There are signs of stabilization in Europe this week, as highly successful debt auctions in Italy and Spain reassured investors and European Bank President Mario Draghi said the bank has averted a serious credit shortage and there are signs the economy is stabilizing. The European Central Bank continued buying an undisclosed amount of bonds to prop up the market. The negative side to all this is that in the face of even mild good news, policy makers may resist cutting interest rates further for now, and as we’ve seen over and over in the U.S., cutting rates is the best reassurance to investors of an active government that is willing to go to great lengths to avoid recession. The Bank of England missed one of these opportunities today when it kept its benchmark rate unchanged at 0.5%.  

Over the last two weeks we made a tactical decision to step aside and not invest in the Short-Term Model Portfolio. In our view the news-driven environment did not give us much of an 'edge.' We were wrong.

Those subscribers who followed our "unofficial" recommendations did quite well over the past two weeks: first, a 15% gain in the Direxion 3X Financial Bear ETF (FAZ) and then an average gain of 8.15% at Thursday's close in our 5 picks from last week. Apparently, the lesson is "Trust the model, Luke!" 

Last week we made a tactical decision to step aside and not publish a short-term portfolio. In our view the cross currents in the news-driven situation did not give us an 'edge.' The timing turned out to be excellent. The market put in a head fake for the bulls and corrected more than 4%.

This week, we are still not interested in buying the dip. Why? The major indices are testing the up-gap that occurred at the end of November. Such moments of enthusiasm are almost always revisited when the market is no longer surprised. The purpose is to check for a consensus among buyers and sellers. If sellers do not rush in around that area, then the breakout is assumed to be a valid move and less emotional buyers will step in.

Bulls and bears are evenly matched at this time, which means rallies are being sold and dips are being bought on a short-term basis. This is options expiration week, however, which often means that stocks get pinned to strike prices and do not move for a few days.

Last week six of the world's major central banks made a coordinated effort to reassure European bond market investors that in the event of a severe liquidity crisis, the banks are willing and able to provide emergency U.S. dollar loans. Global equities breathed a huge sigh of relief.

The news from the central banks was soon followed by equally good reports from Europe on progress toward greater fiscal unity and better than expected data on the U.S. economy. As a result, last week the Dow Industrials posted its second largest weekly point gain in history.

... and other mistaken prognostications.

Nouriel Roubini played right into the gloom and doom last Wednesday, saying in an interview that government gridlock ‘Ensures’ a 2012 Recession, and an hour later he said that the IMF does not have enough money to save Europe, and  "The contagion has now gone viral, cross Atlantic and global."…"It's a slow-motion train wreck."  He predicted, "at least a 50% probability" of a breakup of the eurozone in the next 2-to-3 years, which would almost certainly lead to a fast-motion train wreck.

Meanwhile, also last Wednesday, Pimco's Mohamed El-Erian told Bloomberg TV that U.S. economic conditions were "terrifying" and he cited the disappointing report that day on anemic U.S. economic growth and the Super Committee stalemate as delivering odds of one-third to one-half of another recession.

We argued that the European situation had become so dire, literally overnight, that there was no alternative left for world economic leaders but to do something dramatic, and do it immediately. There was no room for error, and so there would not be any error. It was must-do, and must-do right then.

The most important factor of the current market from a trading perspective is the sudden 25% decrease in volume over the last week or so, although there was a bump up yesterday. Low volume indicates that professional traders and funds are waiting for resolution of the European situation before making a move. It also means that daily volatility should largely be ignored because any moves, in either direction, that occur on low volume have been shown to be unpredictive of future movement.  It is a lot like trading very close to a holiday - large moves can happen, and they mean nothing. Real direction is determined only from periods of normal volume.

On Friday the Dow rallied 260 points as investors breathed a big sigh of relief that Greece and Italy have taken positive steps toward fiscal responsibility. Berlusconi resigned over the weekend and Mario Monti agreed to form a transitional government in Italy. This is like the relief parents feel when their kid enters rehab. It is a good first step. but the hard part, sobriety, lies ahead.

The Italian Prime Minister is departing the political stage, as expected, but the comedic leader will not leave his audience laughing.

News hit mid-day on Tuesday that Prime Minister Berlusconi agreed to resign after the new austerity budget is passed, which boosted equity markets in Europe and the U.S. The Dow closed up 101 points and the S&P advanced more than 1% as financials breathed a sign of relief. That's the good news.

Overnight, however, the European bond market sent a glaring vote of no-confidence when the yield on benchmark 10-year Italian government bonds soared to 7.41%.

Another round of asset purchases (mortgage-backed securities) is a viable option for the Fed. Bernanke reassured the audience that “We are prepared to do more and we have the tools to do more.” Here's the good news and the bad news. When the Fed starts its third round of quantitative easing (QE III), the ECB is likely to follow.

Considering that European banks need to raise capital, they will naturally have to cut back on lending, which will remove a great deal of natural stimulus, tipping the Eurozone into recession. Mario Draghi, the new ECB head, will then likely join the Fed in shifting his focus from worrying about inflation to preventing deflation.

Unfortunately, that will reduce the spread between the Euro (1.5%) and the buck (.25%), weakening the euro and strengthening the dollar. If that happens, the U.S. indices will face a headwind. Hopefully, Mario will drag his feet on that point.

On Friday (October 28) the major indices digested last week's buying panic and today we should get another minor pullback and retest of recent intraday lows.

On Tuesday (October 25)  the major indices made an attempt to test/fill Friday's up-gap. We discussed the likelihood of this test in SpearChat on Monday. The market passed the test.