Stocks posted their worst showing last week in eight months. The action was dreadful with all sectors and market segments being clipped. Small caps fared the worst, dropping anywhere from 5 to more than 6 percent, depending the on the average you choose to examine. Market breadth was equally terrible with declining issues outpacing advancers by more than a 7-to-1 margin on the New York Stock Exchange. Markets around the globe responded in kind.

 

Yesterday it looked like U.S. shares were headed for at least a temporary respite. But the rally was all too brief. Blue chip shares managed to recover by the end of yesterday’s trading, but there were plenty of divergences: small caps, the transports and utilities all lost ground.

 

Initially, investors cheered the Institute of Supply Management’s (ISM) Manufacturing Index data of October, which came in at 55.7, well ahead of expectations at 53 and the prior reading of 52.6. But the devil was in the details.

 

The stock market rally fizzled as a breakdown of the ISM data revealed the pace of new orders, supplier deliveries and customers’ inventories all slowed in the month, while prices paid rose. So while the overall report suggested the economy is healthier than it was, key components suggest the recovery remains spotty, at best.

 

There is much more economic data due out this week that could roil the market. For instance, the unemployment rate is expected to reach 9.9 percent, but a double-digit print will bring out the bears in force. From our perspective, even more important with be weekly jobless claims, which remain persistently high. Money supply figures, which continue to contract, could also set off alarm bells. Without more bank lending the economic recovery is doomed.

 

The Federal Reserve’s policy setting committee is meeting again this week, which could also affect the market. No change is expected with short-term interest rates, but the wording in the policy statement will be closely watched. At this point, with the recovery still quite fragile, the last thing the Fed wants to do is get stocks running significantly higher. That would put pressure on Bernanke and company to start raising rates again sooner than they’d otherwise prefer.

 

In fact, the Fed may offer a somewhat more muted assessment of the economy than it did six weeks ago in its last policy statement. The Fed could seek to engineer a modest correction in stocks. By doing so, the central bankers would help keep long-term interest rates down and make it more palatable to continue with its policy of quantitative easing, further aiding the weak banking sector.

 

Whether we see prices erode from here or if stocks can manage another hurrah back toward the recent highs is open to speculation. One thing is certain, the deteriorating market internals tell us that the stock market is moving closer to its first significant pullback since the spring. Our hope is the correction will be limited in scope, but our fear is it could be far greater than most investors care to imagine.

 

Looking further out, we see inflation as being a very real threat. And we’re not the only ones who think so. Warren Buffett’s decision to buy Burlington Northern Santa Fe, his biggest acquisition ever, is a massive bet by the Oracle of Omaha on inflation since the railroad is levered to commodity prices. The market is recognizing this by bidding up gold prices sharply to a record high, even in the face of a strong dollar.