Stocks Face Tough Test Next Week; Investor Optimism To Be Challenged

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Stocks ended lower on Friday, although I suspect the late day sell-off had more to do with traders deciding not to stay late before the three-day holiday weekend than it did with some sort of awakening to the reality that Europe is failing and the economic recovery is stalling (although one reason traders are anxious about the long weekend is the fear that some unexpected news out of Europe might come through the wire and trap them in an unexitable long position going into Tuesday). Despite Friday's selling, stocks posted their best week of the month, in a performance that--as I noted in a previous article--is an example of investors' blatant denial of financial and economic reality. The Dow rose .7% on the week, while the Nasdaq jumped 2.11% in an especially ironic twist given the dismal performance of Facebook (NASDAQ:FB) in its first full week of trading; the S&P gained 1.74%. Volatility (the so-called 'fear gauge') fell 13.11% for the week, signaling that, incredibly, U.S. investors are somehow becoming less fearful, in a time when Greece and Spain are quite literally experiencing bank runs, the real-world embodiment of the term 'fear.'

Next week, investors' resolve will be put to the test against a tidal wave of economic data. Economic reports due next week run the gamut from housing to employment, providing all the evidence analysts should need to assess the current state of the U.S. economy. On Tuesday the S&P/Case-Shiller home prices index for March (the data are reported on a two-month delay) is released; the last report showed prices declining in 16 of the 20 cities tracked, putting prices back at 2002 levels. The expectation is for a 2.6% decline in prices. Investors will also get a reading on how the U.S. consumer is feeling on Tuesday courtesy of the Confidence Board's consumer confidence index, which was virtually unchanged last month (the index printed at 69.2, missing expectations), and declined slightly in March (the March number was revised down last month). Expectations are for a 70 print on Tuesday.

Chain store sales are released Thursday, an important measure for obvious reasons (consumer spending accounts for 70% of the U.S. economy). The number reflects monthly sales volumes measured against sales from the same month in the previous year. Also released Thursday is the ADP employment report and initial jobless claims. The ADP report (which measures private sector hiring) missed expectations by a wide margin (119,000 vs. estimate of 170,000) when it was last reported on May 2. Investors should eye this number closely as it often serves as an early warning sign of a bad NFP report to come.

On Friday, traders will get the non-farm payroll number, which should have a significant impact on the market. Recall that April's NFP report came in at 115,000 vs. expectations of 162,000, just slightly better than the debacle that was the March report, when investors got a pass as the dismal print (120k vs. expectations of 205k) was released on Good Friday when markets were closed. All in all then, investors will get a feel for the housing market (via Case-Shiller), the consumer (via consumer confidence and retail sales), and employment (via the ADP report, weekly claims, and the NFP report). While investors' confidence has remained largely unshaken in the midst of the European crisis (forgive me, but a 5.7% month-to-date decline in the S&P is nowhere near the pull back we should be seeing given the situation overseas), next week's economic reports could truly challenge the prevailing view that 'everything is going to be okay'.

On top of the economic news due here in the U.S., the market will eye Europe for any sign that the crisis is abating or that European policy makers are crafting a 'solution'. So far, investors have shrugged off wave after wave of bad news (even bank runs aren't enough to incite a sell-off), while hanging on every rumor that central bank intervention could stem the bleeding. One wild card is the possibility that central banks may "intervene with dollar swap lines similar to the ones we saw in November", a possibility that, should it prove true, would likely spark a relief rally. Also, there is a prevailing 'gut feeling' among many that the powers-that-be simply will not allow a nightmare scenario to ensue in Europe that could jeopardize the international financial system. That being said, it may be out of the hands of policymakers at this point, or, alternatively, voters in Greece may indeed choose to exacerbate the crisis by electing the anti-austerity party on June 17.

What is clear is that there are a number of potential landmines in the road next week, coupled with the overhang of the European debt crisis. Investors should ask themselves if the 6% pullback we have experienced in May is truly enough to price-in a Greek exit and the attendant possibility that the situation in Spain could unravel rather quickly. Suggestion: Short S&P 500 (NYSEARCA:SPY) and European stocks (NYSEARCA:FEZ).

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in SPY over the next 72 hours.