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The market reached a multi-month low on Friday following the weak jobs report. The S&P 500 closed at 1,278, corresponding to 128 on the SPDR S&P 500 ETF (NYSEARCA:SPY), representing a 10% decline from its recent highs. The narrative has now shifted to fears of a European crisis, especially the potential for Greece's exit from the Euro and problems with the Spanish banking system, as well as slower growth in the U.S., Europe, China and other parts of the world.

We start this update with a review of the market's 10% decline from its April high to Friday's close. Then we will review our weekly "Risk On / Risk Off" indicators before discussing the bull and bear cases for the market and our investment plan.

The 10% Decline

It was not apparent that the market was marking a top in early April, but we began to worry when the S&P 500 did not make new highs during the Q1 earnings season that began with Alcoa's (NYSE:AA) earning release.

The S&P 500 then seemed to morph into a trading range between 1,350 and 1,425. We thought that the market would repeat its performance from last summer when a multi-month trading range emerged after an impressive rally. However, this time the trading range broke down rather quickly.

(click to enlarge all images)

(Source for charts, unless otherwise noted: FreeStockCharts.com)

It then seemed inevitable that the S&P 500 would fall to the 200 day moving average around 1,280. At first, it managed to halt its decline slightly above this level, but the weak jobs report on Friday provided the catalyst to fall through 1,280.

A lot will depend on the trading action next week. It is important to see if the "reaction to the reaction" confirms the downward momentum. If the market confirms its downward move, the next important level will be 1,250, which was the bottom of last year's trading range.

Review of Key "Risk On / Risk Off" Indicators

We generally focus on the S&P 500 as a gauge of the broader market, but it is interesting to note that some of the other indices are showing more weakness. Below are charts for the Dow Jones (NYSEARCA:DIA), Nasdaq (NASDAQ:QQQ) and Russell 2000 (NYSEARCA:IWM).

The Dow is down on a year-to-date basis, underperforming the S&P 500. Also, the Russell 2000, comprised of smaller companies, was the first to hit its 200 day moving average on May 18. In fact, the Russell 2000 peaked before the other indices and started to flatten out earlier. We are closely following the Russell 2000, since it seems to be an early indicator for the other indices.

One of the big stories last week was the rally in U.S. Treasury bonds, which pushed yields to record lows. The 10 year bond closed the week with a yield of 1.47%. With the stock market selling off and problems in Europe, the Risk Off trade was best captured in treasuries. The bond rally can be seen in the iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT).

However, the more risky high yield market continued to decline. The iShares iBoxx $ High Yield Corporate Bond (NYSEARCA:HYG) is a proxy for high yield bonds.

While U.S. treasuries rallied, Spanish and Italian bonds continued to fall. The Spanish 10 year yield closed the week at 6.53%, near all time highs. Similarly, the Italian 10 year bond yield is approaching the key 6% level as concerns about Italian finances become more pronounced.

(Source: Bloomberg.com)

Another indication of the Risk Off trade was the weakness in the Euro. With the problems in the Eurozone, especially the possibility of the Greek exit from the Euro, investors have been favoring the U.S. Dollar over the Euro. In a sign of weakness, the Euro fell below the 1.25 level this week. However, it rallied on Friday, thereby diverging from some of the other Risk Off indicators following the weak jobs report.

As the European crisis continues to play out, we are anticipating that at some point the European Central Bank (ECB) will come in and support the Spanish banking system. Increasingly, there have been calls for greater European fiscal integration, which could also lead to Euro bonds that would be used to support Spain and other countries that have difficulties in the debt markets on a stand-alone basis.

The process would take a while and Germany may not agree until a larger crisis emerges that would give it more bargaining power over the future of European integration. It will be interesting to see the comments from European leaders in advance of, and following, the EU summit on June 28 and 29.

The EU summit follows the U.S. Federal Reserve meeting on June 19 and 20. There is speculation about the potential for another round of quantitative easing as Operation Twist, the latest action by the Fed to lower interest rates, is set to expire at the end of June. The weak jobs number on Friday will add pressure on the Federal Reserve to come up with a program to support the economy. However, the Fed's ability to further support the economy may be challenged as interest rates are already at record lows. Nonetheless, the Fed meeting and EU Summit have the potential to be market moving events.

The global economic slowdown is producing one positive side effect - the price of oil has been declining. WTI crude oil closed the week at $83.32 per barrel and Brent crude oil closed the week at $98.81 per barrel. Oil's decline will likely help many companies that use it as a raw material, but will be a drag on energy stocks.

(Source: Bloomberg.com)

Similarly, the Thomson Reuters/Jefferies In-The-Ground CRB Global Commodity Equity Index (NYSEARCA:CRBQ), a proxy for commodity prices, has been falling. While the decline of commodity prices is helpful for many companies, it is an indication of global economic weakness, especially in China, which has been a key consumer of commodities over the last few years.

As the market has been declining in response to negative economic headlines, the CBOE Volatility Index (VIX), often referred to as the fear index, has continued to rise. However, the VIX closed the week at 26.66, far below the mid-40 levels reached in previous episodes of market panic. It will be interesting to see if the VIX spikes higher, indicating a market meltdown, or continues to be restrained.

The financial sector lost a key support level this week. We follow the financial sector closely since it has been the source of market crashes and corrections in recent years and was one of the leaders in the Q4/Q1 rally. On Friday, the Financial Select Sector SPDR ETF (NYSEARCA:XLF) fell through its 200 day moving average. We will look for a confirmation of the downward move before becoming more negative on the sector. If the financials remain weak, it will be hard for the overall market to reverse course.

Among the banks showing weakness are JPMorgan (NYSE:JPM), which is continuing to decline following its $2 billion trading loss, and Citigroup (NYSE:C), which is approaching its 2011 lows. If the XLF confirms its 200 day moving average breakdown, we would expect JPM and C to trade down to the 2011 lows. In such a scenario, we may want to short some of the other banks that have held-up until this point, but may be dragged down with the sector.

The combination of oil price declines and low natural gas prices is dragging down the energy sector, as seen in the Energy Select Sector SPDR ETF (NYSEARCA:XLE). We are not looking for new long opportunities in this sector until the price of oil begins to stabilize.

Finally, we are wondering if Apple (NASDAQ:AAPL) may be diverging from the overall market downtrend. Apple's stock has come down from its recent highs and failed to sustain a pop in the stock price following Q1 earnings. However, it bounced off its 100 day moving average and is not making new lows together with the rest of the market.

We do not yet see a trend emerging, but we will follow Apple to see how it trades relative to the rest of the market. In an optimistic scenario it would trade in a range near its recent highs before moving up further. As the largest component in the S&P 500 and one of the leaders of the Q4/Q1 rally, Apple is an important stock for the overall market.

The Bull Case

If the S&P 500 can move back above the 200 day moving average and sustain that level, then the bulls may be able to say that the downward trend was halted and the market may stabilize.

Even if the market moves down in the near term, it may find support if there isn't another major crisis event. The Fed meeting and EU summit at the end of June could generate policies that would support the market. Additionally, China may increase its stimulus to support its domestic economy and thereby help global economic growth. If the U.S. housing sector bottoms and gains momentum there could be an increase in U.S. job creation, despite the recent weak job numbers.

The Bear Case

After the events of last week, it seems that the bears have the momentum in the short term. Corporate earnings have not helped the market for the last few months and the next earnings season does not start for another month. It is unlikely that there will be a market moving announcement from the Fed or EU until their respective summits later this month. So, the short term momentum seems to be negative.

Additionally, the situation in Europe could get worse before it gets better. Germany may not react to support Spain or Italy until they reach a crisis point, so that it will have more leverage over those countries. Growth in China seems to be weak and other emerging markets are growing at a slower pace than expected. Furthermore, the U.S. economy could face serious problems later in the year from the Fiscal Cliff.

With all of these negative trends, investors may pull out of the market leading to a downward spiral of more and more selling.

Investment Plan

Over the last few weeks, we adopted a cautious approach to the market. We were trimming our long positions, building up cash and initiating small short positions. On Friday, we made a bunch of moves to adopt a more market neutral approach for the portfolio. In general the shorts positions we initiated on Friday are tactical shorts. We think that the stocks we shorted are headed for further weakness, but we will likely hold these positions only for the short / medium term.

We are now waiting to see if there is downward confirmation for the SPY's move below the 200 day moving average before increasing our shorts. Although most of our recent activity has been on the short side, we continue to research potential long opportunities that will become relevant when the market turns around.

Disclosure: We have a position in JPM and the ProShares Short S&P 500 ETF (NYSEARCA:SH). We may trade these positions or the stocks/ETFs mentioned in the article in the next 72 hours.

Source: Market Update: Indicators Flashing 'Risk Off' But The Real Test Is Next Week