Stock Market Gains Show Signs of Wear

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Stocks head into Friday with a 1 percent gain for the week so far, but traders are increasingly seeing signs of wear, particularly as a growing list of disappointing economic reports stacks up against the market's gains.

Friday's data includes consumer sentiment at 9:55 a.m. ET, and leading indicators at 10 a.m.

(Watch Now: What Happens When Fed 'Tapers' Down)

Those reports follow on Thursday's Philadelphia Fed survey, weekly jobless claims, and housing starts, all disappointing in some way. Industrial production Wednesday and the Empire state survey were also weaker than expected. The Philadelphia Fed index fell from a positive 1.3 to a contraction of 5.2 in May. Weekly jobless claims increased by a surprising 32,000 to 360,000, and housing starts fell 16.5 percent to 853,000, but permits rose.

"This week has been nothing but a series of negative surprises," said Mark Luschini, chief investment strategist at Janney Montgomery. "There seems to be a disconnect here between the moves in the stock market and the underlying fundamentals."

Traders have been pointing to how the S&P 500 is now more than 12 percent above its 200-day moving average, a bearish sign.

At the same time, talk about the Fed paring back its quantitative easing program has been a big focus, so traders closely followed comments from a number of Fed speakers Thursday.

Stocks have gained this week even amid talk that the Fed could start "tapering" or reducing its $85 billion monthly purchases of Treasurys and mortgages later this year. But a comment from one Fed official about tapering triggered selling late in Thursday's session. San Francisco Fed President John Williams said the Fed could start dialing back its purchases as early as this summer, if the job market continues to improve.

(Read More: Fed's Williams Gets Markets Moving in Final Hour)

"Maybe the Williams' comment was a catalyst, but it's not like he said I want to taper now. I think the market responded to that," said one trader. " The voting members stayed dovish and the non voting members talked about tapering."

David Gilmore, market strategist at FX Analystics, said Williams made the same comments previously, but it's interesting that he made them weeks later and after a series of weaker economic reports.

Traders said the market reacted because the comment was more aggressive than expected, even though Philadelphia Fed President Charles Plosser earlier in the day reiterated that the Fed should begin cutting back on its purchases in June.

"I still see fiscal drag, disinflation. I see weakness overseas. I see a rising dollar, so what…do I get excited about housing coming off of incredibly low levels? And I see a modest improvement in the labor market," said Gilmore. "I just don't buy this escape velocity ahead, and that the economy is mended. Credit is flowing. I don't buy any of that."

Gilmore said it is possible the Fed will taper before the end of the year, and he is waiting to hear whether Fed Chairman Ben Bernanke makes any comments about it when he appears before the Joint Economic Committee of Congress next Wednesday.

"I think from the Fed's point of view, the Fed is not comfortable doing more QE, growing its balance sheet," he said. "But I don't see a strong fundamental reason in the economy and prices to justify that."

The Dow fell 42 to 15,233 and the S&P 500 lost 8 to 1650. The yield on the benchmark 10-year Treasury note retreated to 1.87 percent from 1.94 Wednesday, as the disappointing economic reports brought in buyers.

Adrian Miller, director of fixed income strategy at GMP Securities, pointed out Thursday morning an interesting break in the correlation between high yield corporates and equities during the four trading days ending Wednesday. Stocks gained two percent to record highs, and high yield corporates declined a half percent in that period. The average high-yield corporate bond yield fell below 5 percent last week, but it was up to 5.193 percent by Wednesday.

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"It's definitely something I'll be watching closely to see where it goes. We're beginning to see new issues shake a little bit out of the break," he said. "It's been overvalued to begin with, not unlike near term equities. Near term equities are ahead of themselves. High yield's been stretched for a long time, which makes it vulnerable to shifts in sentiment." Miller said its usually stocks that break the correlation first.

The SPDR Barclays High-yield Bond ETF JNK is down 0.4 percent for the week so far, while the S&P 500 is up 1 percent. According to Lipper, $478 million went out of high-yield ETFs in the past week, while $416 million came out of investment grade bond ETFs.

What to Watch

The House Ways and Means Committee holds a hearing on the Internal Revenue Services' screening of conservative groups at 9 a.m. ET.

JC Penney holds its shareholder meeting at 11 a.m. in Plano, Texas.

Minneapolis Fed President Narayana Kocherlakota speaks at 1:45 p.m. on the future of financial regulation and monetary policy.

Facebook stock will be one year old on Saturday.