Saturday, May 3, 2008

Overbought Readings on Most Indexes

Here are charts of the S&P 500 and Nasdaq compared to Telechart's T2108 indicator. As I have mentioned before, readings of 20 or below often indicate a market that is severely oversold. Likewise, reading over 80 indicate markets that are extremely overbought. We are not quite at the 80 level yet, but we are fast approaching it. What I noticed about these charts is that the last time this indicator hit the 80 level was in early October of 2007. It was only a matter of days until the market began to sell off and the bear market we are in now officially started. Could it happen again? Certainly, and this is one reason I am becoming more cautious on the long side here.


T2108 vs. S&P 500T2108 vs. Nasdaq
Charts from Telechart2007, Courtesy of Worden Brothers, Inc.


This second chart shows the Nasdaq and Nasdaq 100 index with a custom overbought/oversold indicator I put into Telechart. I read of this indicator in one of the nightly Worden Reports and have used it occasionally when going long or short stocks. Individual stocks give off the overbought or oversold signal more than the indexes do. As you can see below, the indexes rarely give off these signals, and when they do, it is somewhat significant. The last time the overbought indicator popped up was in early October, 2007. Just like with the T2108, this was an early sign of trouble, as the market topped a week or two later. Right now, the Nasdaq is the only index showing this particular overbought indicator but I will keep an eye to see if others show up.


Overbought/Oversold Indicator on Nasdaq
Charts from Telechart2007, Courtesy of Worden Brothers, Inc.


Based on these charts and a few other reasons, this is my current thesis about this market and where we are headed. Mr. Market likes to bring as much pain as he can to as many market participants as possible, and usually is successful in doing so. Right now, there are still a ton of people shorting this market, and although bullishness has increased, it is not as extreme as it could be. We are right at or almost at the 200 day moving average on all indexes, and I am sure the bears see this as heavy resistance. If we get over these levels, I thing that many of the up-to-this point stubborn bears may throw in the towel, cover their shorts, and begin to go long, figuring that this market is indeed headed higher. Because of this, I would not be surprised for the market to rally for another week or so. I can't see us heading that much lower with as much short interest as there is right now.


I still, however, have a hard time believing our economy is now completely over this credit crisis and everything is all of a sudden A-OK. For the most part, this rally has seemed to be driven by retail traders and short covering, and at some point, they have to run out of steam. They can't carry a market on their own for long periods of time - the institutions do that, and they have been absent for the last month and a half. When the last of these retail traders get pulled in and start buying, I think that's the point we turn. I don't know if we're there quite yet, but I think we are very close to that point.


Because of this, I think the topping process of this bear market rally will still take a week or two to complete itself. In many ways, this rally off of the March lows remind me of the August to October 2007 rally that was the last hurrah of the 2003-2007 bull market - the percentage moves are about the same, and both lacked volume on their moves upward. In October, at the top, distribution days started popping up very quickly. As you can see below, that showed that the market rally was over. Right now, the S&P 500 has four distribution days on its count and the Nasdaq has two.


Distribution Days in October 2007
Charts from Telechart2007, Courtesy of Worden Brothers, Inc.


Right now, I would call myself a very cautious, short-term bull. I will manage the positions I have but am hesitant to jump on new ones at this point. The data above has me expecting an end to this rally in the next week or two, perhaps after we move higher still, getting past the 200 day moving averages and pulling in a few more bears. I want to be prepared for that possibility. I will be watching for distribution days - if they start popping up more often, that will be a sign the party might be over. After writing all of this, I may be completely wrong. That's the great thing about the stock market - no one knows what it is going to do next. If we just pullback on lower volume, perhaps March really was the bottom and a new bull market is starting. I somehow doubt it though. We'll start finding out next week. Best of luck.


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