Equity markets closed out the week of trading today with significant losses. The S&P 500 lost 4% this week, while the Russell 2000 Index of small cap stocks lost over 6%. More importantly, the S&P 500 broke the uptrend line in place since this rally began in March, potentially signaling major weakness to come. See the chart below:

Worrisome

On the surface, this is puzzling given the strong growth in third quarter GDP announced on Thursday, which at +3.5% on an annualized basis was better than consensus expectations and marked the end of the recession.  In addition, third quarter corporate earnings have been good – over 80% of companies that have reported so far have beaten earnings expectations, an unusually high number.

So with the generally positive news flow, why is the market showing such weakness?  As we discussed during yesterday’s conference call, much of the growth in the third qaurter was artificially supported by government stimulus, such as the cash for clunkers program and the first time homebuyers tax credit.  In fact, automotive sales plummeted following the end of the clunkers program, and home sales appear to be faltering now that the tax credit is near expiration.  Perhaps investors are recognizing that these programs simply pulled demand forward, setting up the next few quarters for disappointment.  If 3.5% GDP growth for one or two quarters is all we get from the massive government stimulus, and business and consumer spending does not take up the slack when the stimulus inevitably fades, then it is time to take profits from the massive rally off the March lows.

Next week is shaping up to be important for near term market direction.  Volatility spiked this week as the VIX index rose 24% today, indicating a sharp rise in investor caution.  Should the U.S. Dollar continue to strengthen, the rally in virtually all risky asset classes (think stocks, commodities, high yield bonds) will be over.

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