The stock market's momentum definitely reversed in the third quarter. The first quarter of 2011 saw a +5.5% gain for the S&P 500. Equities stalled in the second quarter a fractional loss of less than 1% (virtually zero). The third quarter produced a -14.3% decline. It was the worst quarter for the stock market since the bear market of the "Great Recession". From the Q3 top in July to the August lows the S&P 500 saw a -18.8% plunge. Normally drops of -20% or more signal a new bear market. Technically we are not in a bear market yet but we're getting close.

I can sum up last week's trading pretty quickly. Stocks initially rallied early last week on hopes that Europe was making progress on its Greek debt problem but lack of details on any new plans left the rally without any fuel and stocks reversed sharply midweek. Technically the oversold bounce has failed. Stocks began to fall on Greek default fears and growing concerns over a U.S. and global economic slowdown. Worries over China began to grow with Chinese CDS spreads rising. The latest Chinese PMI data came below 50 for the third month in a row. Numbers under 50 indicate economic contraction. The country is still expected to grow at more than +8% but there were renewed worries of a hard landing.

It did not help that we are starting to see some earnings warnings (from DRI, NUE, IR, and MU). A bullish revision to the U.S. Q2 GDP number was ignored. A better than expected drop in the weekly initial jobless claims was discarded since the data was tainted by a technicality. You may have thought that Germany's vote of approval to expand the European Financial Stability Facility (EFSF) to 440 billion euro would have been good news but investors essentially sold the news. Then late in the week the Economic Cycle Research Institute (ECRI), the firm that produces the weekly leading indicators index, published their opinion that the U.S. was indeed falling into another recession.

Greece & Europe

Germany's vote on amending the EFSF bailout fund was critical but it will still take some time for the rest of the Eurozone members to approve the changes. Unfortunately Greece may not have much time left. EU leaders are meeting together on October 13th to decide if Greece will receive the next tranche of bailout funds (approximately 8 billion euros). If this next loan is not approved then Greece is expected to run out of money by October 17th. This could make the next two weeks pretty volatile for stocks, especially if European politicians decide to do any posturing prior to the meeting to appear tough on the issue before finally giving in. I discuss the situation with Greece in a little more detail in tonight's "new plays" section but you already know the story. Eventually Greece will default. Right now the EU is just trying to delay the inevitable.

Major Indices:

If you're looking at the U.S. markets tonight I don't see a lot of changes from my comments a week ago. If anything we are in worse shape. We've seen the oversold bounce and the bounce has failed. We have a new lower high and we are about to make a new lower low. Many of the major indices have produced both a bear-flag pattern and a bearish H&S pattern over the past several weeks. I warned readers that if the S&P 500 breaks down we're probably looking at a drop toward 1,050 or 1,000. I would bet on a drop toward 1,000 with a sharp bounce at 1,050 on the way down. On a very short-term basis the S&P 500 could still see support near 1120 and then at the 1100 mark.

Bear Flag pattern on the S&P 500 index:

Weekly chart of the S&P 500 index:

Technology stocks have been hammered lately. The NASDAQ composite has suffered a rough three days and closed on its lows on Friday. Instead of quarter end window dressing it was window washing instead. Money managers were dumping tech stocks to get them off their books. It looks like the NASDAQ has broken down from its bear-flag pattern but there is still potential support at 2415 and then at its August lows near the 2340 area. The flag pattern would suggest a multi-week drop toward the 2100 area. This would line up with the weekly chart's support near 2100.

Daily chart of the NASDAQ Composite index:

Weekly chart of the NASDAQ Composite index:

Small cap stocks are more volatile than their big cap rivals. The Russell 2000 index has produced both a bear flag pattern and a bearish head-and-shoulders pattern. The sharp oversold bounce has failed and the $RUT is testing its August lows again. Odds are against this level holding again but it remains support until broken. The bear-flag would suggest a multi-week target near 550. The H&S pattern would suggest a downside target near 580ish. Coincidentally the 2010 summer lows were near 588.

Daily chart of the Russell 2000 index

Weekly chart of the Russell 2000 index

The first week of the month is always a busy one for economic reports. We'll see the ISM manufacturing index, the ISM services index, the ADP employment report and of course the nonfarm payrolls (jobs) report. Economists are expecting the ISM to come in near the dividing line of 50. Numbers above 50.0 suggest growth while numbers under 50.0 indicate contraction. The major report for the week is the jobs report on Friday. Analysts are expecting the U.S. to have gained +60,000 in September. Odds are good that last month's number will be revised down into negative territory. Expectations are negative so an upside surprise in the jobs number could spark a nice short squeeze.

- Monday, October 3 -
(National) ISM index for September
Construction Spending
Vehicle Sales

- Tuesday, October 4 -
Factory Orders

- Wednesday, October 5 -
ADP Employment Report for September
(National) ISM Services index for September

- Thursday, October 6 -
Weekly Initial Jobless Claims

- Friday, October 7 -
Nonfarm payrolls (Jobs) report for September
Wholesale inventory number
Consumer Credit

Looking ahead I am worried that the stock market is on the verge of a new multi-week decline. Let's assume for the moment that Europe continues to kick the Greece debt problem down the road. The market's focus should then turn toward corporate earnings. The Q3 earnings season is going to start in about two weeks. Will we see positive earnings growth or earnings misses? Will corporate guidance be strong? Or will management offer cautious guidance and lack of visibility? The bulls are arguing that stocks are cheap at current levels. I'm going to steal a concept from the 1996 movie Jerry Maguire. Corporations are going to need to show us the money otherwise their stocks are going to get a lot cheaper as investors sell the earnings news!

Seasonally the stock market tends to rally in the fourth quarter. However, the first half of October is usually pretty volatile. Right now I am very cautious on stocks and would not launch new bullish positions. The next two or three weeks will be critical. The S&P 500 is nearing support in the 1120-1100 zone. This is essentially the edge of the cliff. A breakdown under 1100 could spark a very significant sell-off. On the other hand, if we rebound, we could see another big round of short covering. The combination of earnings season and getting past the next major deadline for Greece in the next few weeks should catapult stocks one way or the other.

- James