Warning Signs Ahead

 | Mar 05, 2012 | 8:45 AM EST  | Comments
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"One timely cry of warning can save nine of surprise." --Joshua Thompson

Although the senior indices were steady last week, the market is showing increasing signs of stress. Probably the most obvious problems are the recent underperformance of small-caps and the sharp reversal in precious metals last Wednesday.

Big-caps such as Apple (AAPL) and IBM (IBM) are keeping the DJIA and S&P 500 near their highs, but the action in a large number of secondary stocks has been deteriorating. Given how long the market has gone without any sort of pullback it isn't surprising that many stocks are tired, but there has been extremely stubborn underlying support and the bears have not been able to gain any significant traction so far.

The bears have been talking about the negatives for a while now, particular high oil and gas prices, and they have some additional ammunition this morning as economic numbers in Europe are a bit weak and China lowers its growth targets. The excuses for selling are increasing and it going to be tougher to ignore them especially as the upside momentum starts to cool.

My advice recently has been to stick with the trend as long as possible and not to become bearish until there is some actual weakness. The important thing is not to look just at the major indices but to take into the account the action under the surface in individual stocks. Not fighting the trend doesn't mean you keep buying if you don't see good action. The indices can cover up a lot of poor action, which is exactly what they did last week.

Warning signs are developing. While we haven't yet seen a major trend change, there are good reasons for increased caution.

Keep in mind that market tops are processes that usually take time to play out. We generally don't reverse one day and go straight down, especially after we have had a sizable run like the one that started in mid-December.

What usually happens as the market tops is the dip-buyers start to lose their energy. Instead of jumping in on weakness and sending the market back into the green, buyers start to flip into a bounce and the momentum quickly cools off. Eventually, more and more dip-buyers find themselves trapped in failed bounces and they add additional selling pressure as they look to escape. Rather than create short squeezes that keep momentum going, they add selling pressure that helps build downside momentum. As the dip-buyers lose steam, the bears gain confidence and the trend shifts.

That is what we have to watch for at this point. We have the additional problem of news flow providing a good excuse for selling, as well as an extended market that has not corrected more than 1% in a single day so far this year.

Dip-buyers are a stubborn bunch. They are likely to make a stand but if they lose energy, it could get ugly very fast. Watch how the market acts on a bounce. If the momentum cools off quickly, be ready to hit the exits.

We are off the early premarket lows and the market has a tendency to bounce on Monday mornings, but there are good reasons for caution at this point. We aren't broken but there are some severe cracks forming.

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