Another rocky week for stocks left the market on a sour note ahead of the three-day Labor Day weekend. By the time we hit the closing bell on Friday investors were rushing back into safe-haven trades. Gold was soaring back towards the recent highs. Meanwhile bonds rallied again leaving the yield on the 10-year note at 1.99% for the first time in about 50 years.

The volatility index (VIX) is traditionally used as a "fear gauge" on investor sentiment. Currently the VIX is at elevated levels near 34 but it is not trading near the recent panic highs in the 45-48 levels. Are investors turning numb to the market's big swings? Or have traders already bought all the protective puts they need during the last four weeks so there is no need to buy more and thus the VIX isn't spiking higher again? If investors already feel protected because they bought puts on the last two market sell-offs then maybe we will see a little less panic selling in stocks.

Daily chart of the Volatility (VIX) index:

Looking back at the first half of the week the stock market was in rally mode. The East coast was recovering from Hurricane Irene but the big headline on Monday was out of Europe. News of a merger between Greece's two largest banks was taken as a positive development in hopes it might strengthen the country's financial system. The headline helped fuel gains n financial stocks around the globe on Monday.

Tuesday the main stories were consumer confidence and the FOMC minutes. Analysts were hoping to find hints in the minutes of the last FOMC meeting about any future stimulus proposals. Yet the minutes were devoid of any significant details. Meanwhile the August consumer confidence report was a bust! Economists had been expecting a drop from 59 to 52. The report showed confidence plunging to 44.5, which is the lowest level since April 2009. Analysts believe that consumer confidence has an impact on consumer spending and consumer spending accounts for about 70% of the U.S. economy.

The correlation between consumer confidence and spending doesn't always hold up. Thursday we saw August same-store sales data for several major retailers. Generally these were results came in better than expected. Consumer attitudes may be deteriorating but they haven't closed their wallets yet. On Thursday we also saw the ISM manufacturing survey for August. Economists were expecting this ISM number to drop from 50.9 to 48.5. Readings under 50.0 indicate economic contraction. The August number came in at 50.6, which would suggest the U.S. is clinging to growth but at a very slow pace. Elsewhere on Thursday the latest PMI manufacturing data from Europe came in below expectations.

Stocks initially rallied on Thursday morning. Unfortunately the rally reversed at resistance near 1230 on the S&P 500 index, which happens to be the 50% retracement between the July highs and the August lows. Once the market failed at resistance we started seeing profit taking as market participants turned cautious ahead of Friday's jobs report. It looks like they had a reason to worry.

The August nonfarm payroll report was a disaster. Economists had been expecting job growth of +70,000 to +80,000 new jobs in August after July's +117,000. Yet the total job growth in August was zero! Current estimates put private sector job growth in August at +17,000 but this was erased by -17,000 job losses by the government. Analysts had been expecting private job growth of +100,000. Pouring salt on the wound were downward revisions for July from +117K to +85K and June's +46K to +20K. Remember, we need at least +150,000 a month just to stay even with population growth and new workers.

The trend of downward revisions to the job report does not bode well for August. What are the odds that a month from now we'll see this report revised lower into negative territory? The official unemployment rate was unchanged at 9.1% but real unemployment is closer to 16.2%. Looking at the details of the jobs report the average hours worked and average hourly earnings both ticked lower, which is not a healthy sign of future demand to hire new workers.

There were two more big stories on Friday. One was Operation Twist and the other was the FHFA lawsuits. The jobs data was so bad that several analysts firms are suggesting the Fed will try and lift short-term rates while pushing down longer-term interest rates with a move called "Operation Twist". The Federal reserve can accomplish this by selling short-term notes while buying long-term notes. The speculation suggests a September time frame to start this process.

After big gains earlier in the week the financials were hammered lower on Thursday and Friday. The losses on Friday were exacerbated by news that the Federal Housing Financial Authority (FHFA) is suing 17 financial firms, including several major banks for more than $200 billion. The FHFA claims that these firms committed fraud with their representation of the mortgages and mortgage backed securities that they sold during the end of the housing boom.

You may recall that two weeks ago the financials were falling but analysts kept claiming this isn't 2008 and that the banks are much healthier now than they were during the subprime and Lehman Brothers meltdown. There was speculation about which banks might need to raise capital again. The media made a big fuss about Bank of America's (BAC) $5 billion deal with Warren Buffett's Berkshire Hathaway because previously BAC claimed to not need any capital.

Now this new FHFA lawsuit is going to keep banks on the defensive. Instead of loaning money they're going to keep hoarding cash because banks will not know how much they might need to come up with should this lawsuit proceed. Lawsuits like these take years to process. This could be a wet blanket on our economy for a long time. Banking analyst Richard Bove speculated that the impact could be devastating for both the U.S. banks and the U.S. economy.

Major Indices:

The failed rally in the S&P 500 index last week looks pretty ugly. Stocks failed twice, on Wednesday and Thursday near the 50% retracement of the July high to the August (closing) low. You can see this on the daily chart below. You'll also notice on the shorter-term chart that the sell-off last week is also trading to the various Fibonacci retracements with Friday's drop to the 50% retracement. There is the possibility that the S&P 500 is actually building a bear-flag pattern. If this proves to be the case then a breakdown from the bear flag would currently forecast a drop toward the 1,000-980 area.

On a short-term basis the S&P 500 might see some support near the 1160-1150 area but the real support levels to watch are 1120 and 1100. Should stocks rally then we're still looking at resistance near 1205, 1230, and 1250.

Daily chart of the S&P 500 index:

Intraday chart of the S&P 500 index:

Potential Flag pattern on the S&P 500 index:

The technology-stock heavy NASDAQ also saw its bounce fail at the 50% retracement of the July-August sell-off. This was also near resistance at the 2600 area. Now the Thursday-Friday sell-off has produced a 50% pull back of the most recent bounce. On a positive note the NASDAQ has also filled the gap from August 29th. The NASDAQ could see a bounce soon. If it does not then we might be looking at a retest of the 2400-2350 area. Should the market rebound higher again then we're back to watching for resistance near 2550 and 2600.

Daily chart of the NASDAQ Composite index:

Intraday chart of the NASDAQ Composite index:

It's a very similar story with the small cap Russell 2000 index. The daily chart shows a failed rally and reversal at the 50% retracement of the sell-off. The intraday chart shows a 50% pull back from the bounce off its mid August lows. Further weakness will probably see a decline toward support in the $66-64 area on the IWM (or 660-640 on the Russell 2000 index). Overhead resistance is the $72-74 zone (720-740 for the $RUT).

Daily chart of the Russell 2000 ETF (IWM)

Intraday chart of the Russell 2000 ETF (IWM)

The economic calendar for this coming week is light. There will be two reports to watch for this holiday shortened-week. The first is the ISM services for August. Second is the Fed's Beige Book report for an anecdotal look at business conditions in the twelve regions. The biggest event for the week might be President Obama's speech on Thursday night. This newsletter tries to refrain from making political comments but it's no secret that Obama's disapproval rating hit a new all-time high last week at 52%. His administration needs to do something. Yet given the fiasco over raising the U.S. debt ceiling it could be nearly impossible to pass any new major spending bills or stimulus. As an American I hope that Obama can present some fresh ideas to foster a positive economic environment that would organically create job demand instead of wasting billions on temporary government jobs.

- Monday, September 5 -
U.S. markets closed for Labor Day holiday

- Tuesday, September 6 -
ISM Services for August

- Wednesday, September 7 -
Federal Reserve's Beige Book report

- Thursday, September 8 -
Weekly Initial Jobless Claims
Trade Balance numbers for July
Consumer credit numbers for July
President Obama's speech on Jobs

- Friday, September 9 -
Wholesale inventories for July

Looking ahead we could see more fireworks out of Europe. The problems in Italy and Greece are festering. The EU, IMF, and ECB seem unable to lance this wound. Italy is facing criticism over its austerity package. Berlusconi's coalition government keeps changing it. The ECB argues that Italy's austerity measures have to be as strict as the ones agreed to a month ago. Meanwhile Greece is likely to miss its 2011 austerity targets. At least that's what the current EU inspectors are claiming. The bond markets are already predicting a default by Greece. The country can't access the credit markets when the yield on its one-year note is 72% and the two-year Greek bond is yielding almost 50%.

No one can predict where the market will be a week from now. Odds are really good that Asian and European markets will be down on Monday as they react to our Friday morning plunge thanks to the jobs report. If European markets can bounce on Tuesday prior to our market opening then we might see a bounce. Otherwise I would expect a weak open on Tuesday. Long-term traders may want to just sit back and watch. Waiting for another dip or a bounce from the 1120 or 1100 level is not a bad idea. My only concern would be the bear-flag pattern forming on the S&P 500 index.

I should not say that is my only concern. The parade of weak economic data seems to be getting worse. Every single week there is another disappointing report. There was an article several days ago on CNN discussing a poll that showed 8 out of 10 Americans believe we are already in a new recession. It certainly appears that the U.S. economy is heading for another downturn. The question is can Washington or the Federal Reserve do anything about it?

In Bernanke's Jackson Hole speech he strongly suggested the Fed would do something at its next meeting on September 20-21. Speculation over some sort of QE3 program will hit a feverish pace prior to the meeting. We could reach the point where bad news is good news. What does that mean? Every piece of bad economic news could be viewed as more fuel for the Fed to cook up some sort of stimulus.

At the moment the U.S. stock market just produced its worst two-day start to the month of September since 1974. Traditionally September is one of the worst months of the year for stocks. However, there is a chance that money managers will be reluctant to sell in front of the next Fed meeting on hopes that Bernanke does announce some sort of stimulus package. Many mutual funds close their fiscal year at the end of October so they only have a couple of months to recover if they are having a bad year.

The combination of market volatility and economic uncertainty is a tough environment to make long-term option bets but it also presents opportunity. We just need to be patient and pick our entry points. I am suggesting that if you are going to trade then readers should trade small (positions) and try to limit your risk as much as you can. I'd rather wait to buy a bounce than try and catch the absolute bottom buying the decline.

- James