The blemishes in Wall Street's glow

U.S. large-cap stocks surged to new all-time highs on Friday, thanks to a surprise interest rate cut from the People's Bank of China overnight, the first such move in two years. That was seen as a response to the ongoing slowdown in Chinese economic output, with factory activity now at a seven-month low.

Also contributing was fresh commentary from European Central Bank head Mario Draghi that eurozone economic weakness and a decline in inflation expectations could result in more aggressive bond buying as stimulus measures.

All of this fed the market's ongoing dependence on cheap money largesse from the world's major central banks, something that has been threatened lately after the Federal Reserve ended its "QE3" bond-buying program back in October.

In the end on Friday, the Dow Jones industrials and S&P 500 gained 0.5 percent, the Nasdaq Composite rose 0.2 percent and the Russell 2000 ticked up 0.1 percent.

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Never mind that the Chinese press warned that this wasn't representative of a surge of new liquidity (because Beijing is cognizant of a recent rise in bad loans and a possible credit bubble).

Or that small-cap stocks didn't play along (the Russell 2000 small-cap index has flat-lined over the last four weeks).

Or that the market's hefty Friday opening gains were trimmed into the close.

Or that Treasury bonds are moving higher, and yields lower, as fixed-income traders start worrying about something.

Or that this represented the 26th consecutive day that the S&P 500 closed above its five-day moving average.

The bulls are rampaging in a way that has been rarely seen in history. But despite the impressive persistence of the rally out of the Oct. 15 low, blemishes are starting to appear that have me worried.

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These include the way high-yield corporate bonds -- which tend to act as a leading indicator for stocks -- have been rolling over since June, setting a pattern of lower highs and lower lows. You can see this in the chart above of the High Yield Bond ETF (JNK).

The stock market is also looking somewhat fragile, sustained by a lack of downside moves since the Oct. 15 low and marred by signs of illiquidity. You can see this in the multiple exchange glitches over the last few weeks as well as large, jarring swings in stocks and exchange-traded funds (ETFs) driven by computer algorithms. Friday, precious metals ETFs like the Gold Trust (GLD) suffered large, inexplicable intraday declines that illustrate this problem.

One gets the feeling that, despite the appearance of strength on the surface, the market is more vulnerable than it looks. This is corroborated by weak market breadth measures -- with fewer stocks participating to the upside now than at peaks in July and September. That's a sign buyers are finding fewer stocks attractive at these levels.

As we head into the holiday-shortened Thanksgiving week, and the calendar prepares to flip into December, a number of major downside catalysts loom, including a possible fiscal fight in Washington as President Obama and Congressional Republicans -- now in conflict also over immigration issues -- face off over the need for a continuing budget resolution by Dec. 11. The month ahead also has the Federal Reserve's final policy meeting of the year, which could bring forward the timing of the first short-term interest rate hike since 2006.

The all-time record for short-term stock market consistency was in 1986, when the S&P 500 held above its five-day moving average for 27 straight days. Also in the mix is the market's long-term persistence, with the S&P 500 working on its 29th straight month above its five-month moving average. Plus, valuations are looking full, with the S&P 500's price-to-earnings multiple above 19x vs. a historical average near 15x.

While stocks could always go higher, investors need to ponder the risk vs. reward of continuing to hold equities at these levels, or piling in more, vs. trimming positions and taking some chips off the table here.

I've been recommending raising some cash and moving into more defensive positions such as precious metals via funds like the ProShares Ultra Silver (AGQ) ahead of an expected reappearance of selling pressure in the weeks to come. If I'm wrong, and stocks keep rising, the next stage of gains looks set to be led by emerging market stocks such as those contained in the iShares Emerging Markets (EEM).

  • Anthony Mirhaydari

    Anthony Mirhaydari is founder of the Edge , an investment advisory newsletter, and Edge Pro, options newsletter. Previously, he was a markets columnist for MSN Money; a senior research analyst with Markman Capital Insight, a money management firm; and an analyst with Moss Adams focusing on the financial services industry.