Prepare for a (Weak) Oversold Bounce

The S&P 500 has fallen back to the bottom of a two-month trading range, and it remains stuck in a zone extending back to October, 2008. After a swift 3-month rally from the March lows, this kind of action has all the feel of a near-term top. Technicians will note the formation of a head and shoulders top.

The 200-day moving average (DMA) is still moving downward, the 50DMA is flattening out, and many individual stocks are breaking down as they experience 2-month long downtrends. However, the market is getting oversold and is likely to experience an oversold bounce before any follow-through of these topping patterns.

Oversold conditions are marked by the stochastics (see chart below). But perhaps more importantly, T2108, the percentage of stocks below their 50DMA, has dropped all the way down to 27%, its lowest level since mid-March. T2108 at or below 20% represents an oversold condition in the stock market. Given that the stock market is coming off such a strong rally, I am inclined to believe that T2108 will work much better as an oversold indicator than it did during last year's market collapse.

I am adding this potential topping pattern to the now growing list of items exposing a change in character in the stock market. As the market soared into June, I was beginning to think that it could tag 1000 or even 1050 before a Fall correction. Now I think the market will be lucky to retest the June highs before then. (My analysis of the "sell in May" axiom demonstrated that the stock market typically breaks the May highs in each month during the summer).

What might we expect from an oversold bounce this time around? I suspect it will be sharp but short. The first oversold bounce since the March lows started on May 18 with a one-day 3% bounce that eventually led to the June highs and a 7% overall gain. The second bounce was very weak and produced less than a 1% gain before fading in late June. This time, strong resistance looms overhead combined with a T2108 that is near oversold. Another earnings season has begun, and the risks of disappointment are high given the rising expectations for an imminent healthy economic recovery. Last week featured two significant warnings that I am sure flew under the radar.

These rising expectations were cooled somewhat by last week's awful jobs report, despite generally accepted conventional wisdom that unemployment is a lagging indicator and matters little on an aggregate level. I was a bit surprised by some of the belly-aching over the numbers (even renewed calls for MORE stimulus!) given the results seem more or less in-line with forecasts for unemployment to rise into next year (for example, see the Federal Reserve's March minutes).

Perhaps the main problem is that "happy talk" has spread like peanut butter claiming that the recession is essentially over or ending now, and many have extrapolated this to mean that the economic data will suddenly turn "green." Even IF the recession's demise meets some type of technical definition, economic malaise is likely to persist long after the statisticians and economists have declared victory over this latest business cycle. Again, even the Federal Reserve expects a very tepid recovery starting in 2010. (Also see Mohamed El-Erian's latest - "American jobs data are worse than we think").

Overall, the next several weeks should extend more of the same churning and grinding from the past two months as bad and "better than feared" economic and earnings data continue to wage war on expectations for economic recovery. This should generate another relatively weak bounce from current oversold conditions.

Be careful out there!

Full disclosure: Long SSO calls. For other disclaimers click here.

Comments

[Socialism c...:]

Oversold??? Hahaha. Overbought, really. Prepare for the crud to hit the fan the next 2 weeks.

Jul 09 01:42 PM

[CrazyCilinder:]

Good Analysis! I am looking at S&P up to 930 area, and possibly higher. I would look to add on SSO at just slighly above 890. Keep my stop-loss just below 870.

Jul 09 03:15 PM

[squark62:]

i agree, nice work doc! the others that posted before crazycylinder seem to have ideological problems. especially cetin. i own SSO & a healthy dose of SDS. among other things, i look at RSI between these 2 ETFs. when they cross is a clear indication of market direction. SDS RSI currently is > SOS RSI. this will have change before i act according. -cheers!

On Jul 09 03:15 PM CrazyCilinder wrote:

> Good Analysis!

Jul 09 03:35 PM

[Larry House:]

Caution is indeed called for. I just can't see the market making a bottom with only one touch on the low (in March). With the magnitude of the dislocation we have been through, I think it will take more testing down there (maybe lower) and time to form a bottom from which a sustainable advance can be launched.

Jul 09 03:40 PM

[Mad Hedge F...:]

That seems like the smart play. ) CNBC held a dynamite interview with David Rosenberg, former Merrill Lynch chief economist and current strategist at Gluskin Sheff, who offered the kind of big picture, 30,000 foot view that I love. We are well into an epic post bubble credit collapse. Deleveraging in the private sector is dramatically overwhelming any fiscal stimulus Obama can throw at it. The $50 trillion US household balance sheet is shrinking at an unprecedented rate. The unemployment rate will easily sail through 10.8% to a new high and spill over to a higher foreclosure rate. We’ve had two decades of baby boomers living beyond their means, and it is now time to revert to the mean. The stock market has already priced in an earnings recovery which we won’t see until 2012 at the earliest. Bull markets move in perfect 18 year cycles, and we are only half way through a generational washout in equity ownership that started in 2000. “Buy and Hold” is dead. An S&P 500 trading around a 13 multiple means will be stuck in a 650-950 range for years, and that’s being generous. Rent, don’t own stocks. The one place to be is commodities, because they will be underpinned by the undeniable demand coming from Asia, and have benefited greatly from consolidation. The big “Tell” here is that in last year’s huge sell off , they all bottomed at the previous cycle’s peak prices. It’s nice to hear someone reading from the same sheet of music as I. Too bad Merrill Lynch didn’t listen to David. Wow, do you think I should be selling rallies here at 886?

Jul 09 03:49 PM

[tobi:]

I would not go short at this point of time because today and yesterday 880 on the s&p held and we are overdue for an up bounce. So I would call for a very careful bullish option play for a quick profit.

Jul 09 05:39 PM

[Maxe Paul:]

I continue to support the view that a correction in the s&p to the low 800's is well underway. I expect a further test of the upside, s&p 1000/1050 level before year end.

The risk is that the bear market 3rd leg is now in progress, which will ultimately bring new lows, lower than March. The sudden moves lower in oil and commodities support this view, but I am sticking with my original plan at this stage.

IMO a break of 800 in the s&p would be a 3 rd leg down scenario, a hold above would be a continuation of the bear market rally.

Place your bets!

Jul 11 06:35 AM

[CrazyCylinder:]

May be we will touch lower 870, but not before trying to reach 930 area. If we do see the swing down to 880 - that will be the last attempt to re-liquify market - that make happy shorts, and furtsrate bulls (who got on the board late).


On Jul 09 03:40 PM Larry House wrote:

> Caution is indeed called for. I just can't see the market making
> a bottom with only one touch on the low (in March). With the magnitude
> of the dislocation we have been through, I think it will take more
> testing down there (maybe lower) and time to form a bottom from which
> a sustainable advance can be launched.

Jul 13 12:23 PM

[Dr. Duru:]

Thanks for the comments folks. I think today (Monday) is the bounce I was looking for. At least I was positioning for at least a 2-3% move. The higher this goes from here, the more caution is needed for short-term traders trying to go long. Lots of overhead resistance from here...

Jul 13 02:34 PM

[squark62:]

kudos, doc!!!!

Jul 13 02:46 PM