Caution Is the Buzzword After Last Week's Stock Market Drop

Risk aversion was the story of the week last week amid rising exasperation with Eurozone countries to act in unison to solve their debt afflictions and swelling concerns that financial reform may constrain U.S. financial companies' profits. Economic reports didn't offer much help to the stock market, as industrial manufacturing outlooks showed a surprising amount of slowing.

Stocks mounted a modest bounce on Friday after a week that saw the major market averages sink another 2% to 4%. All of the positive action in the week came in a single low-volume session on Thursday that didn't ultimately do much to erase the negative tone of the worst May since the Kennedy administration.

More troublesome was the fact that positive corporate earnings news and mergers failed to bolster the appetite for stocks. Companies as varied as Dell Inc. (Nasdaq: DELL), Chicos FAS Inc. (NYSE: CHS), Brocade Communications Systems Inc. (Nasdaq: BRCD) and Sears Holding Corp. (Nasdaq: SHLD) beat analysts' expectations this month but saw their shares thrashed by up to 20%.

Most emerging markets fell hard during the week, and there was a broad sense that institutional investors were purging portfolios of high-beta assets that could be vulnerable to a slowdown in earnings growth. This is why bland food makers like Campbell Soup Co. (NYSE: CPB) and General Mills (NYSE: GIS) have survived the month without a crunch, but more economically sensitive companies like Johnson & Johnson (NYSE: JNJ) and Intel Corp. (Nasdaq: INTC) have flailed.

While the Standard & Poor's 500 Index did not close on Friday above its 200-day average -- the level that separates bull cycles from bear cycles -- the Nasdaq 100, Midcap 400 and Smallcap 600 did. This will be used by bulls as evidence that the May decline was just a modest setback on an upward journey.

Yet bears are making a good case that this is much more than a mere correction. Breadth has been hellaciously negative except for the 11-1 positive session on Thursday, and less than 100 stocks are making new highs on the three major U.S. exchanges. Plus volume has been much bigger on down days than up days, a sign of distribution.

With only 10% of NYSE issues over their 10-day moving average for four of the five days last week, bears' appetite for more bull meat is being whetted. The "megaphone" pattern in the Dow Jones Industrial Average, shown above, provides a nasty target if it continues to play out.

Driving the Decline

Crushing hopes last week were renewed concerns about the ability of southern European countries to pay their debts. The focus of attention switched to Spain, where the regulators seized a major regional bank to prevent its collapse, and the government launched into a battle of invective with union leaders who oppose a new budget that slashes $18 billion worth of civil service jobs and retirement benefits. Union leaders said they plan a general strike, so you can count on some new street battles to alarm investors in coming weeks.

Elsewhere in Europe was more talk about austerity plans, which are now beginning to sound like planned recessions.

Italy's cabinet said it plans to cut public sector hiring and pay, delayed some workers' retirements and cut funds to local governments. The two-year package is expected to cut the 2011 budget deficit by 13 billion euros. Only 20% of those who leave public jobs would be replaced between 2011 and 2013. Healthcare was also a major target of cuts.

The Italian public hates this idea, but listen to the words of the country's top administrator: "Europe is asking us for strict budget cuts.''

That is really interesting because it shows that countries have really put themselves in a place where an outside organization is telling them what to do. How would Americans like it if their Treasury secretary said that "world government leaders have told us " to slash spending on Medicare and Social Security?!

In the United Kingdom, the finance minister of the new government outlined $8 billion in spending cuts to curb the budget deficit and said much bigger cuts lay ahead in June. British leaders are under the gun to cut spending to maintain a triple-A credit rating. An official said the cuts would "send a shock wave" through government departments, with public services hit hardest.

"Countries are waking up to the dangers of a sovereign debt crisis and taking action to live within their means, " said incoming Tory Party finance chief George Osborne at a news conference in London. "That is what this new government is all about. "

Major U.S.-based tech and drug stocks have been reeling on this news because the Tories have specifically named IT and health-care spending as targets of their budget knives. Analysts that I spoke with said they believe that companies like International Business Machines Corp. (NYSE: IBM) and Bristol Myers Squibb Co. (NYSE: BMY) may be forced to accept cuts in U.K. government purchases of as much as 20% -- an amount that is not accounted for in any current earnings models.

Meanwhile, we can see that worldwide energy companies are also suffering big hits to their estimates as analysts cut their expectations of offshore drilling revenues and the effects of lower oil and gas prices. Transocean (NYSE: RIG), the big Swiss-based firm that operated the bedeviled platform in the Gulf of Mexico, sank another 9% today, confounding many contrarians' belief that its massive decline was already overdone, while Halliburton. Co (NYSE: HAL), the platform's general contactor, fell 4%, and BP PLC (NYSE ADR: BP), which owned the rig, sank 4.5%.

The fallout is now rolling over to smaller contractors on the rig, such as Cameron International Co. (NYSE: CAM), and peers who had nothing to do with it, such as Schlumberger Ltd. (NYSE: SLB). These are all very large S&P 500 companies that are going to drag down the index until the prices come down to a price that buyers believe discount the worst.

You can see in the chart above how much more violent the recent downturn has been in contrast to declines in the past year. The weekly chart puts a 15-week "envelope " around the S&P 500. It's rare for the bottom of the envelope to ''tear,'' but when it does, it typically leads to a four to six week rip lower, as is did in December 2007, October 2008 and February 2009.

There was some good news, however, so you can at least feel good that the Chicago national activity index rose to the highest level since December 2006, meaning that the U.S. economy is expanding at a higher than normal pace. Home price data was positive too.

And I'm getting higher and higher estimates of May payrolls. The latest to clock in with a big number was Deutsche Bank AG (NYSE: DB), which told clients that it expects nonfarm payrolls to hit +475,000 when reported on June 4. That includes Census hiring of 250,000. Deutsche said that if the current rate of hiring keeps up, the final number could actually come in at around 550,000.

The Bottom Line

Sellers have racked up some major points in their favor recently. One is the recent crummy performance of most stocks: Lowry's Research Corp. reported that for the four days through Wednesday, fewer than 10% of all NYSE stocks were below their 10-day averages -- a condition that has never occurred outside of a bear market in the past 75 years. My observation that austerity measures in Europe will almost certainly curb U.S. multinational companies' profits in the coming year in ways that are not accounted for in current earnings models.

The upshot: Remain conservative and not try to catch the absolute low, if that turns out to have been the case yesterday. If the bull cycle is about to reassert itself, the 10- and 20-day averages (or 9 and 18 if you're impatient) have to stop pointing down, stabilize, flip over, and then turn up as you can see they did in the chart of the Nasdaq 100 Trust above in February. If they do that, there will be plenty of upside left; if they don't you can save yourself a lot of grief by waiting.

Week in Review

Monday: Existing home sales rocketed 7.6% higher in April as the second-round of homebuyer tax credit expired. Tempering the good news was a jump in supply of 11.5% to 8.4 months. More supply, and the lack of tax incentives, sets the stage for a sales slowdown and price erosion in the months ahead.

Tuesday: Despite the large fall in the stock market and the debt worries in Europe, consumer confidence made a surprise increase in May, jumping to 63.3. This was well above the consensus estimate of 59 and the period month result of 57.9.

Wednesday: New home sales jumped 14.8% in April to 504k versus the consensus expectation of 425k. Again, the boost was due to the expiration of the homebuyer tax credit. The surge in sales resulted in the biggest decline in new home supply in 42 years -- which will help support the home construction industry. Separately, durable goods orders for April surged 2.9%, well ahead of the 1.5% consensus estimate.

Thursday: The government's revised estimate of Q1 GDP growth declined slightly to 3% from the 3.2% reported previously. The consensus was expecting 3.5%.

Friday: Consumer sentiment increased slightly while personal income continued to grow. Consumer spending increased 4.6% on a year-over-year basis. The overall impression is of a labor force feeling more confident and opening their wallets again thanks to fatter paychecks.

The Week Ahead

Monday: Markets closed for Memorial Day.

Tuesday: An update on activity in the nation's factories when the latest ISM Manufacturing Index report is released.

Wednesday: The Pending Home Sales Index will be released.

Thursday: An update on the important services sector courtesy of the ISM Non-Manufacturing Index. Also, updates on factory orders and a preview of Friday's jobs report with the release of the ADP Employment Report.

Friday: The all important May payroll report will be released. Analysts are looking for a net gain of 549k jobs for the month and a slight decrease in the unemployment rate. Census hiring is expected to add 250k to payrolls.

[Editor's Note: As the preceding market analysis demonstrates, Money Morning Contributing Writer Jon D. Markman has never been afraid to make a prediction.

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