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Unwinding the underperformance Commentary: Stocks give investors reasons to prepare for pullback

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Unwinding the underperformance
Commentary: Stocks give investors reasons to prepare for pullback

NEW YORK (MarketWatch) — Wall Street's tepid response to an astonishingly strong reading of the labor market, for whatever reason, may be a warning that it is time to start preparing for a pullback.

Automatic Data Processing's (ADP) National Employment Report showed that private-sector payrolls increased by 297,000 in December, or about triple what was expected.
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Players at the Golden Nugget resort in downtown Las Vegas will now have the option of getting gold bars from an ATM instead of cash. Video courtesy Fox News.

Accordingly, the yield on the 10-year Treasury note jumped 13.7 basis points and the U.S. Dollar Index surged 1% on Wednesday. The 1% rally in crude oil futures, helped by a bigger-than-expected drop in inventories for the latest week, was even more impressive since they were down more than 1% early in the session.

Meanwhile, the Dow Jones Industrial Average /quotes/comstock/10w!i:dji/delayed (DJIA 11,675, -22.55, -0.19%)  rose just 0.3%, with only 17 of 30 components contributing to gains.

There are a few reasons why stocks may have underperformed the other asset markets.

For one, the sooner the labor market starts to show real improvement, and the unemployment rate starts to fall at a more rapid rate, the sooner the Federal Reserve will start to become less accommodative. Good news on the economy starts looking like potential bad news for stocks.

The Fed's monetary policy-setting committee is adding two voting members, Philadelphia Fed bank President Charles Plosser and Dallas Fed President Richard Fisher, who might oppose current policy accommodation, while losing just one, Kansas City Fed President Thomas Hoenig. The Fed's next meeting is Jan. 28.

Another reason for the Dow's underperformance could have been because investors are uncomfortable buying when the index has reached what should be very strong resistance within the 11,700 to 11,850 range. The Dow produced a triple-top reversal pattern at that level in mid-2008, to turn back a rally just prior to the collapse resulting from the Lehman Brothers bankruptcy. The Dow rose 32 points to 11,723 on Wednesday.

Or perhaps investors just aren't used to buying when the dollar is rising, since that makes U.S. exports more expensive and lowers the value of profits earned overseas by multinational companies. And rising longer-term Treasury yields can't be a good thing for the fragile housing sector, which the Fed said continues to be "depressed."

There's a saying on Wall Street that the market's reaction to a number is more important than the number itself. So whatever the reason for the Dow's subdued rise, perhaps it's a warning that the upside is limited, which in turn indicates that a significant pullback is right around the corner.

When it comes, there should be some support at the 11,450 to 11,500 level, and in the 11,200-11,250 range. The key downside levels to watch, however, are 10,950 to 11,000, which was strong support in late November, and 10,700 to 10,750, which encompasses resistance in August and the 200-day simple moving average. In addition, a long-term uptrend line, beginning at the March 2009 low, now comes in around 10,750.

On the bright side, a pullback based on the economy being too strong, or because investors are just trying to break an old trading habit, shouldn't extend too far, and so the 10,700 to 10,750 level should be safe.

Tomi Kilgore writes Taking Stock, a column featuring insightful analysis of equity-related topics around the world. This column originally appeared on Dow Jones Newswires.



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