What a Week: Fear Factor

London's terrorism spurs a corrective phase for stocks.
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A week marked by tragedy ended with a rally in the stock market. In a perverse twist, the bombings in London seem to have accelerated a corrective phase for stocks, allowing the major indices to rebound impressively by week's end.

The transformation was evident Thursday, as bulls gradually took over from bears in the wake of terror attacks that killed at least 50 people and injured hundreds more in London.

By Friday, the bulls were firmly in control, as a weaker-than-expected June employment report was roundly cheered by investors who concluded that economic growth remains decent while inflationary pressures are still subdued.

In addition, after much worries about weaker earnings,

Alcoa

(AA) - Get Report

started the second-quarter reporting season on a high note, posting profits that beat expectations. Likewise, earnings at business consultancy

Accenture

(ACN) - Get Report

handily beat estimates.

All this led to a powerful rally, with the

Dow Jones Industrial Average

surging 146.85 points, or 1.43%, to 10,449.14 Friday. The

S&P 500

index added 13.99 points, or 1.17%, to 1211.86; the

Nasdaq Composite

advanced 37.22 points, or 1.79%, to 2112.88, flying by the key resistance level of 2100.

For the week, the Dow gained 1.4%, the S&P rose 1.4% (from 1,194.44) and the Nasdaq advanced 2.6%.

To make the market's performance all the more impressive, stocks advanced even after oil prices breached new highs -- and hovered around them for much of the week -- amid concerns over the impact of Tropical Storm Cyndi and Hurricane Dennis on production in the Gulf of Mexico.

After closing at a record $61.28 per barrel on Wednesday, crude oil finished the week below $60, as traders reconsidered the weather-related premium. August crude closed down $1.10 at $59.63 on Friday.

That brings us to a Friday check on what market guru Woody Dorsey is making of this action, which doesn't completely jibe with his earlier predictions.

The founder of Market Semiotics was once again right in predicting that oil prices would make new highs this week. But he had forecast that stocks would react by continuing their descent before leveling off between July 12 and July 18. What happened?

Well, the unexpected. The London bombings were an "exogenous shock" that precipitated temporary lows "a bit ahead of schedule," Dorsey says.

"The market reversal has been quite bullish.

Thursday's trading showed that the market has discounted oil and other negatives and

Friday's performance is very impressive," he says.

The major indices will likely not go up in straight line toward the August highs, as oil prices -- influenced by the vagaries of tropical storm season -- may again test $65 or above.

But oil prices are near the end of their near-term bullish run, with the "smart money" already beginning to cash in on the gains of the past several weeks, Dorsey says.

To back it up, he cites the behavior of some of his clients and his own research showing the resurging prevalence of the oil theme in the media -- a telltale sign for contrarians that the commodity is peaking.

Again, storms and hurricanes in the Gulf of Mexico could lead to one-day spikes in oil prices and to 100-point-plus losses for the Dow, but the trend over the next six weeks will be for oil to cool down. Likewise, gold and commodities will likely trend lower.

All this will further fuel bullishness for stocks until they peak in mid- to late-August, the Market Semiotics founder believes.

What of inflation jitters, which were also expected to precipitate the lows previously expected for next week? The stock market is "still in denial" about it, Dorsey says.

"We think inflation is a big force that is not being recognized by the market so far. High commodity prices have not translated into a real

inflation concept and as a whole, the inflation story isn't front-page material," he says.

Yet inflation jitters could come back to the fore by late August/early September, which is when Dorsey expects the stock market to enter a "very bearish" phase.

This week, the equity market paid little attention to bond prices, which have steadily declined since the Fed last week gave no hints that it intended to pause its rate-hike campaign. The benchmark 10-year Treasury bond fell while its yield rose to 4.09% after trading below 4% for most of last week.

A series of strong economic reports -- the ISM manufacturing and service-sector surveys, factory orders, consumer sentiment, retail sales and Friday's employment report -- is allowing a so-far orderly reassessment of the Fed's intentions -- at least in bond pits.

The key employment report showed the economy added 146,000 jobs in June, disappointing some of the more bullish expectations for gains north of 200,000. Yet, adding upward revisions of 44,000 to the May numbers, the report was more or less in line with average market expectations and points to steady monthly job gains in the neighborhood of 180,000 jobs.

The report does have implications for inflation, according to Peter Kretzmer, senior economist at Bank of America. The sustained pickup in hiring gains while GDP growth slows "is a trend that pushes up unit labor costs and pressures profit margins," he says.

But the market won't really start paying attention until August, according to Dorsey.

To view Colin Barr's video take on today's market, click here

.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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