The rally in U.S. stocks had started to stall with three declines in a row. That changed on Friday with a big short squeeze on better than expected economic data. The major indices surged back toward their recent highs. For the week the S&P 500 gained +2.0%, the small cap Russell 2000 added +3.0%, the NASDAQ composite rose +2.8%, while the NASDAQ-100 index surged +3.4%. If you think those are impressive gains look at the gains for the month thus far. The S&P 500 is up +9.4% and the NASDAQ is up over +12%. There are only four trading days left in the month and we're on track for the best September performance in 70 years.

Friday's rally started overseas. It was a relatively quiet week in Asia with several markets closed on Wednesday or Thursday for holiday but China and Japan still posted minor gains on Friday. The real action was in Europe. A better than expected reading on business confidence in Germany helped put traders in a bullish frame of mind. Meanwhile the country of Spain slashed its budgets and raised taxes on those making more than 120,000 euros a year so the country could reaffirm their debt-to-GDP targets for 2010 and 2011. The Spanish government is trying to bring down the deficit from 11% in 2009 to 6% in 2011. European markets also reacted well to the U.S. durable goods data. Friday's session saw the English FTSE rise +0.9%, the German DAX rally +1.8%, and the French CAC-40 jump +1.9%.

The euro currency continued to rally as well marking its fourth weekly gain in the last five weeks. Concerns over a slowing U.S. economy and expectations for the Federal Reserve to launch another massive round of quantitative easing come this November is weighing on the U.S. dollar. The dollar has been plunging almost non-stop the last two weeks and settled at new eight-month lows on Friday. This dollar weakness is pushing commodities higher. Metals have been big winners with significant gains in copper, silver, and platinum. Of course gold gets all the headlines as gold futures tagged $1,300 an ounce intraday on Friday. Some are predicting gold will hit $1,500 an ounce. While Friday's trade at $1,300 is a new all-time dollar high, bear in mind that adjusted for inflation the January 1980 high of $875 an ounce would equal $2,318 an ounce today. Agriculture commodities are surging too with wheat, sugar and coffee on the rise. Starbucks (SBUX) just announced that they would have to raise prices for some of their coffee drinks to account for the rising cost of coffee beans.

Daily chart of the U.S. dollar ETF (UUP):

Daily chart of the GLD gold ETF:

Daily chart of the SGG sugar ETN:

The big event on Friday was the U.S. durable goods orders. Durable goods are items expected to last at least three years like automobiles, refrigerators, and washing machines. According to the Commerce Department August durable goods orders fell -1.3% versus estimates for a -1% decline. This was the worst decline in a year, weighed down by a -10.3% drop in transports. This was fueled by a -40.2% plunge in commercial aircraft orders but this is a very volatile sector. The August drop in plane orders follows a +69% surge in July. Excluding the volatile transport sector, demand for durable goods rose +2.0%, which was better than expected and a nice improvement from July's -2.8% decline. The +2% gain in August is the best reading, ex-transports, since March of this year. To sum up this paragraph the positive reversal in orders from July to August is a good sign that businesses and consumers are still spending. Business investment is still moving at a strong clip while manufacturing appears to have recovered from its recent stumble. We'll have to wait and see if the next round of manufacturing data supports this.

The Commerce Department also released the August new home sales figures. The government said the seasonally adjusted annual sales pace came in at 288,000. This was better than expected but it still tied July for the second worst reading on record. May's 282,000 was the lowest reading since records began back in 1963. Year over year the August number reflects a -29% drop in new home sales. Builders can't compete with the flood of foreclosures on the market so they have scaled back their production. The inventory of new homes on the market is down to 206,000, which is the lowest level in 40 years. Believe it or not new home construction is up +25% off its lows but we're still down almost -75% from the 2006 peak. Homebuilders rallied sharply on then news and the DJUSHB index gained +2.6%. The HGX index rose +3.3%.

Technically the market remains very overbought. We're up four weeks in a row with very big gains. Normally I would be looking for a correction but the calendar could interfere with that. Money managers that have been waiting for a dip to jump on board this market rally might feel compelled to buy the market even at these levels. Pretty soon we'll hit the beginning of October and the first few days of the month tends to see an influx of new money. To make matters even worse the end of October is also the fiscal year end for the majority of mutual funds. Not only will they be compelled to lock in gains before their year is out (which could amount to selling pressure in October) but they will also be tempted to do some year-end window dressing for their statements. This push-pull could easily create some serious volatility in October. Will the pressure to sell and lock in gains overpower the pressure to chase this rally and window dress their portfolio? Or will it be the other way around? Plus, there is a widespread expectation that the fourth quarter will be bullish for stocks. A lot of money managers are crossing their fingers and praying for a pull back so they can hop on board. At the same time investors know that taxes are going up next year. Do they choose to sell now and pay taxes now in 2010 before they go up? How will that affect the fourth quarter?

On a short-term basis we can look for support on the S&P 500 in the 1130-1120 zone and near the 1100 area and its now rising 50-dma. If the S&P 500 can breakout past resistance near 1150 there is potential resistance at the mid May high around 1172 and then the 2010 highs near 1210-1220.

Daily chart of the S&P 500 index:

The tech-heavy NASDAQ composite has been a real leader during September with big gains. The NASDAQ has seen a nearly non-stop rally from 2100 to 2381. This index is very overbought. Yet on a positive note the inverse head-and-shoulders pattern is forecasting a rally toward the 2010 highs (near 2525). It's not going to get there in a straight line, in spite of the last four weeks, so the challenge is waiting for the right entry point. The 2300 area and 2250 region should offer some support.

Daily chart of the NASDAQ index:

I also want to bring your attention to the NASDAQ-100 index (NDX). The NDX is the largest 100 stocks in the NASDAQ composite and the large caps are on fire. The NDX is up over +15% from the late August lows. It's also getting very close to potential resistance at the 2010 highs. This is a very good spot for us to expect some profit taking. However, if you look at the weekly chart below you'll also see that the NDX has produced what almost looks like a bullish cup-and-handle formation suggesting an eventual breakout past these highs.

Weekly chart of the NASDAQ-100 (NDX) index:

The charts for the small cap Russell 2000 and the Dow Jones Transports look similar in that they have both rallied to resistance. A breakout for either would be bullish for the market but both are overbought and due for a correction. We also want to keep an eye on the SOX semiconductor index. Word that Oracle (ORCL) was interested in buying a semiconductor company sent the whole sector higher on Friday and the SOX vaulted past its 50-dma and managed to close the gap from early August. Yet the SOX still has a bearish pattern of lower highs and lower lows for now.

Daily chart of the Russell 2000 index:

Daily chart of the Dow Jones Transportation index:

Daily chart of the SOX semiconductor index:

We have a very busy week of economic data in front of us. If we continue to see a trend of "less bad" numbers or even positive gains then stocks should find support. Any significantly negative surprises could be used as an excuse for profit taking. On Monday we'll have the Chicago Federal Reserve activity index. Tuesday we'll see the latest consumer confidence numbers and the Richmond Fed survey. Analysts believe confidence will fall from 53.5 to 52.9. Tuesday will also bring the Case-Shiller 20-city home price index. Thursday is a busy day with weekly initial jobless claims, GDP estimate, New York ISM, Chicago PMI, and the Kansas Federal Reserve manufacturing survey. This is the third estimate for Q2 GDP growth and economists don't expect any changes at +1.6%. Friday will see the final reading for September's University of Michigan consumer sentiment number. We'll also see the latest auto sales figures and construction spending on Friday. The big event on October 1st is the national ISM manufacturing index and analysts are expecting a drop from 56.3 to 54.5.

If this new wave of economic data does not confirm the recent trend of moderate growth then stocks could fall sharply as investors price back into the market a growing risk of a double-dip recession. I don't expect that to happen but it is a risk. Bigger picture we have to deal with monthly and annual money shuffle for mutual funds. They are going to feel a lot of pressure to chase this rally, especially if the S&P 500 can maintain its gains above 1130. There is a chance we'll see some selling pressure ahead of the Q3 earnings season, which begins in a couple of weeks. However, as we approach the midterm elections I'm expecting stocks to show strength the second half of October and into November. Our challenge right now is an entry point. We don't want to chase stocks following a +10% rally from the August lows. Yet I suspect that pullbacks are going to be shallower than we might normally expect.

- James