In this past weekend's missive, in the "Technically Speaking" section, I wrote: "While the future is yet to be written, and certainly anything can happen, the one thing that has me the most concerned is the very high level of investor complacency at the current time. There is NO fear of a market 'sell off' which, from a contrarian investment viewpoint, is concerning all by itself.

The similarities between both periods are shockingly close. A May sell off followed by June bounces, July consolidations triggering major 'sell signals' in early August leading to further downside pressure.  With yields rising in Spain once again, little action from the Eurozone forthcoming and high levels of market complacency, as shown by the chart of the Volatility Index on the next page. The set up for an August swoon is ready – all that is currently lacking is the catalyst.

The Volatility Index is a measure of 'investor fear,' or lack thereof, in the markets. During the summer of 2011 fear rose modestly as the market begin to sell off but quickly fell to lows as Greece received their first bailout.   The same action occurred precisely one year later as 'fear' quickly subsided as Spain received an agreement for their bailout.   As stated above – it is the next catalyst that we are concerned about heading into August."

This morning we awoke to Spanish yields eclipsing 7.5% and concern that the entire country of Spain may need a bailout.  The problem for the Eurozone is that such a bailout is far great than previously anticipated and more than either the ESM or the EFSF could feasibly support.   Furthermore, the IMF has now stated that they will no longer back Greece for further bailouts.  The risks are mounting for another surge of risk in the continuing Eurozone saga and this time there will be no "rate fixing" schemes to bailout banks on the wrong side of the trade. 

This brings us back to the replay of the "100 Days of Summer" that we have been discussing over the past several weeks.  The current spike in the volatility index is important, as of this morning's open, as the index broke out of its previous downtrend.  The breakout in volatility, combined with a failure at resistance for the S&P 500, leaves investors vulnerable to portfolio risk in the coming month if things continue to progress.  As the replay of the 2011 summer continues to unfold the lack of any real resolutions in Europe, and the inability to implement any action, is putting the Eurozone in the ditch - again.  Those risks, combined with weakening economics in the U.S. and declining corporate revenue, leaves investor's at much increased levels of danger of further market declines. 

CFNAI

Speaking of economic weakness - the parade of economic indicator disappointments continued this morning with the latest release of the Chicago Fed National Activity Index (CFNAI) which is a very broad measure of 85 sub components relating to the economy. The index bounced a bit in June but remained in contractionary territory (-0.15) while May was revised downwardly from -0.45 to -0.48.

The bright spot in June was an uptick in the production and income component, however, this is a highly volatile component and likely will reverse in the July report. The remaining indicators either weakened, or remained, in contractionary territory with Unemployment and Hours sliding from 0.1 in May to 0.0 in June providing further evidence to future employment weakness. Personal Consumption and Housing remained in contractionary territory at -0.2 up slightly from -0.3 in May. Sales, Orders and Inventories fell into contractionary territory from a 0.0 reading in May to a -0.1 reading in June supporting the recent revenue weakness in corporate earnings

The chart shows the year-over-year change in the S&P 500 versus the 6-month average of the CFNAI.  While the market can remain detached from real economic activity in the short term - it is important to remember that the companies that make up the stock market are a reflection of the economy and not vice versa.  The 6-month average of the CFNAI is a decent leading indicator of the S&P 500 in this regard.

In regard to the mounting evidence of recessionary economic risk the CFNAI Diffusion Index is on the cusp of moving into recessionary territory.  Since 1967, anytime that the diffusion index of the 85 sub-components moved below -.20, the economy was either in, or about to be in, a recession. I have been writing the last part of that sentence a lot lately as more and more indicators line up to further economic deterioration. 

We have been vocal that a recession is likely by the end of this year or early 2013 without further intervention from either the Federal Reserve via a further balance sheet expansion program or fiscal policy action from Congress.  Action from Congress is unlikely either before or after the election which leaves the Fed as the "only game in town" to steal words from Senator Schumer.  However, the Fed is also boxed into a corner until at least September as they await further confirmation of weakness in the 2nd Quarter GDP data.

This leaves investors at heightened levels of risk in the short term.  With our macro sell-signal very close to triggering - we are maintaining our positions of underweight equities (30% low-beta investments with yield), market weight fixed income (35%) and overweight cash and cash equivalents (35%).  As we stated in our recent article on "Long Term Investing" - hedging against the market risk and protecting capital is key to meeting investment objectives over the long term.

NOTE:  Apple reports tomorrow with estimates at 10.35 a share.  Watch top line revenue as well as bottom line EPS.  If Apple misses, or displays weakness, the negative impact on the overall market will likely be fairly large.  This is the key report this week to be watching earnings wise.