Saturday, May 19, 2012

Guess What - We're Oversold. Now What?

After five straight losing sessions on Wall Street (three of which were more than 1%), the buzzword for all traders right now is "oversold".   You have probably read several articles or blog posts already this weekend discussing how oversold this market is, and yes, there is no doubt we are very oversold.   What I did this weekend is look at a few of the indicators that are my personal favorites for judging overbought and oversold conditions to see what we can expect to happen from here.  Those indicators include the McClellan Oscillator (otherwise know as Worden's T2106) and my own RSI(2) indicator that keeps track of the percentage of stocks above 90 or below 10.

Let's start with the T2106.  We closed Friday at -419, which is extremely low but not as low as it has been at two points during the prior two years.   As you see below, however, those two lower points were the only ones over the past four years lower than where we are at now. 

After comparing current levels to prior levels, I matched the extreme oversold readings shown above to the corresponding action on the Nasdaq over the past four years.  Most people just assume that extreme oversold readings will automatically lead to a big bounce and the start of a new move higher.   As you can see below, that is not really the case at all.   The best case scenario in most cases was a sharp bounce of two to three days, followed by a lot of choppy, extremely volatile trade for a month or two.

If you take a look at the last two extreme levels below, you'll see that after a sharp bounce, the market sold off hard immediately and chopped around for weeks (or months last summer).   When we hit -479 last August, however, the selloff we saw had several huge down days, something we have really not seen yet today.  That selloff included a -5% and a -6% session.   So far, our worst day in this selloff was a -2% day on Thursday.   That makes me think that when this relief bounce does come, it will not be as sharp as some think. 

All Charts from TC2000, Courtesy of Worden Brothers, Inc.

In looking at the RSI(2) indicator I came up with and have kept track of the past few years, I see a market that is again not as extreme in terms of this recent selloff as some may think.  I think this indicator gives me a look at how oversold individual stocks are and as you can see below, we are nowhere near as extreme as we were almost a year ago in August 2011.

This makes some sense when you look again at the fact that we've only had one 2%+ selloff in this recent decline (and that was barely over 2%).   Over the past week, I have continued to see short setups emerge, which I found odd given that the market just kept selling off, but even this weekend, I see stocks like DECK, ZAGG, and RNDY as shorts, and if the market wasn't down five straight sessions, I would look to short them on breakdowns.  I have to assume that this means the possibility of further downside before a bounce emerges is a strong one.

In my opinion, what this all means is that at best, we're looking at a market that will have a relief bounce soon and then chop around for a while while individual charts repair damage.  This possibility seems even stronger to me as we enter the summer trading season, where volume decreases and volatility increases.   Just look at last summer for a clue - up, down, up, down, but we went nowhere.   It was tough for a swing trader and that's what we could be looking at for the near future this summer as well.   Although I will have no problem playing it if it occurs, I have a hard time seeing a market bounce and just keep moving straight up over the intermediate-term from here.

I still hold two short positions as of now, but will be looking to close those early next week if we see any more selling just because I don't want to get greedy.  We are at levels that can produce a relief bounce and I am certainly looking for it, but at the same time, the selling last week was so steady, controlled, and deliberate (and also without any panic from what I could see), I realize it's possible that we'll see that T2106 get even lower and maybe challenge that August 2011 level.  A bounce is likely but not a given, and if it does occur, it will only last a few days before another selloff occurs that tests the bulls(based on the charts above). 

I will be looking to get long this market via some ETFs on any sign of a reversal or bounce, but I will also keep my stops tight on any long attempts just in case.   If I am lucky enough to catch a bounce, I will be looking to sell into it a few days later.   In general, my timeframe will now be very short-term.  After significant sell-offs, swing trading can be hard due to volatility, so you have to adjust your style.  That's what I am going to do and I would advise you to do the same.

Summary Points:                    
  • Market is in position to bounce and is likely at some point this week but it is not a given.  May need to get a little more extreme before a bounce occurs.
  • Most likely the bounce will be short-lived and be followed by a sell-off that will test the bulls' mettle out.   Sell into the bounce.
  • After the bounce is tested with some selling, that's when you reassess things.  Most likely the market will chop around for a while.   Trade with a very short-term time frame and keep your profit targets more conservative than usual.  Take what you can get.
Good luck next week.  It should be interesting.


elingford roban said...

Excellent article. Great read!

GoodTrader said...

Great analysis of the current situation in the stock market.

ppmoore said...

yes, I agree, great analysis.