Is the Market Headed toward a Big Break? Maybe -- If There's a Catalyst

Here's the conundrum: On Thursday, stocks slumped, with the major averages suffering their worst one-day sell-off since June.

On Friday, stocks recovered strongly, with a rally that accelerated into the close. The Dow Jones industrials closed at a new high; the Standard & Poor's 500 Index just missed a new high.

So, was Thursday saying the market had reached a tipping point or was Friday saying "Not to worry?"

Related: US Economy Adds 204,000 Jobs In October, Unemployment Up to 7.3%

There ARE risks to the stock market right now that give market bears ammunition to warn the end to the 2013 rally is near. At the same time, however, there are quite a few reasons to like the market at least for a while.

The situation at Friday's close was this: The Dow was up 168 points, or 1.1 percent, to 15,762. The S&P 500 added 23 points, or 1.3 percent, to 1,771. The indexes finished at higher for a fifth straight week. The Nasdaq Composite and Nasdaq-100 indexes suffered their second weekly declines in a row. This despite the Nasdaq's 1.6 percent gain to 3,919 and the Nasdaq-100's 1.4 percent gain to 3,367.

Stocks ignored the rise in interest rates set off Friday when the Labor Department reported 204,000 job gains in October and revised higher its estimates for August and September. The 10-year Treasury yield moved up to 2.746 percent, from 2.613 percent on Thursday.

The Dow and S&P 500 are up 20.3 percent and 24.2 percent for the year, respectively. The Nasdaq and Nasdaq-100 are up 29.8 percent and 26.5 percent respectively. The Russell 2000 has gained 29.5 percent, and the Dow Jones Transportation Average has gained 32.2 percent.

The Dow and S&P 500 are looking at their biggest annual gains since 2003. The Nasdaq may have its best price rise since 2009.

The risks to the market come from the sheer gaudiness of those 2013 gains and that the major averages have suffered just two monthly declines all year.  

There have been some cracks in the façade. There's the matter of the two weeks of losses for the Nasdaq and Nasdaq-100. The Russell 2000 peaked on October 29 with a 32 percent gain on the year. Then, it fell 3.8 percent by Thursday before rebounding 1.9 percent on Friday.  It's still off 2.1 percent from its peak.

Technical indicators such as 14-day relative strength indexes suggest the major averages are nearing levels that tends to produce selling. And the price/earnings ratio for the S&P 500 suggests frothiness is building. It was 19.37 on Nov. 1, according to Barron's, up from 16.09 a year earlier. In January 2008 as the market crash was starting to develop, it was 21.

In addition, recent declines in key momentum stocks such as Netflix NFLX, Facebook FB and Tesla Motors TSLA might tell some investors that a near-term top has been reached and the market is ultimately headed lower. Tesla is down more than 29 percent since hitting an intraday high of $194.50 on September 30. Facebook has dropped 13.1 percent its intraday high on October 18. Netflix has dropped 6.1 percent since October 21.

More than anything, however, the biggest risk to the market is the Federal Reserve. The Fed may decide in the next few months to begin tapering down its $85 billion-a-month bond buying program. With Friday's jobs report estimating 204,000 jobs created in October, the decision could be made in December. Wall Street is betting the vote won't come until October.

The tapering would mean the Fed's policy of ultra-low interest rates is over. And the jump in bond yields on Friday is a bet by some traders that the tapering is coming. It's just a matter of when.

That said, the stock market has some considerable strengths that may limit the downside.

The major averages are trading well above their 50-day and 200-day moving averages. The first is a key indicator of investor confidence. Falling below the latter is a clear signal of worry. They've only been breached twice since the 2009 market bottom and only for two months at most. By contrast, the S&P 500 traded under its 200-day moving average for the entire period between early September 2008 and September 2009.

Related: Postal Service to Deliver Amazon Mail on Sundays

Lastly, the economy may not going gang-busters, but it has improved. Auto sales have been running above a 15.4 million-unit seasonal rate this year. That's up 6.8 percent from a year ago and up 70 percent from the lows of 2009.

Housing starts are up 13 percent from a year ago and have climbed nearly 50 percent from their low in 2009. Of course, starts are still down about 57 percent from their 2005 peak of about 2.07 million units.

And data from Friday's jobs report shows that 7.2 million jobs have been created since jobs losses bottomed in February 2010. But that's still 1.5 million jobs short of recovering all the jobs lost during the Great Recession.

Still, markets do not rise without a break. And the breaks can be startling. Between its April 29, 2011, peak and the bottom in October 2011, the S&P 500 fell 19.4 percent. All year long, analysts have been predicting the major averages might fall back 10 percent to 15 percent.

At current levels, a 10 percent decline might pull the Dow down to 14,186, the S&P 500 to 1,539 and the Nasdaq to 3,527. A 15 percent decline would drop the Dow to 13,400, with the S&P 500 dropping to 1,505 and the Nasdaq to 3,330.

But you need a catalyst to produce such sharp declines.

The 2008-2009 crash resulted from the near-death of the global banking system. The 2011 break was set off by the debt-ceiling crisis and downgrade of U.S. debt. The big break between the spring of 2000 and October 2002 was a combination of bursting of the dot-com bubble and the effects of the September 11, 2001, terror attacks.