I believe there were more traders scared of holding short over the weekend than there were traders who wanted to be long. The result was yet another short squeeze.

Market Statistics

Rallies can take many forms and technically a breakout is still a breakout. Most bull markets begin with a series of short squeezes as bears still in denial continue to short the highs only to cover over and over again as the market moves higher.

Expiring October options also provided a boost because most hedge funds and institutions had bearish positions. Closing those positions produces a bullish bounce. There is also the fiscal year end for most mutual funds next Friday. Funds have to adjust positions before next Friday to reflect their year-end objectives and reduce cash on the books. With hedge funds still predominately short in a rising market, short covering is a necessary event. Hedge funds are currently only 45% net long. Add in the potential for a resolution in Europe and the incentive to cover shorts was increasing.

Economic reports are improving and earnings have been surprising to the upside. Thomson Reuters said Friday 133 S&P-500 companies have reported and 68% have beaten estimates with 19% missing estimates and 13% reporting in line. S&P numbers are slightly different at 70% beating, 11% in line and 19% missing estimates. The earnings growth is still more than +12% and the forecast for the full quarter is close to +15%. The sector dragging down the numbers is the financials.

Improving economics, strong earnings despite several high profile disappointments and the potential for some kind of resolution in Europe was a good recipe for continued gains. Obviously it could have gone either way with traders loading up on shorts and exiting longs ahead of an expected disaster in Europe but in this case the market moved higher. Just because the Dow and S&P closed at two months highs does not mean a case of foot and mouth disease from some overzealous politician in Europe won't crash the markets on Monday.

We still have to get past the EU headline events this weekend. There are numerous events culminating with an EU meeting on Sunday and then another one on Wednesday. Getting all 17 finance ministers from different countries to agree on what to have for lunch would give an event coordinator a nervous breakdown. Getting them to agree to spend a few hundred billion more so Greece does not have to pay all its debts is going to be a significant challenge. The markets are pricing in a positive result and that solution remains undefined, unapproved, unimplemented and unproven.

The most likely outcome of the scheduled meetings is that the decision will be put off past Wednesday, possibly until the G20 meeting the following week. The markets would not react well to another delay.

Helping to improve sentiment over Europe was news on Friday the EU finance ministers had approved the next tranche of loans to Greece of eight billion euros. This was the sixth tranche for Greece and will take them into 2012 without any further cash infusions. Considering the on again off again status of this payment over the last two months this was a positive milestone.

In the U.S. next week there are four more key economic reports as we close in on month end and the next nonfarm payroll report. Monday has the Chicago Fed National Activity Index. Tuesday is the Richmond Fed Manufacturing Survey. Thursday has the first look at Q3 GDP and that could be a whopper of a problem. Current estimates have risen to +2.5% compared to +1.33% for Q2. Did we really double our GDP over the last three months? The markets could be in for a big disappointment there. Thursday also hosts the Kansas Fed Manufacturing Survey. That one should do well as a result in the increase in auto production. If economic conditions really picked up starting in late September then those reports should be the evidence.

Economic Calendar

Fed Vice Chair, Janet Yellen, gave a speech on Friday where she raised the possibility of more asset purchases by the Fed. She said the Fed could buy a broader range of securities "it if wants to bolster economic growth in the future." She said U.S. growth in the second half of 2011 could be "noticeably stronger." However, she warned the U.S. is still growing at a "disappointingly slow pace" and "there are significant downside risks."

Fed Governor, Daniel Tarullo, said on Thursday the Fed should consider buying mortgage backed securities to push mortgage rates even lower and support the depressed housing market. His remarks came after Eric Rosengren, president of the Boston Fed, suggested on Thursday the Fed should buy mortgage backed securities. Charles Evans, president of the Chicago Fed has also suggested broadening the Fed's purchases.

Do you think the Fed heads are trying to talk the market up or are they staking their positions out ahead of the November meeting so a new announcement by the Fed will not be such a surprise? They are not talking about preventing another dip but accelerating the recovery. That would be bullish for the markets so these comments are probably making the shorts nervous.

Earnings on Friday were not specifically exciting but Friday earnings rarely are. General Electric (GE) earnings hardly ever create any excitement. The company said earnings were 31-cents and that was in line with estimates. In reality the earnings were weaker than that but they were offset by a lower tax rate that added 2-cents to the headline number. Margins were also under pressure because the majority of their industrial order backlog was booked over a year ago and prices for components have risen over the last year. Margin declines were evident in every GE division. GE said the wind turbine business was especially weak because of competition. Order backlogs rose to $191 billion, an increase of 16%. A key analyst said many of those older orders were sold at bargain rates to get the business and keep plants operating. It could be another 12-18 months before the low priced orders flow through the system and GE gains any operating leverage. GE said on the call the "outlook for earnings and margin growth were stronger for 2012" but it was a generic statement. GE shares declined -2% on the earnings report. This stock is dead money for the time being.

GE Chart

Honeywell (HON) posted a nice +6% gain after posting a 44% increase in profits. HON earned $1.10 per share compared to 76-cents a year ago and estimates of $1.00 by the street. Revenue increased +14% and margins increased +120 basis points to 18.2%. Honeywell predicted full year earnings would rise to $4.05 and a +35% increase over 2010. They also raised revenue guidance to $36.6 billion. Guidance was strong and analysts covering Honeywell had only positive comments.

Honeywell Chart

McDonalds (MCD) posted earnings of $1.45 compared to estimates of $1.43. Revenue rose to $7.17 billion and well above estimates of $7.03 billion. Same store sales in the U.S. rose +4.4%, Europe +4.9% and Asia +3.4%. October sales are expected to rise between 4% to 5%. The company said it was expanding its menu and will be raising prices to offset higher beef costs. McDonalds said its expanded beverage and breakfast menu now accounted for 25% of its U.S. sales and the smoothies, coffees and healthy options like oatmeal were attracting new customers. Shares of MCD rallied +4% to a new all time high.

McDonalds Chart

Disappointing the street on Friday was oil services company Schlumberger (SLB). The company posted earnings of 98-cents and three cents short of street estimates. Basically the weakness came from the Middle East where oil activity has slowed due to the Arab spring and events in Libya. Elsewhere the U.S., Canada, Iraq, Saudi Arabia, Mexico, Brazil, Russia and Angola were strong. The most important part of the Schlumberger call was the guidance. The CEO said that although the weak global economy was expected to "slow" demand growth in 2012 "there is a tight cushion of excess supply that will continue to support exploration activity." If anyone should know there is a supply problem it should be Schlumberger since they service in some form almost every major oil field in the world. "Tight cushion of excess supplies" is a politically correct way to say oil production is barely keeping up with rising demand.

Schlumberger Chart

Earnings for next week have a little bit from every sector. Most notable would be the ones highlighted in green. CAT on Monday could tell us about the economic growth on a global basis. UPS on Tuesday will tell us how package traffic (economic activity) is shaping up for the holidays. COP, CVX, XOM, OXY and about a dozen other energy stocks will summarize the sector. There is also a big list of healthcare and drug stocks reporting with Merck closing out the week.

This is the busiest reporting week of the cycle and it should create some additional volatility as the stocks react to the short term overbought conditions after each company reports.

We really know how the quarter is going to end since 26% of the S&P have already reported. By the end of next week that will be closer to 60%. I think the market is going to react more to Europe than earnings although the individual stocks are sure to move sharply when they report.

Earnings Calendar

Mortgage insurer PMI Group (PMI) was seized by Arizona insurance regulators because of a serious capital deficiency. Two months ago two PMI units were ordered to stop writing new business due to their failure to meet capital requirements. PMI has suffered throughout the housing crisis as foreclosures mounted. The homes being foreclosed were normally those where companies like PMI and MGIC had written mortgage insurance to protect the lenders from a default. The lenders have buried these companies with claims for reimbursement and the volume of new business plus their capital reserves have been insufficient to cover the losses. Mortgages being written today only go to the best credits and with enough money down to not require mortgage insurance. It is a tough market for the insurers and it does not look like it will improve any time soon. PMI competitors include MGIC Investment (MGIC), Radian Group (RDN) and Genworth Financial (GNW).

The Arizona Department of Insurance said PMI claims would only receive 50% of the claim and the remaining claim amounts deferred. As current mortgages continue making their monthly payments the monthly insurance payment will go into a fund to cover deferred losses and new claims.

Most states allow a maximum of 25:1 risk to capital ratio. MGIC was at 24:1 at the end of September. The company said it was going to add $200 million in capital and that could lower its consolidated risk to 21.3 to 1.

PMI shares closed at 31-cents on Friday and MGIC at $4.30.

PMI Chart

Yahoo (YHOO) finally broke through resistance at $16 last week but that level is still exerting drag on the stock. Yahoo perplexed potential bidders by preventing them from talking to each other by using a clause in the confidentiality agreements to stop cross talk. In theory this was supposed to keep a climate of competition among the bidders. Instead it drove some of the bidders away. Yahoo has a lot of parts and nobody wants all of the parts. To make a deal work a bidder will have to joint venture with other bidders to organize a post acquisition breakup where everyone gets the piece they want. If the bidders can't talk to each other then the potential for a joint venture that maximizes the value is going to be harder to achieve. That means any single bidder is likely to lowball the bid and then hope they can sell off the pieces after the deal is completed. Yahoo management is so incompetent it is no wonder the company is declining in value. The no cross talk provision is said to have come from founder Jerry Yang.

Google is rumored to be considering a bid in conjunction with several private equity firms. In theory Google will provide financing and the PE firms will divide the carcass after the deal is completed. It is doubtful Google could keep any of the parts since there would be a significant antitrust considerations. Microsoft has also been rumored as working on a deal where it would finance the acquisition and several PE firms would sell off the parts they did not want. Microsoft's interest in the deal is to protect an existing joint venture between Yahoo and Microsoft.

Even in the current state of confusion the value of Yahoo continues to be estimated at $19 to $31 per share. At the current $16 price there is still room for a profit if a deal is announced but you never know when Yang might go off on an ego trip and reject any bid like he did with the $31 Microsoft offer several years ago.

Yahoo Chart

Oil prices may rise again on Monday after the heir to the Saudi throne died in New York over the weekend. Crown prince Sultan bin Abdul-Aziz Al Saud, 80, died of an unspecified illness suspected to be colon cancer. He had been treated for that in New York off and on for the last two years. King Abdullah, 87, also in poor health must name a new successor from the royal family. The king has 40 sons from multiple wives and an unknown number of daughters. FYI, the Sultan had 32 children with multiple wives. One of which is Bandar, former ambassador to the USA.

Traditionally the king names his successor. However, king Abdullah had created a 33 person Allegiance Council, composed of his brothers and cousins, as one of his reforms and gave it the mandate to choose the heir but not until after the Sultan had assumed the throne. In other words the king chose his heir but the Sultan's heir would have been chosen by the council. It is unknown if king Abdullah will now turn to the council for a replacement for the Sultan.

The assumed next in line for the throne is the Sultan's 78 year old half brother Prince Nayef. The prince is a more controversial figure and is against some of the reforms the king has put in place like giving women voting rights starting in 2015. Nayef has in the past referred to Israel as the "Zionists" and spoke negatively of Jews in interviews. Nayef is the Mukhabarat official (secret police) and he is in charge of internal governmental affairs. He is also very outspoken and critical of Iran. Nayef was involved in the decision to send troops to Bahrain in March to crush Iranian sponsored pro-reform Shiite demonstrators.

Having Nayef become king would create a Saudi Arabia with a short temper against its neighbors and open hostility towards Iran. Nayef is seen as more independent and resistant to change and desirous to return to the Saudi customs of decades past. How that will play out in its dealing with OPEC and with its sales of oil is unknown. The uncertainty should cause at least a temporary spike in oil prices even though there is no immediate change forthcoming. It could be years before King Abdullah dies and the succession details are known.

Crude prices rose on Friday on short covering ahead of the weekend meetings in Europe. Oil is currently stuck under resistance at $90 but a positive resolution in Europe could produce a breakout that could be strong.

Crude Oil Chart

Groupon has reactivated its IPO plans and is expecting to receive less than they initially wanted. The company will sell 30 million shares between $16-$18 per share and now expects to raise $479 million. That is down from the $750 million expected when the IPO was first launched. The SEC and prospective purchasers questioned its accounting practices and the company had to pull the IPO and restate the earnings. Groupon rejected a $6 billion acquisition offer from Google. Recent filings show Groupon posted revenue of $430.2 million in Q3 but it is still not profitable. That is up from $81.8 million in revenue in Q3-2010.

Groupon claims 142.9 million subscribers of which 29.5 million had made a purchase in Q3 and 16 million made more than one purchase. Groupon admits it has a lot of competitors, nearly 600 of them. Groupon is selling shares but insiders are not giving up control. There will be two classes of shares with A shares having one vote and B shares having 150 votes per share. Insiders will hold the B shares and retain more than 58% of the voting power. The class A shares will list on Nasdaq with the symbol GRPN. The IPO is expected to price the first week of November.

American Airlines (AMR) declined -6.6% on Friday after a Morningstar analyst said bankruptcy is inevitable. He said the airline is at a disadvantage to its peers and the carrier's viability is in jeopardy. Another analyst at CRT Capital said there was no immediate bankruptcy risk because they have plenty of cash and ways to borrow more. AMR ended Q3 with $4.3 billion in unrestricted cash. They could also have a sale on frequent flier miles for future use or borrow against planes and spare parts when those assets are freed up in 2012. AMR is trying to avoid bankruptcy by renegotiating union contracts with pilots, attendants and ground crews. Unlike United and Delta AMR did not file bankruptcy over the past decade so their costs are higher.

AMR Chart

Regardless of the reason for the Friday rally the result was a bullish breakout above multiple levels of resistance. ANY higher close on Monday would be a technical confirmation and suggest the markets are going higher.

The S&P broke over recent resistance at 1225 plus resistance highs at 1230 from August and the 100-day average at 1232 to close at 1238. The key to future gains will be another positive close on Monday. If the S&P can avoid a decline back below those resistance levels and post a higher close over 1240 the remaining shorts should begin to cover in volume. I would bet the majority were in denial on Friday and fully expected a dip at the close or worst case a major gap down on Monday after some kind of failure at the talks in Europe. If that gap turns into a gap up instead of a gap down we could get a major continuation of the short squeeze.

However, there is still risk until a comprehensive deal is announced on Wednesday. That could keep some shorts on board until after the Wednesday summit. It could be a very painful ride.

Support is now old resistance at 1225 followed by 1200. Resistance is 1250 followed by the 200-day average at 1274.

S&P Chart

The Dow also duplicated the strong breakout of the S&P with prior resistance at 11,625 left well in the dust with a close at 11,808. The 100-day average at 11,692 did not even cause a blink. The next resistance is 11,925 followed by the 200-day average at 11,965.

This is a clear and convincing break of resistance and ANY positive close on Monday should be a confirmation of a bullish change in market sentiment.

Dow Chart

Dow Transports Chart

The Nasdaq is the weak link in the market picture. Continued declines in Apple are keeping the Nasdaq from breaking free with its index brethren. Friday's gain was decent but the index was coming back from some serious Apple inspired losses.

Eventually Apple is going to attract bargain hunters. The decline on Friday was only a couple dollars but that was with a very positive market. If a negative market appears we could see a retest of $370 on Apple shares and that would be a decline of -$23 with a corresponding weight on the Nasdaq. I am also concerned that funds could sell Apple after month end.

However, if the other techs are successful in dragging the Nasdaq above resistance at 2665 I think the Apple faithful will reconsider their bearish views and we could see a strong rebound on Apple push the Nasdaq even higher.

That is a lot of "if" statements and the Nasdaq does not depend on Apple for all its gains. However at 20% of the index it would definitely help if Apple could at least show some small gains.

Support is 2600 and resistance 2665.

Nasdaq Chart

The Russell closed right at short term resistance at 712. The Russell has been lagging the large cap indexes and has so far failed to break out of the congestion range from last week. A lack of buying on the small caps means no confidence in the rally by fund managers.

The Russell needs to break over 720 and eventually over 740 to catch up with the Dow/S&P gains. When the Russell begins to accelerate higher we will know a real rally has arrived.

Russell 2000 Chart

With 133 S&P companies reported the current expectations for the full quarter are for +14.7% earnings growth. That compares to a +13.1% estimate on October 1st. Projections for Q4 are for 12.5% growth, down -3% from October 3rd. The first quarter of 2012 is only projected to grow by +7.6%, down from +10.2% in early October. If the Q3 earnings and guidance continues to beat expectations those Q4/Q1 numbers will have to be raised and possibly significantly. That would mean current stock valuations, already cheap, would become even more undervalued compared to future earnings.

This suggests that not only are we seeing a technical breakout in the markets but the rally is also based on improving earnings fundamentals. Add in the slight improvement in the U.S. economic picture and the rally could have legs.

The only thing really holding back the markets is the radioactive cloud over Europe. If the EU leaders could actually agree on a comprehensive plan this week it would go a long way towards improving the global economy. The financial systems of many nations are bound up in what might happen in Europe. Once that cloud is lifted we could see a significant improvement in the global markets. Obviously that depends on the heads of 27 diverse nations setting down and deciding how to protect their assets from the chronic overspending of five errant nations. They have to pledge enough assets to cover the debts and future needs of those few while fencing in their financial systems to prevent further personal losses down the road. They can do it but getting 27 leaders to agree on anything is next to impossible. Hopefully they have seen the events of the last several months and it has scared them enough to bring out the big guns to end the problem once and for all. While I seriously doubt it will happen next week I can at least hope for a resolution.

I am encouraged by the rally and I think it has possibilities but we are still hostage to headline risk. The wrong headline could kill this rally just as quick as the ones that started it.

Sell too soon!

Jim Brown

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" Obstacles are those frightful things you see when you take your eyes off your goal."
Henry Ford