Managers battled all week to keep the indexes high into quarter end and they managed to prevent all but a minor decline.

Market Statistics

Considering the majority of September's gains came on only two days of short covering I think fund managers did a good job of holding those gains for their quarter end statements. They definitely had a headwind from negative events in Europe and negative earnings and economics in the USA.

The Dow battled back from a -111 point loss at the open and almost regained positive territory on the less bad news about Spain's banks. However, if it were not for a buy program at 3:40 the Dow might have closed on the lows of the day.

I always get a kick out of the headlines as reporters try to put the best spin on the news. For instance a Reuters headline claimed "Wall Street marks best third quarter since 2010." That may look good for the numerically challenged but there has only been one other Q3 since 2010.

The S&P rallied +5.9% over the last three months. That is definitely respectable since September is normally the worst month of the year. Thank QE for that gain. The ECB announcement on Sept 6th created a monster short squeeze and the QE3 announcement on Sept 13th created the other one. The rest of the month was flat or down. The S&P was at 1437 just before the QE3 announcement and traded as high as 1474 the next day. The S&P closed at 1440 on Friday, -34 points off its high.

S&P Chart - Only Two Days of Gains

U.S. economics are not setting up for a positive Q4. The Q2 GDP on Thursday declined to only 1.25% growth from the prior 1.73% and a forecast of 1.8%. The Durable Goods Orders for August fell -13.2% compared to a downwardly revised +3.3% gain in July. The Kansas Fed Manufacturing Survey fell from 8.0 in August to the low for the year at 2.0 in September.

On Friday the Chicago ISM fell to 49.7 from 53.0 and the lowest level since Sept 2009. New orders fell from 54.8 into contraction territory at 47.4. Order backlogs remained flat at 41.6 and well into contraction. That suggests manufacturing is not going to be picking up in the near future. Employment fell to 52.0 from 57.1.

This was not a good report and it is just another in a long line of reports showing economic declines. The chart below is worth 1,000 words.

Chicago ISM Chart

While I am on the topic of manufacturing reports the Philly Fed Survey last week was in contraction territory for the fifth consecutive month. The three-month average for the coincident index, which captures wage metrics and state employment, fell to a post recession low of 24 compared to its reading of 80 just three months ago. Historically a reading this low suggests the beginning of a recession. The index averaged 41 three months prior to the start of the last four recessions.

Philly Fed Coincident Chart

The final revision of Consumer Sentiment declined a point from the earlier reading for September. The headline declined from 79.2 to 78.3. That still represents a gain of +4 points over August. As I stated in the prior commentaries the bounce in Sentiment and Confidence reports for September were likely related to the positive speeches from the political conventions. There were no other factors we could apply to the outsized bounces other than possibly the spike in the market on Sept 6th. The QE3 spike was too late to be reflected in these surveys.

Consumer Sentiment Chart

The economic calendar for next week could kill that positive sentiment. The national ISM Manufacturing Index is on Monday and odds are good it will disappoint. The ADP Employment and ISM Services on Wednesday could also decline. The FOMC minutes are probably going to show us what the Fed was worried about when they announced QE3 on the 13th. However, the Bernanke press conference should have covered those bases so the FOMC minutes should not provide much volatility.

Bernanke speaks again at 12:30 on Monday on Monetary Policy.

Factory Orders on Thursday could be a major disappointment after the major decline in Durable Goods orders last Thursday. There are private estimates for a decline of more than -5% compared to the consensus estimate for a decline of -1.6%.

The Nonfarm Payrolls on Friday are two days after the Presidential debate on Wednesday. You have to wonder if that was a factor in the debate scheduling. The consensus estimate is for a gain of +120,000 jobs compared to the +96,000 jobs in August. With the constant stream of worse than expected economics for September I would not be surprised to see numbers well below that 120,000 consensus.

This is going to be a tough week for economics and will likely give the bulls another wall of worry to climb. Let's hope the wall does not fall on us.

Economic Calendar

The market got a slight boost last week after Spain and Greece outlined new austerity measures that would further cut government spending. Tax hikes were also proposed in hopes of influencing the Troika (EU, ECB and IMF) to see they were making progress on cutting their debt. However, as we know from past experience just announcing something does not make it happen. It just provides another bubble of hope that eventually the problem will go away. It does nothing to actually address the problem.

Greece announced further budget cuts of 11.5 billion euros over the next two years. Without the announced cuts the Troika would not have authorized the next round of payments from the prior bailouts. We have not yet seen the results of the recent Troika audit and most analysts believe Greece failed. The Troika really does not have any other options other than make the next payment of 31 billion euros or they risk Greece leaving the eurozone and the prior bailout funds would be lost. Greece will receive a list of additional reforms needed to get the next tranche of funds and the parliament has to vote on it before the next meeting of the EU finance ministers on Oct 8th or the payment will be delayed. A story in a German newspaper this weekend said the Troika would formulate the reforms in such a way so that Greece will get the payment because the results of nonpayment are too drastic.

Spain signaled it was going to cut its deficit in 2013 and the budget they released last week cuts spending by 40 billion euros at least on paper. Spain is the fourth largest economy in the 17 nation eurozone with a GDP of $1.8 trillion. The pomp and circumstance around the budget cuts is seen as a preliminary offering in advance of actually asking for a full bailout. European leaders appear to want Spain to ask for assistance because they can then demand fiscal accountability in the future and force Spain to slow spending even further.

However, Spain has regional elections on Oct 21st and Prime Minister Rajoy's party is not favored. Any formal request for aid will likely come after the elections. Rajoy will keep a firm political posture until after those elections. As part of this new budget he is raising pension payments by 1% in an effort to calm the masses that have been protesting austerity. In order to do so he had to raid a reserve fund that has not been touched since 2000. More than 60% of the 2013 budget will go to social programs including pensions.

When Spain eventually asks for a bailout they are likely to be downgraded by the ratings agencies. Eagan Jones downgraded them last week. They are already rated only one level over junk so a downgrade will be expensive in terms of raising new money. Unemployment is 24.2% and rising with youth employment even higher. That age group feeds into the demonstrations so those are likely to continue.

Complicating Spain's problems is the Catalonia region, which includes Barcelona. As much as 20% of the population turned out for a demonstration supporting independence last week. Catalonia wants to break away from Spain and that would be a serious problem for Spain because of the revenue and taxes produced in what is Spain's most economically important region. If Catalonia succeeded in breaking away Spain would likely default on its debts and be forced to leave the eurozone. The Catalonian parliament has approved holding a referendum on independence. Spain has threatened to block any separatist vote. There were prior non binding votes on independence held in a city by city basis in Catalonia and independence was preferred by as much as a 90% margin. The 7.5 million Catalans pay as much as $20 billion more in taxes annually than they get back in infrastructure and social services.

Map of Spain, Catalonia in red

The U.S. Postal Service will default on a $5.6 billion payment due to the Treasury Dept on Sunday. This is the second billion dollar default in the last two months. The Postal Service has been trying to get approval from Congress for more than a year to end Saturday mail delivery and shrink a required $5 billion annual payment for future retiree health care benefits ordered by Congress in 2006. Post office operations are expected to lose $15 billion this year. The postmaster general, Patrick Donahoe, said the post office will avoid bankruptcy in 2012 but without action by Congress to allow it to scale back on services and concessions from the postal unions 2013 could be a disaster. "We have done a lot to reduce costs. There is nowhere left to go." Unions are protesting the attempt to stop Saturday deliveries and closure of post offices in rural areas without sufficient mail activity. The Senate voted to give the Postal Service $11 billion in April but the House demanded budget cuts be attached to the funding and the bill was never passed.

China's manufacturing PMI will be released on Monday and it is not expected to be pretty. China's manufacturing is rapidly imploding. Shipbuilding, steel, cement, solar panel manufacturers, etc are on the verge of bankruptcy. On Thursday the country's biggest steelmaker announced it was shutting down a mill in Shanghai due to weak demand. On Friday a major shipbuilder, Guangzhou Shipyards Intl, warned its profit for the next three quarters would be down -50% due to a decline in orders. The shipbuilding industry in Zhejiang province lost more than half its jobs in August. China Business News reported shipbuilders northwest of Shanghai were carrying out "disguised layoffs" by giving employees extended vacations. Barclays said a major Chinese shipbuilder told its analysts that orders for bulk cargo carriers had dried up and delivery of those under construction was delayed because customers could not pay for them.

On Friday there was a headline saying three state-owned shipping companies have placed an order worth $4.5 billion for 50 supertankers known as very large crude carriers or VLCCs. They carry up to two million barrels of oil. This is not only a stimulus program from the government but a move to reach China's goal of 80 VLCCs by the end of the decade. China will be the largest crude oil consumer by 2020. The consume half of what the U.S. consumes today. Growth of 7% GDP is still growth and oil consumption is still increasing.

Stock news was pretty scarce on Friday with Apple and Research in Motion the main headlines. RIMM reported earnings Thursday night that beat estimates and shares rallied to $8.20 intraday before declining to close at $7.50 and a 5% gain. Besides the better than expected earnings report, a loss of -27 cents compared to analyst estimates for -46 cents, the company said it had $2.3 billion in cash and just entered into a $500 million credit facility. That news suggests RIMM will be able to successfully launch BlackBerry 10 in early 2013. Shipments rose to 7.4 million phones and well ahead of analyst estimates of 6.9 million for the quarter. People are still buying Blackberry phones even with the BB10 six months away and the iPhone 5 being delivered today. On Wednesday they said total subscribers rose by two million for the quarter. The company said feedback from dozens of carriers in more than 16 countries was overwhelmingly positive for the BB10 phones. Time will tell.

Analysts believe the cash is worth about $4 a share and their infrastructure is worth another $4. That means investors are getting the phone business for free if they bought RIMM at $7.50. However, analysts are also overwhelmingly negative on the long term outlook for RIMM.

RIMM Chart

Apple shares declined again with a -$14 loss after Apple CEO Tim Cook released an apology letter to customers. The uproar over the Apple maps application is growing. Nonsensical routes, misplaced landmarks and a primitive interface are creating some serious user hostility. Cook suggested customers try alternative map solutions from Microsoft and Google while Apple improves its map application.

Cook said in his apology letter, "We are extremely sorry for the frustration this has caused our customers, and we are doing everything we can to make Maps better." Company officers tried to justify the forced move into the Apple map application by saying Apple could no longer afford to depend on Google for such a crucial function. Most analysts believe this is the right move only at the wrong time. Apple has a reputation for building high class devices but a history of problems in the software services segment. Smartphones are becoming more and more an Internet device rather than just an intelligent phone. That means the software to access Internet functions is going to become increasingly important. Apple's Achille's heel has been its Internet services. Even Steve Jobs, a hardware perfectionist, tended to pay less attention to the software components. Immediately after Cook posted the apology letter Google posted a step by step blog explaining how to use Google Maps on the new iPhone using the browser function. Google also acknowledged it was now developing a map application for iOS 6 for release before year end.

Apple Chart

Sharp Corp, the Japanese company that makes liquid crystal displays and iPhone and tablet screens for Apple received an emergency loan of $4.6 billion to keep it afloat. A syndicated loan from two groups will keep the company from filing bankruptcy through June of 2013. Sharp had to agree to drastic cost cuts including selling overseas TV assembly plants and closing solar manufacturing plants outside Japan. Sharp has been having quality control problems with the iPhone 5 screens and has been cited several times as the reason Apple deliveries are lagging.

Dow component McDonalds (MCD) declined -$1.52 on a downgrade from Janney Capital Markets. The Janney analyst said Wall Street may be overestimating same-store sales for Q3 and difficult year over year comparisons could be tough. The analyst also said he was hearing from industry sources that revenues could be light in September. That was not only a warning for McDonalds but also the economy if sales at the leading burger restaurant declined. The analyst cut McDonalds rating from buy to neutral with a price target of $100.

McDonalds Chart

Starbucks (SBUX) said it was opening its first store in India by the end of October. It will open in an upscale section of Mumbai. Earlier this year Starbucks said it expected to open 50 locations in India before year end.

Transocean Offshore (RIG) was served with an injunction stating it has to halt operations in Brazil by Oct 27th. This stems from a minor leak Chevron had in the Frade field offshore Brazil. The leak was only 3,600 barrels and 200 miles offshore and it was a nonevent. However, an overzealous prosecutor immediately sued Chevron and Transocean, the driller for Chevron, for $20 billion. The case instantly garnered headlines pitting the prosecutor against big U.S. oil companies and was a political win even though it has no basis.

Chevron said from the first day that Transocean had no part in the spill. It was a Chevron problem. They were injecting water into the field to increase pressures and force more oil to the surface. Unfortunately it forced oil to the surface through cracks in the seafloor as well as through the well bore.

Drilling was immediately halted and the spill cleaned up. The Brazilian regulator fined Chevron $17.3 million and said Transocean was not at fault. End of story right? Not in the highly charged political environment. The case was even transferred out of the jurisdiction of the zealous prosecutor but the politics followed it.

The court issued an injunction forcing Chevron and Transocean to halt operations within 30 days or pay a fine of $245 million a day. The Brazilian regulator, ANP, has petitioned the court multiple times trying to get the injunction lifted or set aside. The problem is huge. Chevron has halted production on the 60,000 bpd Frade field and that is hurting revenue for Petrobras and Brazil. Even worse, Transocean has 10 deepwater rigs operating in Brazil and seven of them are working for Petrobras. If the injunction stands this would severely slow the $237 billion, five-year development effort by Petrobras. It will also harm Transocean because they get 11% of their revenue from Brazil. Petrobras has also sued to halt the injunction.

On the positive side Transocean announced it had signed a $7.6 billion contract with Shell to cover the use of four rigs over the next ten years. Transocean will invest $3 billion to build four high capacity deepwater drillships, the first of which will be delivered in mid 2015 and the rest in six month increments. The new rigs will be able to drill in 12,000 feet of water and drill wells 40,000 feet deep.

Shares of Transocean declined -48 cents. The negative Brazilian news has been priced in for the last two months. Personally I don't think the country of Brazil can allow this injunction to continue but politics produces some unusual circumstances.

Transocean Offshore Chart

Gasoline futures expired at the close on Friday and did so with a bang. Historically gasoline prices decline after Labor Day but various factors including Hurricane Isaac, refinery explosions, low inventories in the northeast and violence in the Middle East have provided support. Investors betting (shorting) the futures over the last two months in expectations of a decline were caught in a squeeze at the close on the expiring contract. Prices of the expiring October contract rose +19.8 cents to $3.34 per gallon. The price on the November contract was a tame $2.92 per gallon. There was huge volume the last two days as traders bailed out.

October Gasoline Futures Chart

November Gasoline Chart

Hedge funds and large speculators put roughly $30 billion into commodities since early July in anticipation of the QE announcements by the ECB and Federal Reserve. They withdrew $5 billion last week for the first major drop in net longs in more than six weeks. The CFTC said it was the biggest position decline in four months by "money managers." Reuters said the value of net long positions declined from $117.8 billion to $112.3 billion for the week ended Sept 18th. The number of long contracts declined -6% or 87,955 for the week ended Sept 25th. Oil was the biggest loser with net outflows of $3.4 billion or 36,885 contracts. However, net longs in gold futures hit seven-month highs.

An Iranian news agency reported as fact a fictitious news story in The Onion, a just for laughs online newspaper. The story quoted a fake survey saying U.S. voters would rather go to a baseball game with Iranian President Mahmoud Ahmadinejad than President Obama. It included a fictional quote from a West Virginia resident saying he liked Ahmadinejad better because "he takes national defense seriously and would never let some gay protestors tell him how to run his country like Obama does." Homosexual acts are punishable by death in Iran. Ahmadinejad once said in a 2007 speech at Columbia University that "in Iran we don't have homosexuals like in your country." The Iranian news agency Fars picked up the story and ran it in its entirety until somebody finally pointed out that it was a joke and it was immediately removed from the website. Oops!

The AAII Investor Sentiment Survey showed that bearish sentiment rose to its highest level since July. The bearish sentiment component rose +2.7 points to 36.5% and a nine-week high. This is the fifth consecutive week above its historical average of 30%. Bullish sentiment declined -1.4 points to 36.1% and neutral sentiment fell -1.3 points to 27.4%. This was the fifth consecutive week bullish sentiment has been below its historical average of 39% and the 25th week out of the last 26th. That is a pretty telling history since the market was testing recent highs. Buyers are not convinced and bears are gaining converts.

Earnings for Q3 don't really kick off until the following week but the outlook is not good. Estimates are for a decline in earnings of -1.9% to -3.0% depending on what company is reporting the statistics. We have had several high profile earnings warnings from Intel, FedEx, Caterpillar, P&G, Notfolk Southern, Ford, Dow Chemical and Nike plus a few warnings from smaller companies. However, despite these high profile events the warning season has been relatively tame. There has not been a flood of events.

Analysts believe this is due to the overabundance of caution with the Q2 earnings. Companies were already guiding lower then so there was no need to warn late in this quarter. Analysts now believe the worst is already priced into the market so there is room for upside surprises. Basically "less bad" numbers would be seen as an upside surprise.

With another week to go before the earnings start to fly the market next week will be focused on economics and Europe. Headlines will rule the day.

The end of Q3 saw the markets begin to weaken. Window dressing provided support but it was a challenge. Now that the third quarter statements are in the rear view mirror fund managers are free to restructure their portfolios to provide the most profits going into their fiscal year end on Oct 31st.

That may mean selling some winners and two of those winners are Apple and Google. Managers can cover over a lot of sinners by taking monster profits in those two stocks. Since Apple is roughly 18% of the Nasdaq and 10% of the S&P any declines in Apple and Google will be felt in the broader market.

I am worried about the next two weeks. October is known for market bottoms because of the portfolio restructuring scenario. In order to have a bottom we are going to need to see some selling.

If I were going to pick an initial downside target it would be S&P 1400. That is only 40 points away and represents a minimal -3% decline on profit taking. The 200-day at 1360 would be the next target with just over a 5% decline. I do not anticipate we will see more selling than that but I could always be wrong with Europe a disaster waiting to happen and the fiscal cliff looming in our future.

Soon we will have to start dealing with the potential for the capital gains tax increase. I doubt we will see a lot of selling to dodge the tax increase until after the election. The tax posture of the winner will determine if those gains are taken in 2012 or investors hold on in anticipation of a positive change in the tax law. The 15% capital gains tax is set to rise to as much as 43% on January 1st.

I have mentioned before that I don't think we will be allowed to fall off the cliff simply because the damage would be too great. With the economy growing at a +1.25% rate in Q2 and Q3 estimates even lower we don't want to be creating any self inflicted wounds.

The opposite side of this argument is the standard "Don't fight the Fed" rally. In this case it is don't fight the central banks because they are all easing. We are in the race to debase when it comes to currencies and that is long term positive for stocks and commodities. If by some chance the markets continue to head lower in the face of this global easing then we will have a serious problem. The Fed is all in and they have nothing left to use if this play does not work.

For next week we could see some retirement funds hit in the first few days but the market has seen a net outflow of funds all year so there may not be a large amount of cash heading into retirement accounts or at least into equity accounts. Fixed income and bonds continue to see inflows as we approach the fiscal cliff.

Trading next week should be relatively simple. I would short a break of S&P 1430 (30 day average) and target 1400. If we do happen to rebound early in the week I would look to short any obvious failures with resistance at 1460.

S&P Chart

The Dow managed to close over 13,400 despite spending most of the morning below that level. While 13,400 could be seen as initial support the real support level now is 13,300 followed by 13,000. I think the odds of a retest of 13,000 are very good. Blue chips have been outperforming on the way up and that is where fund managers will be extracting their stored cash in October.

I would not attach too much importance to the Dow moves next week. The S&P is a better market guide because of the Dow's narrow breadth. Resistance at 13,500 and 13,600.

Dow Chart

Contradicting the Dow rally is the three month decline in the Dow Transports. The chart is choppy but the Transports did close at a three month low on Friday. The warnings by FedEx and Norfolk Southern are weighing heavily as investors wait for the next transport stock to warn. Dow Theory supporters are ringing the warning bells on the non confirmation by the transports.

Dow Transport Chart

With Google, Apple, Amazon, Intuitive Surgical and Priceline all negative on Friday the Nasdaq did not have a chance. The composite index lost -20 points and the Nasdaq 100 -22 points. In reality it could have been a lot worse.

I am very concerned the Nasdaq big caps are going to be sold over the next two weeks simply because of the big gains over the last six months. There is a tremendous amount of uncaptured profits and fund managers will not want to see their year destroyed by losing those big gains.

Initial support is 3085 and that was hit on Wednesday. The next material support level is 3040 and then 3000. Those are the key levels to watch in October.

Nasdaq Chart

The Russell is holding up very well with only a 30 point decline from the highs. The long term support at 832 was tested last week and held but 820 is the next likely target.

Russell Chart

I expect a dip in October most likely in the second and third week. The election could impact that depending on who is ahead in the polls at the time and the jobs numbers on Oct 5th. This could be a really rocky month.

Enter passively, exit aggressively!

Jim Brown

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"Wherever God erects a house of prayer,
The devil always builds a chapel there.
And it will be found upon examination,
The latter has the largest congregation.”

Daniel Defoe 1701