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The market started off the week strong on the news that the Chinese had decided to allow their currency to appreciate ahead of the G-20 summit this weekend. Markets rose 1.5% to 2% in early trading Monday, before giving up all their gains by the close that same day. It was basically all downhill from there for the rest of the week, even given a decent rise in financial stocks after the financial reform bill made its way out of conference with slightly less draconian measures than were feared in some quarters on Friday. Indexes had their worse week since May with both the S&P and NASDAQ being down over 3.6%. All ten S&P sectors were down at least 1.7% with Energy being the worst performer, turning in a 6% plus decline.

In addition to the lack of the follow through on the change in Chinese currency measures, the market was hit with numerous fears throughout the week. Q1'10 GDP growth was again revised downward to a less than stellar rate of 2.7%. Combined with the overhang from poor May retail sales figures, and a terrible May jobs report; talk of a dreaded “double dip” recession is becoming more frequent. The news from the Gulf was little to cheer about either. The leak continues to pour 60k to 100K bpd of oil into the gulf. The oil has now reached the Florida coast and tourism and fishing are being decimated throughout the region. The current administration is determined to destroy offshore drilling forever in the Gulf; appealing the overturning of its ill conceived and short sighted moratorium recently in court. Hovering over all of this is the continued fear in the European debt markets best illustrated by the negative trends in the sovereign debt CDS market.

What I do not think is fully priced into the market is the possibility and high likelihood of a negative monthly jobs report number by the end of summer. This could happen as early as this month, but it is almost a certainty to happen by the end of the third quarter. This should occur for three basic reasons. (A) The census is basically complete and the resulting lay off of those temporary workers will soon show up in the monthly job figures. (B) Fiscal year starts July 1st for most states. The furloughs, layoffs, and attritions necessary to balance these budgets should start showing in the monthly job reports starting this month. (C) Private sector job growth is likely to remain anemic given lack of certainty about the recovery, reduced bank lending, and the extra costs/taxes soon to be imposed by government due to new regulations, Obamacare, and the expiring Bush tax cuts. When this negative jobs reports hits the wires it should have a dramatic impact in several areas:

Political: Obviously a negative jobs report will have inflict further damage to the current administration regardless how it is spun. The president’s fast declining job approval numbers can be expected to sink further and will probably hit the 42-43% area within a month of this report’s disclosure. Stimulus efforts, which are already vastly discredited by the overwhelming majority of the American populace; will be further repudiated and additional efforts in this area will be dead on arrival.

More focus will be placed on not growing the deficit and nothing of importance is likely to get passed until after the midterm elections. Paralysis will take hold of Washington as a debacle for the Democrats in November will likely be sealed. Although the ouster of the anti-business/union loving/economically clueless lineup of Frank, Pelosi, Waxman, Markey, Miller, etc from the levers of power through heading powerful committees will eventually yield better legislation in 2011 and beyond, having a rudderless ship for six months imposes risks in responding to any unforeseen events in these uncharted waters.

Economic: Obviously a negative jobs report number will have economic impacts. Fears of a double dip recession will likely escalate further with corresponding drops in consumer confidence, small business optimism, and consumer spending. Combined with the other economic headwinds we are likely to face in the second half of 2010, the last half of 2010 is likely to see anemic growth of 1-2%; much lower than consensus forecasts.

Markets: Obviously a negative jobs report that we feel is not priced into the market, will have significant negative consequences. The support level of 1040 on the S&P 500 is likely to be severely tested, and most likely breached. If support does not hold, it is very likely the market will retreat to the 925 to 975 level by end of the third quarter. In addition, small cap stocks that have outperformed their large cap brethren are likely to vastly underperform in the last half of the year given their valuations, dependence of the U.S. market and less access to the credit markets. In this type of environment it pays to stay defensive. Stick to those equities with pristine balance sheets, rock solid business models, reasonable valuations, and decent dividend yields. Most of the stocks that we are finding using these criteria are in the Large Cap Blue Chip area (Vodafone (VOD), Pfizer (PFE), Johnson & Johnson (JNJ), Exxon (XOM), Microsoft (MSFT), American Electric Power (AEP) etc). Keep a good portion of your portfolio in cash or write short term (2 to 6 months) calls against your portfolio to raise cash. There should be better entry points by the end of the year. Be careful out there.

Update: We continue to believe lululemon Athletica (LULU) is one of those stocks that is vastly overvalued. Looks like company insiders agree with our opinion as they have sold over 6mm dollars worth of shares in last ten days.

Disclosure: Long VOD, PFE, JNJ, XOM, MSFT, AEP Short LULU

Source: What Happens When the Monthly Jobs Report Goes Negative?