Week Ahead: Stocks Oversold, but Is Fear Overdone?

The stock market limps into the coming week both technically and emotionally weakened.

Friday's disappointing June jobs number was the latest in a series of downbeat economic reports that have some economists looking to downgrade their growth forecasts to even more sluggish levels.

Paul Giamou | Aurora | Getty Images

Stocks lost about 5 percent in the past week, and the major indices are all now negative on the year.

The S&P 500 fell 54 points, or 5 percent to 1022, 16 percent from its April 23 high.

Traders, meanwhile, were assessing the past week's quick drop through some key technical support levels, which they see as a forewarning of more declines to come. Yet some analysts and money managers are beginning to see value in the oversold market.

"People are driven by fear. The uncertainty is huge in my view. It is overdone," said David Kotok of Cumberland Advisers. "Markets may be discounting a double dip recession. I do not believe it is coming. Slow growth, high unemployment does not feel good, but it is not shrink. It's growth and for American businesses, it is very profitable. We will see that in the earnings season that starts in a few days."

Kotok said he is now fully invested in the stock market and has been using weakness to buy.

"Could the S&P go down 5 percent from here? Sure, but I believe there's a whole bull leg ahead of us," he said.

The Dow fell 457 points, or 4.5 percent, in the past week to 9686, its worst weekly performance since the May 6 "flash crash." The Nasdaq was down 5.9 percent to 2091. Buyers rushed into the safety of Treasurys, driving yields to lows not seen in more than a year, or ever. That was the case for the 2-year note, which temporarily dipped below 0.6 percent. The 10-year breached the psychological 3 percent level, finishing the week with a yield of 2.977 percent.

Richard Bernstein, of Richard Bernstein Capital Management, said he is still positive on stocks, but for now is more neutral and cautious because of the consistently disappointing employment data. In addition to the weak growth in June employment of just 83,000 private sector jobs, Thursday's weekly jobless claims data showed an increase to 472,000 new claims.

The June employment report showed a total loss of 125,000 non-farm payrolls, with much of the decline stemming from the removal of temporary government Census workers. It also showed a decline in unemployment to 9.5 percent from 9.7 percent—largely the effect of discouraged workers no longer seeking employment.

Job Search
Getty Images
Job Search

"I think it's going to be very difficult to have a sustained advance in the equities market without jobless claims getting better," he said.

"Our view is earnings are still going to be pretty strong, and I think that's probably going to help, but the way I look at it is the global financial markets right now are hinging on the health of the U.S. household sector's cash flow. That's the whole story. Decoupling be damned...If you're worried about the stability of the household sector's cash flow, you have to be worried about a lot of other markets, a lot of other economies around the world," he said.

Bernstein favors U.S. small caps and Treasurys for now, a position he has held for months.

Jim Paulsen, chief investment strategist at Wells Capital Management, agrees jobs are a key to the market's performance.

"We may go down and test that 1000 level in the S&P in the next couple of weeks, but if we do, I would have to think it looks like a great entry point. I think claims will do better before the year is out and that is going to be a great catalyst," he said.

"There are some things that could help sentiment," he said, noting that before the market's began selling off in April, the yield on the 10-year was close to 4 percent, and oil was heading to the high $80s a barrel range, both drags on the consumer. Since the 10-year's yield has slumped, mortgage rates are now at record lows and oil is at $72.14 a barrel, down 8.5 percent in just the past week.

Paulsen and a number of other analysts have said the earnings period, which starts the week of July 12, may provide a temporary positive for stocks.

Citigroup economist Steven Wieting said S&P 500 operating earnings should grow 25 percent in the second quarter, compared to the first quarter's 53 percent jump. For each of the third and fourth quarter, he expects operating earnings growth for the S&P of about 23 percent. But for 2011, his forecast is for a more normal growth rate of 7 percent.

What Blocked Jobless Benefits Means

Washington Wary

Analysts and economists say the failure of Congress to extend unemployment benefits in the past week has created an immediate negative for the economy.

"It'll probably take a half percent off second half growth," said Paulsen.

Career Fair
Getty Images
Career Fair

Mesirow Financial chief economist Diane Swonk said because there is no regular program and the benefits are decided by Congress, the economy will now feel the pinch as the spending from those benefits is lost. It also means the individuals will have to be supported in other ways.

"On the weekly claims data, we still don't know how much are reclaims, but now that they discontinued the unemployment insurance for 1.3 million people, the risk is that those people move into more costly social or welfare programs to get coverage," she said.

"We do not have safety nets that are structured in the U.S. to deal with long-term unemployment," she said.

Bernstein said, besides the unemployment benefit vote, Congress is showing that it is immobilized on other fronts, even as the Senate moves toward a vote on financial regulatory reform in the coming week.

"I don't think people realize it's the stale mate of nothing getting done," he said, regardless of whether they believe the economy needs more or less stimulus, tax cuts or tax hikes. "Washington has entered a monstrous policy stale mate and the markets have managed to roll over. You've got an employment situation that's eroding."

Swonk said the jobs situation is even worst than she anticipated. "We expected a jobless recovery. It's one thing to expect it. It's another thing to live it," she said.

She expects the second quarter to grow at a rate of 3.4 percent and the second half at about 3.6/3.7 percent.

"The question is what do we do for 2011, and we're working on that now. 2010 we had closer to 3.8 percent and that's looking more precarious," she said.

"There's a lot of mixed news. Even though the ISM (manufacturing survey) is weaker, we've still seen a lot of positive news on corporate investment. Shipments are good. Investment in technology is good," she added. "The recovery continues but you don't see anything normal in it...There's a constraint on the consumer's ability to leverage."

"It looks like we're healing, but we're healing with deep scars," she said.

Dollar Drama

Markets have the long holiday weekend to stew over June's disappointing jobs report. U.S. markets are closed Monday for Independence Day.

In the coming week, non-manufacturing ISM is the big data point, due out Tuesday. Also important will be retailer's monthly sales reports Thursday, as well as the closely watched jobless claims data, also reported Thursday.

The Bank of England and European Central Bank have rate meetings Thursday.

The dollar lost some of its safe-haven shine in the past week, as investors started to vote against it with each weak economic report. It was down 1.3 percent against the euro, which rose above $1.25 on a successful Spanish bond auction and as European banks requested less funding from the European Central Bank than expected.

David Gilmore of Foreign Exchange Analytics said the dollar could continue on its current course temporarily.

"I would say there's more downside for the dollar in the next couple of days. I would look for the euro to trade up to $1.28. I think people are going to be concerned again about Europe's banks. We have stress tests coming up at the end of July. We don't have a good idea of those stress tests. Are they credible and how do banks perform? That's something that could check enthusiasm for the euro," he said.

Questions? Comments? Email us at marketinsider@cnbc.com