The following is an abridged version. For full details see The Coming Week: Stocks, Commodities, Forex – 3 Key Market Drivers July 19^th -23^rd

Prior Week

Bullish Market Movers

‘Successful’ EU Sovereign Bond Sales
Overall Positive US Earnings
Goldman Sachs Fraud Case Settlement

Bearish Market Movers

US Earnings Negatives
Poor Economic Data

Coming Week

EU Bank Stress Tests – The Main Event This Week
EU Bond Sales
US Corporate Earnings Week II

Conclusion-Downside Risk Greater, EU Banks Stress Tests Likely To Decide Near Term Market Direction

Prior Week

Bullish Market Movers

‘Successful’ EU Sovereign Bond Sales

The most likely trigger of the next stage of the EU sovereign debt crisis would be a failed bond auction by one of the PHIIGS. Thus markets correctly interpreted healthy demand for Greek, Italian, Portuguese, and Spanish bonds as a positive for risk appetite, even if the sales were at unsustainably high rates.

As long as these countries can sell bonds, the EU buys time to conjure up a longer term solution. A deferred crisis may arguably be better than an imminent crisis. See The Coming Week: Stocks, Commodities, Forex – 3 Key Market Drivers July 19^th -23^rd for details.

Overall Positive US Earnings

Positive US earnings results for the first week of Q2 earnings season provided much of the lift behind the below average volume rise in the bellwether index Monday-Thursday. Alcoa (AA), General Electric (GE), Bank of America (BAC), Citigroup (C), JPMorganChase (JPM) all had better than expected earnings.

Goldman Sachs Fraud Case Settlement

Goldman Sachs settled its SEC fraud case for a $550 mln wrist slap and its shares rose 5.9% on the removal of that question mark, as markets took the fine to be a mere ‘wrist slap’ and as a sign that any other banking misdeeds would not threaten the perpetrators nor the sector as a whole. Despite the very good news of SEC impotence, the financial sector lost 3.5% on the week, mostly due to Friday’s losses.

Bearish Market Movers

US Earnings Negatives

Google (GOOG) missed its forecast, Bank of America (BAC), and Citigroup (C) beat them but still sold off ( (BAC -9.1%) and Citigroup (C -6%) ) on concerns about their ability to raise top line revenue. JPMorganChase (JPM) sold off along with the rest of the sector and market as poor consumer confidence, PPI, CPI, retail sales, industrial production and initial claims helped fed ongoing concerns that the U.S. recovery is rolling over into a double dip recession.

Poor Economic Data

UoM Consumer Sentiment: Showed the biggest drop since Sept ’08. This was arguably the most significant scheduled report this week because it suggests coming declines in consumer spending, which comprises about 70% of US GDP. Disappointing TIC report (net foreign investment in the US)
CPI dropped from 1.8% to 1.1 biggest drop since 12/08 feeding deflation fears
China annualized growth slowing: suggesting the worlds’ leading member of a handful of growth engines could be facing headwinds
Other negative reports this week: included PPI, CPI, retail sales, industrial production, initial claims, and the FOMC’s US growth downgrade, all of which helped fuel the growing belief that the US faces a deflationary double dip recession
ECRI Weekly Leading Indicators (WLI) Indicates Coming Double Dip Recession: Perhaps the most compelling new evidence this week came from the latest ECRI report on leading economic indicators. The annualized growth rate of the ECRI Weekly Leading Index (WLI), a measure of future U.S. economic growth fell to minus 9.8 percent from minus 9.1 percent the previous week, Per Ed Harrison, “David Rosenberg noted in June that a minus ten reading is a recession lock for the entire 42 years of ECRI data available. The minus 9.8 reading is about as close to a double dip warning as you are going to get from the WLI.”

Coming Week

EU Bank Stress Tests – The Main Event This Week – Possibly This Summer

Many questions surround this coming Friday’s release of stress test results and thus it’s very difficult to predict both the results AND how markets will interpret them. Some of the unanswered questions include:

What threshold will be used to determine whether a bank has passed the stress test?
Will the results contain more detail than a simple pass/fail label?
If a bank fails the test, how long will it have to raise the funds, where it will come from, and what measures will be taken in the interim period to protect the bank, its depositors, investors, and creditors?
For sovereign bond holdings, by what amount should bonds of different governments be written down to account for default risk?

The EU has a tough balancing act to perform. If markets perceive the tests as lacking transparency or as overly optimistic, then this attempt to calm markets will backfire. However if the tests are too tough they could also scare markets, though having some failing banks would likely lend credibility to the tests.

Given that the EU has been the source of the markets’ downtrend over the past months, and the already low expectations for the US UK, and Japan, if the EU succeeds in calming markets, the risk rally will likely find new legs barring an unlikely poor US earnings season.

EU Bond Sales

This week, EU sovereign credit concerns are again tested as Greece attempts another 1.5 billion euro auction of 13-week bills July 20th.

US Corporate Earnings Week II

See The Coming Week: Stocks, Commodities, Forex – 3 Key Market Drivers July 19^th -23^rd for detail

Conclusion-Downside Risk Greater, EU Banks Stress Tests Could Decide Near Term Market Direction

Markets are in the middle of a tug of war, pulled between mostly solid earnings results and guidance on one side, and lackluster-to-poor macro economic data. Logically this can’t continue. At some stage we are either going to see companies tweaking earnings estimates slightly lower or we will see a rebound in economic data over the coming months.

The overall evidence noted above suggests the rally in stocks and other risk assets over the past 2 weeks was a mere countermove in the longer term downtrend – even positive earnings news, a Goldman (GS) settlement, and a ZIRP (zero interest rate policy) couldn’t sustain this rally. Imagine what will happen when interest rate increases appear on the horizon, as they eventually must.

We’re expecting a test of at least 1000 or lower September, and that’s assuming no sovereign debt crises in the EU.

The fundamental basis for the growing consensus of a coming US double dip recession is that despite massive stimulus, the jobs and wages picture is at best stagnant and more likely deteriorating, as a growing army of long term jobless households exhaust unemployment benefits, further undermining spending (70% of US GDP), and thus having a knock on effect on real estate prices, and thus the banking, construction and manufacturing sectors. See here for more.

The technical basis for expecting more downside in late 2010 includes: See The Coming Week: Stocks, Commodities, Forex – 3 Key Market Drivers July 19^th -23^rd for details.

Barring a new EU sovereign debt crisis, market response to the EU bank stress tests will likely be the biggest factor in deciding if the uptrend of July can continue, followed by the US earnings.

How To Profit And Protect

Continue to use rallies as opportunities to sell risk assets, and build positions in safe haven assets or short positions in risk assets. See our July 19^th-23^rd Quick Review/Preview: Stocks, Commodities, Forex for specific ideas.

DISCLOSURE: NO POSITIONS