The Foundation Is Weakening

 | Jan 24, 2012 | 8:25 AM EST
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"The loftier the building, the deeper must the foundation be laid." --Thomas Kempis

The indices have been holding up extremely well but the foundation is weak, momentum is slowing and the danger of a pullback is growing. Many market players were anticipating a "sell the news" reaction as earnings reports rolled in, but they were surprised when old, slow-growth technology names like Intel (INTC), Microsoft (MSFT) and IBM (IBM) suddenly turned into momentum stocks.

There has been an unusually high number of warnings and lowered outlooks coming into the quarter, yet we have been running straight up since Dec. 19. The combination of high expectations, overbought technicals and tepid earnings sounds like a perfect recipe for selling, but it just hasn't happened yet. In fact, the obviousness of the setup has probably helped to produce a bit of a short squeeze as the bears have been overly anticipatory in looking for weakness.

As I've written quite often, one of the tendencies of the market since the low in March 2009 is to become overbought on low volume. We have seen dozens of these V-shaped moves higher in the face of a long list of negatives. If you have been too quick to anticipate a market rollover, you have been burned time and again.

The big question is whether the market players are going to be more aggressive as earnings reports come rolling in. Tonight we have the report from Apple (AAPL), which is probably the most important stock in the market. Several analysts have upped their estimates in the last few days and the stock is hovering around its all-time high. Expectations are high, which means the risk of disappointment is high as well, but AAPL has a tendency to surpass even very high hopes.

The most important thing to keep in mind as we navigate is that we are walking the high wire and it's a little wobbly. That doesn't mean we are going to suddenly fall. Markets at their high generally don't suddenly collapse. What happens is that upside progress becomes more difficult, we see a greater number of intraday reversals and there is a lack of leadership. As more folks recognize that stocks are slowing, profit-taking picks up and we have a correction.

But what really determines whether a market correction takes hold is the dip-buyers. When the market goes straight up like this one has the past month, it creates a big supply of underinvested bulls anxious to buy pullbacks. They don't like to chase strength, which leaves them sitting on the sidelines to a great degree, but the more the market runs up without them the more inclined they are to buy weakness.

Dip-buying always sounds like a great idea when the market is trending to the upside, but dip-buyers often lose their nerve quickly when faced with real weakness. It is when the dip-buyers are no longer as confident when a significant correction sets in.

I don't want to be overly bearish as the market has still not done anything wrong, but limited upside, slowing momentum and intraday reversals are signals that he market is slowing. I want to be mentally prepared to deal with a more challenging environment.

We have softness this morning on chatter about Greece's continuing problems, but I suspect that market players are aware of the extended technical conditions and are looking harder for excuses to sell. Stay quick and nimble. We may be able to hold up in front of AAPL's big report tonight but the foundation is weakening.



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