The roller coast ride continues and it looks like there are traders that want to get out before the next plunge lower. After an 8% rally in the market we were poised for some profit taking. Sometimes it can be very challenging to correctly identify what is moving the markets. Now is not one of those times. A rash of bearish economic data and disappointing earnings guidance was enough to spark the sell-off on a low-volume summer expiration Friday.

This past week was all about disappointment. The markets were unhappy with the less than optimistic tone in the FOMC minutes. Investors were unhappy with the disappointing manufacturing data with big declines in the Philly Fed and New York (Empire State) Fed surveys. Traders have been very unhappy with the quality of earnings from the financial sector. To top it all off it looks like the consumer is retreating again thanks to a huge drop in the preliminary consumer sentiment report.

High profile banks like JPM, BAC and Citigroup (C) all report earnings this past week. It looked like JPM knocked the cover off the ball but the company only did so by releasing billions from their loan loss reserves. CEO Jamie Dimon admitted these were not "normal" earnings. Therein lies the challenge for the banks. Investors want to know what their "normalized" earnings are going to be. For months we heard about how great the wide yield spread was for the banks and how they could just rake in a profit. Yet the big disappointment with JPM, BAC, and C is declining revenues and rising costs. Mortgage revenues are down. Trading revenues are down. It is not shaping up to be a very healthy earnings season.

Financials are a huge part of the market and the major averages can't have a sustained rally unless the banks participate. While we're on the subject of financials, I thought the Goldman Sachs settlement with the SEC would have had a much more bullish effect on the market. Yet there are industry analysts that feel like GS gave up too early and when they caved into the SEC's fraud charges all of Wall Street lost with them. Of course most of these settlements let the accused get away without admitting any guilt or wrongdoing. GS got away cheap with a $550 million (record-setting) fine. Plus they had to admit they made a "mistake" with how they market some of their mortgage-related securities. On the same day the U.S. senate passed the financial reform bill 60-39. This is a monster bill with 390,000 words. No one knows yet how all of these rules are going to get implemented. President Obama may sign it into law soon but the actual regulations haven't been written yet and the impact may not be felt for months or years to come. What does that mean to the banks? It means the shadow of uncertainty is still close by and could keep a lid on the banking sector.

Aside from the earnings parade Friday was dominated by bearish results from the preliminary Consumer Sentiment numbers for July. The headline composite number plunged -9.5 points to 66.5. This is the 8th largest drop in the history of this report. Why does this matter? Wall Street believes that consumer sentiment will forecast consumer spending. We saw a similar move in the most recent consumer confidence number, which declined -10.4 points to 52.9. We already have declining retail sales numbers. If consumers are pulling back even more it will significantly raise the risk of a double-dip recession in the U.S.

Another concern, in addition to declines in manufacturing and a nervous consumer, has been the inflation data. Both the CPI and PPI have been declining. We're actually starting to see a deflationary trend. The markets fear deflation because it is so much harder to fight than inflation. The Federal Reserve will have to get creative again since they can't lower interest rates, which are already in the 0.0%-to-0.25% zone.

Technically the markets look pretty ugly. The rally (a.k.a. oversold bounce) in the S&P 500 came to a dead stop near the 1100 level. This was also near the declining 50-dma. This index, like many of its peers, is now in a bearish trend of lower highs and lower lows. I have been warning readers that any rallies would probably be short and sharp, which is normal for a "bear" market. Officially the S&P 500 is not in a bear market yet but it's moving that direction. I suspect we'll see the S&P 500 retest the 1020 level before the end of August if not sooner.

Weekly chart of the S&P 500 index:

Daily chart of the S&P 500 index:

We can still look for potential support near the 1,000 level on the S&P 500 but longer-term odds are good we'll see this index decline toward the 950 area. That makes it very challenging to place long-term bullish LEAP trades. The NASDAQ doesn't look any better. The oversold bounce failed near resistance at its 50 and 200-dma (now in a death cross pattern). I would be watching the 2,000 level as support for the NASDAQ.

Daily chart of the NASDAQ index:

Unfortunately the small caps are struggling too. The Russell 2000 index failed near 640 and its 200-dma. Shares might see some support near the 580 level. The bigger concern is the bearish trend of lower highs and lower lows.

Daily chart of the Russell 2000 index:

Optimistically earnings results and improvements in Europe might be able to turn the market around. Yes, you heard me right, improvements in Europe. The debt crisis in Europe has not gone away but last week Spain was successful with a three billion euro 15-year bond auction. We will see more debt auctions from struggling EU nations later this month. If these auctions are successful it could help heal the fears still circling around the EU, the euro, and the fate of the region. Plus, we should hear from the bank stress test on 91 of Europe's banks in about a week's time. Currently expectations are for a strong showing but you could argue positive results from this stress test is already baked into the market.

Meanwhile earnings will be the primary focus this week. The next five trading days will be the busiest week of the Q2 earnings season. If corporate guidance improves and investors choose to take a more bullish interpretation from corporate guidance then stocks might turn around. Our problem is the sour note cast by JPM, BAC, C, GOOG, and GE. Once you get off on the wrong foot it can be hard to recover.

I have been cautioning readers to expect the market to top out in mid July. It looks like the reversal occurred a little bit earlier than expected. I'm not saying it's straight down from here. Earnings results could produce some short-term pops but look for traders to sell into strength.


Previous Comments on my Long-Term Outlook:

My long-term outlook has not changed. I still expect the economy to see a double-dip, "W"-shaped rebound with the second dip in late 2010 (some analysts are predicting it will not show up until 2011). Lousy consumer spending, rising foreclosures, and lagging job growth will be the main culprits. Several weeks ago there were some comments out of the U.S. Treasury concerning foreclosures. The Obama administration's HAMP loan modification program can only help a certain number of homeowners and one official said that even if the HAMP program was a total success we should still expect millions of new foreclosures. Estimates were in the 3 to 5 million foreclosures over the next three years but a White House advisor was quoted with estimates in the six to ten million range over the next three years. This only reinforces my own belief that we will see another tidal wave of foreclosed homes in 2010 and 2011. What is that going to do to consumer confidence and consumer spending? It's not going to help! You can review my long-term outlook here. It's the second half our my "Two Months Left" commentary.

~ James Brown