U.S. equity markets rallied all five days last week, bolstered in part by news that five of the world’s central banks would provide dollar-denominated loans to the European Central Bank, which would then lend the dollars to Europe’s banks.

The move lifted—for now—the threat that European banks would have liquidity issues. The Dow Jones Industrial Average gained 4.7% on the week, or 516.96 points, to catapult over the 11,000 threshold to 11,509. Nasdaq enjoyed the largest improvement, jumping 6.25% to end the five days at 2622.31.

News of the central-bank support for Europe fueled a rally in financial shares both domestically and in Europe. JPMorgan Chase (ticker: JPM) rose 4% and Citigroup (C) added 8%. Europe’s banks improved the most, with Deutsche Bank (D shares gaining 12% and Credit Suisse Group (CS) tacking on 14%. The exception to the rule: UBS (UBS), whose shares were flat on the week after news that a trader lost $2 billion of the firm’s capital on trades gone wrong.

But the gains—both in bank stocks and the broader market—may be short-lived. The liquidity the central banks are providing Europe doesn’t make Greece any less indebted nor does it take loans to the PIIGS (Portugal, Ireland, Italy, Greece and Spain) off of European bank balance sheets. The central banks “pushed the problem out into early next year,” says Wayne Nordberg, head of New York City-based Hollow Brook Associates. “The only way you can solve the problem is to write off the bad debts.”

His forecast: The stock market will continue to fall as the European drama plays out, as earnings estimates get cut and as the political drama in the U.S. unfolds.
More immediately, the Federal Reserve Open Market Committee will meet this week, and is expected to announce Operation Twist—the purchase of longer-dated Treasuries to bring long-term interest rates down further (Source: Barrons Online).

Last week, U.S. Stocks and Foreign Stocks increased. Bonds decreased. During the last 12 months, BONDS outperformed STOCKS.

Returns through 9-16-2011	1-week	Y-T-D	1-Year	3-Years	5-Years	10-Years
Bonds- BarCap  Aggregate Index	-.5	6.3	5.8	7.0	6.7	5.7
US Stocks-Standard & Poor’s 500	5.2	-7.2	2.7	-3.7	-4.9	0.6
Foreign Stocks- MS EAFE Developed Countries	2.2	-13.4	-5.8	– 3.7	-5.0	3.0

The FED and other Central Banks have not yet followed through with coordinated efforts to support their economies and restore confidence.  Meanwhile, last week’s economic reports indicate the economy has slowed more than economists expected.  These reports coupled with last week’s drop in the stock market, will diminish American’s confidence even further.  And, as I reported in The Weekly Commentary weekly during each of the past four weeks, a continued crisis in confidence will probably result in further economic slowdown, and maybe a full-fledged recession.  I believe the probability of a recession has grown dramatically. 

The following is a succinct summation of week’s events:

Positives:
1) Indonesia, South Korea, Philippines and Malaysia back off from further rate hikes
2) Aug ISM services index unexpectedly rises
3) July Trade Deficit shrinks by $7b, exports rise to record high, Aug though likely different
4) China economic data eases pressure on PBOC to tighten further

Negatives:
1) Short term fiscal stimulus only lasts short term, we need permanent policy changes
2) Greece on verge of outright default as having difficulty meeting Bailout conditions. If were to occur, can it be contained? Likely not at first
3) European bank stress intensifies, euro basis swap widest since Dec ’08, 3 month euribor/OIS spread back at Mar ’09 levels
4) Canada and Australia both report unexpected job losses in Aug
5) Initial Jobless Claims 9k higher than expected at 414k
6) Even with a mortgage rate of just 4.23%, refinancing apps fall 6.3%, lower for a 3rd straight week and purchases rise just .2%

Investors realized last week that a resolution to Europe’s financial crisis may be far more important to the future of the U.S. financial markets than just about anything President Obama can say or the Federal Reserve can do.

A rumor Friday morning that Greece would default on its debt over the weekend sent U.S. and European shares into a tailspin, despite the Greek government’s strong denial of such talk.

Contributing to the dour mood was the resignation of Jürgen Stark, Germany’s top representative on the European Central Bank’s executive board. His departure reinforced the impression that the ECB, like the U.S. Federal Reserve, suffers from internal disagreements about how to help the economy. The discord raises questions about the effectiveness of these institutions, and more immediately, whether Germany will support the funding of future euro-zone bailouts.

Problems across the pond overshadowed the $447 billion jobs program that President Obama unveiled Thursday night before a joint session of Congress. The Dow Jones Industrial Average fell 303.68 points, or 2.7% Friday, and 248.13 points on the holiday-shortened week, to finish the four days at 10,992.13, the Dow’s first trip below 11,000 since Aug. 22. The Nasdaq lost 0.5% to 2467.99.

Signs of distress were even more apparent in markets overseas. Yields on Greek two-year notes climbed as high as 48%, and 10-year Greek paper now yields 18%. Germany’s DAX index of stocks lost 4% Friday, and Spain’s stock market fell by a similar amount.

European bank stocks were clobbered, with Deutsche Bank (ticker: D falling 8.7%, or almost three points, to 31.14. UBS (UBS) slid 6% to 11.87, and Credit Suisse Group (CS) 6.12%, or 1.49, to 22.86. Investors are uncertain about just how much exposure banks have to the sovereign debt of Greece and other ailing European countries. If the weak European nations need to restructure their debt, the banks could need to raise new equity.

U.S. financials suffered less damage, but hardly emerged unscathed. Citigroup (C) and JP Morgan Chase (JPM) shares fell roughly 4%, and Bank of America (BAC) stock lost 3%.

IF EUROPEAN BANKS ARE ABOUT to be hit by a restructuring of sovereign debt, President Obama’s stimulus plan while helpful, will not insulate American companies from the pain that’s ahead. About half the companies in the S&P 500 break out details of how much in annual revenue they derive from Europe. This group reports that 14.6% of total sales are rung up on the Continent—a fact that ought to alarm Wall Street’s most upbeat analysts.

So far, analysts are standing by their rosy earnings forecasts for 2011. S&P 500 operating earnings are expected to total a record $98.59 this year and $112.35 in 2012, says Howard Silverblatt, senior index analyst at Standard & Poor’s. But the optimism embedded in those forecasts looks to be unwarranted.

Friday brought signs that expectations might be about to come down. McDonald’s (MCD)’s August same-store sales rose 3.9% in the U.S., missing expectations for a 4.4% jump due in part to the hurricane that hit the East Coast. The chain’s sales in Europe rose 2.7%, disappointing those forecasting a 5.57% increase. McDonald’s stock lost about 4%, or 3.58 a share, falling to 85.03. Janney Capital Markets reduced its earnings estimate for this year by four cents, to $5.19 a share, and cut its ’12 forecast by five cents, to $5.65.

SEPTEMBER HISTORICALLY is a tough month for the markets, but Bespoke Investment Group notes that it has been particularly weak when the first few days of the month produce losses. The Dow’s 4.08% decline in the first three days of September was its fourth worst three-day start going back to 1900. When the market declines by 2% or more in the first three days, it has averaged a 6.31% decline for the remainder of the month.

In the three other years when the market fell by 4% or more in its first three days of September trading (1931, 1946 and 2002), the results were even worse: an average decline of 13.5% through the rest of the month. In 1946 the loss over the remainder of September was 4.83%. In 2002 it was 8.35%, and in 1931, a stunning 27%.

The results in the rest of the year aren’t pretty, either. Bespoke reports that the Dow has fallen more than 2% in the first three days of September 13 times since 1900. In those years the index fell on average by 10.37% for the remainder of the year (Source: Barrons Online).

Last week, Foreign Stocks and Bonds increased. U.S. Stocks decreased. During the last 12 months, BONDS outperformed STOCKS

Returns through 9-9-2011	1-week	Y-T-D	1-Year	3-Years	5-Years	10-Years
Bonds- BarCap  Aggregate Index	.2	6.9	6.5	7.0	6.7	5.8
US Stocks-Standard & Poor’s 500	-1.9	-11.8	-1.1	-6.0	-5.6	0.1
Foreign Stocks- MS EAFE Developed Countries	-5.5	-15.2	-6.3	– 6.2	-5.4	2.1

Source: Morningstar Workstation. Past performance is no guarantee of future results.  Indices are unmanaged and cannot be invested into directly.  Three, five and ten year returns are annualized excluding dividends.

We first alerted you two and one-half years ago (TWC of 2-23-09) to sell all of your mutual funds with high European concentration.   In 2009, we feared the credit crisis would grow and engulf more countries.  This fear became reality.  The current status of Europe Union is highly fragile.  We recommend you continue to avoid mutual funds with high European concentration. 

The FED and other Central Banks have not yet followed through with coordinated efforts to support their economies and restore confidence. Meanwhile, last week’s economic reports indicate the economy has slowed more than economists expected. These reports coupled with last week’s drop in the stock market, will diminish American’s confidence even further. And, as I reported in The Weekly Commentary weekly during each of the past three weeks, a continued crisis in confidence will probably result in further economic slowdown, and maybe a full-fledged recession. I believe the probability of a recession has grown dramatically.

The stock markets have already dropped in anticipation of the economic slowdown. There is a possibility the forecasted downturn is now fully factored into stock prices. If true, this would not be the time to sell. On the other hand, the economic downturn could be long-lasting and severe. It is very difficult to predict its severity. There is no exact, 100% sure-fire way to time recessions or markets. Due to the lack of clarity in my crystal ball, I recommend the following, depending upon which category fits your unique circumstance:

1. Aggressive investors, moderately aggressive investors, and investors who do not intend to touch their investments for 10 years or longer – continue to hold the current allocation of core investments, and wait to gather more information, and carefully watch central bank activities especially from FED Chairman Bernanke later this week.

2. Investors who need to withdraw from the investment portfolio – “park” any amounts you expect to withdraw within the next 5 years in a short/intermediate term bond fund.

3. Conservative, moderately conservative, preservation minded investors and investors who will start withdrawing from their portfolio in 5 to 10 years– reduce exposure of the more volatile stock and stock mutual fund holdings in your portfolio.

On Thursday evening, President Obama will outline his current thinking on job creation because we are clearly not coming out of the 2008 recession like we normally do. That is because what we just experienced was not a normal business-cycle recession, but a deleveraging/balance-sheet/debt-crisis recession. And the latter simply take at least 5-6 years to work through, after a country begins to deal with the problem, which we have not.

Even if somehow a Republican appeared in the White House tomorrow, there is no magic he (or she!) could bring with him/her to fix the unemployment problem. There are just some things the private sector will have to do for itself, and the sooner the government stops getting in the way, the sooner we will get things fixed. But it will take a long time, no matter what. That is just the way things are (Source, in part, Calculated Risk).