This is probably related to the new 52-week low set on October 4th that set the sentiment tone for the first week of October. When the report is updated for the last half of October it should be higher.

The headline number came in at 57.5, down from 59.4 in September. The internal components both declined slightly. Present conditions fell to 73.8 from 74.9 and expectations declined to 47.0 from 49.4. The reading on the expectations component is a 31-year low dating back to May 1980. Only 17% of survey respondents expect their finances to improve and that is the lowest rate ever recorded.

Apparently when forced to actually think about how they felt the consumers responded with a cautionary view but when it came to spending they were hitting the malls and that is what counts. If pent up spending continues to rise through October and into November the retailers are going to be in trouble for December. Most have severely under ordered in anticipation of slow sales and they are not planning on hiring as many seasonal workers. Best Buy said they cut normal plans for seasonal workers by half. If spending continues to improve those store shelves could start looking bare pretty soon after black Friday and December sales could fall short. With the strong current trend we could see some last minute orders begin to hit wholesalers but it is too late to boost manufacturing for this season.

Consumer Sentiment Chart

The economic calendar for next week contains the first two of the regional manufacturing reports for October. The Philly Fed on Thursday will be the key for the week since it predicts the movement in the national ISM that comes out the first week of November. This is a preview of what to expect for the ISM.

The Fed Beige Book is the most important report because it provides an update of economic activity as seen by the Fed in each of the Fed regions. If the Fed says conditions are improving we could be off to the races.

The biggest danger for the week is the EU summit meeting next Sunday on Greece. There are so many potential developments being floated daily out of Europe it is impossible to gauge which are real and which are just trial balloons. Recent headlines include a 50% haircut for Greek debt BUT structured in such a way to avoid a technical default that triggers the credit default swaps and forces banks into insolvency. That would be a good trick if they can do it but would require the EFSF, ECB and IMF to somehow structure a product that can be exchanged for the debt and have a guarantee from one of those entities.

There are several bank recapitulation plans being floated with the tier one capital requirements being raised as high as 9% from the stress test rate of 5%. That would put 66 banks below the minimum requirements according to the latest analyst updates. This means the troika (EU, ECB, IMF) will have to conjure up some major magic to prevent a serious upheaval. Several of the big banks have already come out strongly against a forced recapitalization because it dilutes their shareholders and increases their cost. Several have said they would sell assets and close branches or divisions to get under the capital levels rather than be forced to accept outside capital. That would further depress Europe to have the banks shrink rapidly and lay off workers.

The troika has a big task ahead of them and it will come to a head next Sunday when they meet to discuss the next payment for Greece, the potential haircut plan and putting a fence around the European banks. Some have suggested the troika will have to put out an explicit guarantee that no other country will see a debt haircut or the problem will simply move from Greece to the next weakest country and start all over again. With Spain downgraded this week it just reinforces the fact there are other countries with similar problems. With borrowing rates for the weaker nations climbing daily the troika will have to consider some sort of subsidy or guarantee of the debt to keep rates manageable or these countries will spiral down into the same situation of Greece with debt payments they can't afford.

Late Saturday the G20 participants released a very stern directive to the Eurogroup to completely fix the problem in the next eight days and announce it fixed at next weekend's EU meeting. I don't know how the Eurogroup is going to react to the G20 giving it orders but I would hope this would underscore the importance to avoid half measures and go all the way to finally end this sovereign debt virus. One option discussed by the G20 was to implement deposits insurance much like the FDIC insurance in the USA. That would halt the run on the banks and it would not cost much since the banks eventually end up paying for it.

Despite all the good headlines coming out of Europe the problem has not gone away and a divided EU meeting next weekend could still send the world markets back into a dive.

Economic Calendar

There were only a couple earnings reports on Friday and none that were important. Mattel was the only one most investors would recognize. Earnings were 86-cents and in line with analyst estimates. Revenue rose +9% thanks to an increase of +17% in the sales of Barbie. That was the biggest quarterly percentage rise for Barbie in more than a decade. The old girl still has appeal for the younger generation. Pretty soon they are going to need a botox Barbie and tummy tuck Barbie to complete the line. Sales of Other Girls Brands, including Monster High and Disney Princess dolls rose +32%. No recession there. Unfortunately investors sold the stock because of a -180 basis point decrease in margins due to heavier advertising. The selling was minor with a rebound into the close shrinking the decline to only -1%.

Mattel Chart

The real earnings kick off next week and by the end of the week we will know how the earnings season will turn out. All the major banks report, including C, WFC, GS, USB, AXP and BAC, plus the remaining major tech stocks including IBM, INTC, AAPL and MSFT. There will also be a few industrials, drugs, manufacturing and transportation. On third of the Dow will report. We will hear from nearly every major sector and their guidance will allow analysts to fine tune their estimates for the rest of the quarter and for Q4.

Earnings Calendar

Google (GOOG) succeeded in pulling the Nasdaq out of its two month trading range. The stock rallied to $599.60 at the open but sellers were waiting so it was close but not quite to that $600 mark. Google still finished the day at $592 with a very strong +33 gain. Friday was a good day for Google but you have to wonder what next week will look like now that the earnings are old news.

Google Chart

Apple rallied strongly on news they sold out of iPhone 4S for pre-orders online and they are expected to increase those sales to as many as four million units this weekend. The phones went on sale Friday in the retail stores with lines down the block in most cases. Even Apple co-founder Steve Wozniak stood in line in Los Gatos California to buy an iPhone 4S on Friday. He was first in line on Friday after starting the line at 2:PM on Thursday afternoon. Steve did not need to wait in line. He said he had several delivered to his house but he wanted to experience the excitement of waiting in line with other Apple aficionados. He said the products have meaning and they are an important part of life that should be recognized and celebrated.

Step away from the counter Steve, I think you have lost touch with reality. When a billionaire waits in line for 20 hours overnight when he already has the phones you have to wonder about his connection with reality. He said he has waited in line in the past for Apple products just to enjoy the experience. The 61-year old Wozniak rode "one" of his two-wheeled Segway personal transporters to the Apple store. Steve, you bring the term geek to an entirely new level and Apple users will be forever in your debt.

Steve Wozniak

Apple Chart

OmniVision (OVTI) lost -9% after Chipworks dissected an iPhone 4S and found a Sony image sensing chip rather than OmniVision, which had been used in the past in at least one version of the iPhone. Since Apple has used dual suppliers in the past to overcome volume limitations and sourcing problems it does not mean there are not phones out there with the OmniVision chip. Unfortunately there are just not enough phones in hands of the forensic investigators to know for sure. Chipworks said it plans some additional tear-downs from different batches to see if there are multiple providers of different chips. Triquint got a significant boost on Thursday when its chips were found in the new phones.

Analysts believe the introduction of the iPhone 4S plus the new versions of the iPad and iPod due out in the first quarter could push Apple sales to $100 billion over the next 12 months. That is simply incredible. An analyst at IHS said Apple could sell more than 100 million iPhones alone.

IBM broke out to a new high on Friday ahead of its earnings on Monday. The stock appears destined to hit $200 and that would be a $30 gain over the last two weeks. This would appear to me to be a setup for a serious bout of volatility around the earnings event. If they beat strongly, is the good news already priced in? It would appear so but that obviously depends on the guidance. If they disappoint there could be a huge decline but then they have not disappointed recently. It would appear to be grossly over extended but as we have seen recently some stocks can become even more extended. Trading this stock on Mon/Tue requires more courage than I have.

IBM Chart

The S&P has rallied +13.9% in nine days with only one day of declines on the Dow. Normal markets do not move that fast or in that much of a straight line. However, short interest at the beginning of October had risen +9.3% since August 1st. Bearish sentiment at the beginning of October was the worst in two years. Europe was circling the drain. There was plenty of dry kindling to fuel a rally.

The sudden change from denial to acceptance and then to action by the EU over the risk to banks was the equivalent of pouring gasoline on that kindling and throwing in the match. Once the short squeeze was in full bloom the news just kept coming. Suddenly there was nobody playing the role of the spoiler in Europe and the positive headlines just kept coming. The economics in the U.S., while not great, suddenly started to improve. Jobs were stronger than expected and there was a definite lack of earnings warnings along with some rare positive guidance. Railcar and truck loadings suddenly spiked and auto sales exploded higher. The short squeeze went from mildly annoying to excruciatingly painful.

Even worse those funds with very high amounts of cash suddenly found themselves on the wrong side of the market. They began chasing stocks in hopes of beating their competition to Q4 gains. October 31st is the fiscal year end for most stock mutual funds. This is because they must provide investors with statements within 60 days of their fiscal year end showing the gains for the year and the tax implications for the investors account. That allows them to have those documents prepared and into investor hands before Dec-31st and the normal tax year for individuals.

That makes October gains and losses critical for most funds. If they are done for the year, which most are for 2011, then this is their last chance to pocket some winners and offset the earlier losses. This is the prime time for fund managers to chase performance and we have definitely seen that over the last two weeks.

Since fund managers were expecting a normal October rebound they were ready to pull the trigger to add to positions on the slightest indication of a rally. Whether that meant adding to existing positions, or putting excess cash to work buying winners to window dress the year end statements, they were all poised and waiting for the starters gun.

IBM would be the perfect example of a fund manager's year end stock play. There is little chance of them missing earnings. They were resting on the support of the 100-day average on Oct-4th. They are a blue chip with a high price so putting a lot of money to work quickly is easy to do. If the rally failed they could just as easily exit because of the high liquidity. IBM is a great stock to have in the portfolio as of Oct 31st when the statement deadline arrives. Who would not want to be invested in IBM at all time highs after two months of a bear market? That is why this rally has been led by the blue chips.

The small caps have seen their share of the action but it was more short covering than outright buying. The Russell 2000 is up +21% from the Oct-4th lows but the majority of those gains came on only three days. The small caps were the most heavily shorted and therefore benefitted from the strongest short squeeze. They have started to perform better on an individual basis over the last week simply because the rally became more broadly accepted and investors started to relax and enjoy the ride.

Analysts have recently pointed out that 84% of stocks are moving in the same direction as the S&P on a daily basis. That is the highest correlation in 80 years. This is due to high frequency trading and increasing use of ETFs as investment vehicles. TrimTabs reported that $94.7 billion flowed out stock mutual funds for the four months ending on Sept-30th but ETFs saw inflows of $17.3 billion. According to Morningstar $32.5 billion left stock funds in August alone. That was the largest outflows since Nov-2008 and compares to -$22.9 billion in July. Money market funds saw inflows of $74.8 billion in August.

The average domestic mutual fund declined -9.6% year to date and the global equity funds lost -15.4%. Individual investors and quite a few fund managers are tired of trying to pick stocks since 84% are moving in lock step with the market. This has been a headline driven year and not one led by fundamentals.

With all that money flowing into bonds and money market funds there was plenty of excess liquidity sloshing around and ready to be put back to work when the market rebounded. Apparently a lot of it is starting to find its way back into equities.

This is the perfect scenario for fund managers. The portfolios are coming back to life and the influx of money into the market is giving them strong gains in their new positions. Life is good as long as the rally lasts.

Unfortunately the world has not turned into an investment utopia and there are still significant risks ahead. Europe is going to falter. The feel good thoughts coming from the EU leaders still have to be put into motion by the full Eurogroup. Remember, the bank recapitulation plan is still undefined, unapproved, unimplemented and unproven. They are sailing in unchartered territory and there are plenty of rocky reefs ahead.

The U.S. economy may be slowly improving but there are risks here as well. Unemployment is still rising and the average duration of a job loss is increasing. Until we start adding jobs by 250,000 or more per month we are just treading water and the longer we fail to improve the better chance of another economic decline. There are various brokers and analysts who believe our chances of a new recession are less than 40%. However, there are quite a few, maybe even more, that believe the risk is closer to 60%. The Fed mulled adding some additional monetary stimulus at the last meeting. Bernanke said the U.S. was on the verge of "faltering" and has been talking up potential Fed policy changes.

China could be on the verge of a hard landing. Various analysts believe they will work through their problems and "hard" may be a decline to +8% growth but there are longer term problems. Everywhere you look in China there are new developments complete with million person cities, new shopping malls and new skyscrapers, all empty. China is keeping their economy growing by keeping its people working. Eventually they too will run out of money. They can't keep building Ghost Cities forever on the hopes somebody will eventually want to live there. This is a long term problem but it will eventually be a challenge. Some analysts believe they can keep growing for another 3-5 years but that remains to be seen. The problem for us is the growing worry that China is eventually going to implode. Whether they do or not is immaterial. It is the perception of the future that will impact our markets long before China actually collapses. That is why you have heard so much about China's decline in growth rate over the last several months.

I have probably thoroughly confused you by now. While I do believe we have a good chance of moving higher next week I think we will plateau after that and move sideways until the end of October. I see market risk in early November as fund managers review positions for the new year based on the results of the European summit on the 23rd. If the U.S. economics continue to improve then we may move higher but it mostly depends on the headlines from Europe.

The S&P closed over initial resistance at 1220 but failed to move much higher. The actual resistance band is 1220-1230 but closing over 1220 was bullish especially for a Friday after a +14% rebound. I think traders are expecting good things out of IBM and others early in the week and the real event risk from Europe is not until the next weekend. There is a sell the news event in our future but nobody knows where. Support is 1200 followed by 1190 and a break under 1190 could get ugly quick.

S&P-500 Chart

The Dow blew past initial resistance at 11,500 but came to a dead stop at 11,650 and resistance from August. IBM earnings after the close on Monday could be a real challenge for the Dow or a major boost. IBM normally manages their earnings pretty well and they will normally buy back enough shares to make sure they post a beat if the numbers are close. However, given the strong expectations priced into the stock it could be tough to move it higher even though it has $200 written all over it.

The Dow is up +1245 points since the Oct-4th lows with only one day of any real profit taking. It is due to rest soon. I would look for 11,700-11,735 as resistance that could slow the gains long enough for some news event to put a cloud over the market. Obviously a positive news event instead could blow right through those levels. The Dow is not normally very reactive to moving averages since it only has 30 stocks and a big move in any stock can cause a significant move in the index.

Dow Chart

The Nasdaq is the wild card here. The Nasdaq exploded higher thanks to Google and Apple. How much longer it continues to move higher depends on IBM on Monday and Apple/Intel earnings on Tuesday. I realize IBM does not trade on the NASDAQ but it is a major technology bellwether. Positive earnings from all three may not be enough to continue the momentum because of the already over extended gains. The next resistance is around 2700 and support back at 2600-2625.

Nasdaq Chart

The Russell 2000 is lagging the other indexes in terms of relative position without testing the same resistance levels. This is because investors are still hesitant to put money into small caps. The rebound was mostly short covering with the majority of the gains came on only three days. There is strong resistance at 720 then again at 735.

Russell 2000 Chart

The Transports stopped exactly on resistance and it may take some strong economic news to move them higher. Based on the rally in this sector a much stronger economic rebound is being priced in when we really only have the smallest glimmer of light at the end of the tunnel.

Dow Transport Chart

The Dow and S&P closed right at resistance on what could have been a final short squeeze gasp at the close. Any move higher should trigger significant follow on buying but a failure here could be a serious challenge. A +14% rally in nine days is extremely over bought.

If there is not any negative news over the weekend we could see the markets open higher assuming Asia does not tank Sunday night. Investors hesitant to buy on Friday may want to jump in on Monday but fear of darkness and IBM earnings on Monday night could produce an afternoon sell cycle. Tuesday morning will be Goldman Sachs earnings and the reaction to IBM. Tuesday night the event risk will be Apple and Intel and expectations will control the close. However, do you really think Apple won't post blowout numbers? They manage earnings very well but investors are probably already expecting a blowout. Intel could be under pressure from the move away from PCs to tablets so I would be cautious there.

Bottom line, I think we could move slightly higher early in the week depending on the news but late in the week I am worried we could see some profit taking. A +14% gain in nine days will eventually need a decent rest. Every day that passes without profit taking increases the risk.

Sell too soon!

Jim Brown

Send Jim an email

"You Can't Out Exercise a Bad Diet!"
Jack LaLanne