Stocks Bow to Reality

Disappointing tech results and an overextended market send shares down, but maybe not for long.
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When golf superstar Tiger Woods doesn't win a major championship in more than a year, people talk about him being in a slump. If pianist Lang Lang skipped a stanza, or merely stopped smiling, classical music fans would be horrified.

In other words, past excellence raises expectations, often to unrealistic levels.

As with entertainers and athletes, so it goes for stocks, which suffered Wednesday from the weight of heightened expectations. Not surprisingly, given their heady gains in the past 11 months, tech stocks suffered most after

Texas Instruments

(TXN) - Get Report

and

Xilinx

(XLNX) - Get Report

separately failed to raise quarterly guidance, something many investors anticipated.

On the eve of the second anniversary of the Sept. 11, 2001, terror attacks, traders were further unsettled by al-Jazeera's airing of a new video from Osama bin Laden.

In reaction, the

Dow Jones Industrial Average

fell 0.9% to 9420.46, while the

S&P 500

shed 1.2% to 1010.93 and the

Nasdaq Composite

tumbled 2.6% to 1823.88.

About 1.4 billion shares traded on the

Big Board

, where declining stocks led advancers 11 to 5. Nearly 2 billion shares traded over the counter while decliners led 23 to 8.

With Texas Instruments down 7.5%, Xilinx off 5.8% and analysts at UBS and SoundView offering some

cautious guidance , the Philadelphia Stock Exchange Semiconductor Index fell 5.3%.

Other negatives included legislation introduced in Congress seeking to impose tariffs on Chinese imports, Treasury Secretary John Snow's request for heightened regulatory oversight of

Fannie Mae

(FNM)

and

Freddie Mac

(FRE)

-- which fell 2.4% and 3.7%, respectively, as well as the widening mutual fund-trading scandal and the imbroglio over the compensation of

New York Stock Exchange

chairman Richard Grasso.

All that was in addition to concerns the stock market had become grossly overextended. Heading into Wednesday, the Comp was up nearly 70% from its October 2002 lows while the Dow and S&P were each up more than 30%.

Play it Safe

While Friday's decline was recouped Monday and Tuesday's setback was largely dismissed as "profit-taking," some observers detected a more serious tone to Wednesday's action. Notably, the S&P closed below the 1015 level, which signaled its

breakout last week.

"Friday and

Tuesday, buy signals swamped sell signals, which were almost negligible and saying we were simply seeing a pullback," said Kevin Depew, technical analyst at Dorsey, Wright & Associates in Richmond, Va. "Today is the first day of pullbacks where we have buy and sell signals

essentially even."

The indicators Dorsey, Wright follow "remain positive," but "risks are high," Depew said, arguing little has changed since

last month, recent gains notwithstanding. The NYSE bullish percentage is at 80% and anything above 70% is considered high risk, he continued.

"That doesn't mean we can't stay above 70% for a long time, but if you've missed out on getting in on this rally, now's not the time to climb back in." (Bullish percentage figures are calculated by dividing the number of stocks trading on new point-and-figure buy signals, by the total listed on the exchange. Point-and-figure charts are pure price charts that plot supply and demand without factoring in time or volume.)

Comparing the stock market to a football team (

sorry, sports nonfans

) Depew said the "offense" remains on the field but "the field position is lousy." Therefore, he recommends "risk-averse plays," such as protective puts or Rydex funds that perform inversely to major averages, such as the

(RYTPX) - Get Report

Rydex Tempest 500 fund, which I own.

Another reason for caution is the lack of participation by financial stocks during the broader market's recent surge, Depew said. "It's a problem when financials aren't participating, although they're not collapsing."

The Philadelphia Stock Exchange/KBW Bank Index fell 1.9% to 860.43 and is approaching 850, a level that would "confirm an important breakdown in point-and-figure terms," he said.

Financials were hurt by lowered guidance from

National City

(NCC)

, which fell 4.5%, and

KeyCorp

(KEY) - Get Report

, down 3.2%; each cited declining revenues from mortgage and refinancing lines.

Meanwhile,

Annaly Mortgage Management

(NLY) - Get Report

cuts its dividend and fell 10.6%. (On the upside,

Capital One Financial

(COF) - Get Report

rose 5.1% after announcing a drop in its loan losses in August.)

Ironically, the announcements from National City and KeyCorp came as the Mortgage Bankers Association reported mortgage applications rose 22% for the week ended Sept. 5, while refinancing activity surged 45%. The first gain in seven weeks for the mortgage index followed a recent decline in Treasury yields, a trend that continued Wednesday. The price of the 10-year Treasury rose 23/32 to 99 28/32, its yield falling to 4.26%.

On Monday I noted similar

concerns about financials from other sources, including Brian Belski, fundamental market strategist at U.S. Bancorp Piper Jaffray in Minneapolis.

"Days like today are clearly more defensive and those areas -- financials, consumer discretionary and tech -- that led the way

up are lagging," Belski said Wednesday. "String a few days like this together and you get a 'surprise correction.' "

Repeating a recent observation, the strategist said most mutual fund managers are more worried about missing the next 5% upside than of any downside risks. A decline of more than 5% could cause some concern, he suggested. "People will say 'now I'm getting worried,' and then you get another 5% to 8% decline and all of a sudden you're down over 10% from the highs."

The Dow and S&P are now down only about 2% each from their recent intraday highs, and the Comp by about 3% from its recent peak. Notably, Paul Desmond, president of Lowry's Reports, believes the current downturn is going to be "relatively shallow."

On Monday, Lowry's selling pressure index hit a new five-year low, he noted, suggesting "investors don't want to get rid of stocks and are confident about the future."

While some see that as evidence of dangerous complacency, Desmond said the laws of supply and demand suggest a more bullish, not piggish, outcome. "This lack of interest in selling stocks is typically what you find in the

early stages

of an important market advance," he said. "Based on what we're seeing, this correction should be shallow and short-lived and not enough to justify reversing positions." (Emphasis added.)

Furthermore, most of Lowry's institutional clients were "overly cautious" during much of the past year, Desmond said, even though his firm has been bullish since

mid-March. The S&P's new highs last week "forced skeptical institutions back into stocks" and many are focusing on

heretofore lagging big-caps, he said, although that's not coming at the expense of small- and mid-caps.

Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.