A Rally With Legs? Give It a Maybe

Includes: DIA, QQQ, SPY
by: Sy Harding
In last weekend’s column I noted that the market was again short-term oversold and due for another rally attempt. But I said, “I’m not ready to turn bullish yet. Let’s see the second quarter earnings reports due out next week and how the market reacts to them.”
I noted that the January – February market correction began when December quarter earnings were released, even though those earnings were impressive, and the more serious April-July correction began precisely when March quarter earnings were released, even though they were also better than forecasts.
However, early this week I did recommend that subscribers at least take profits on our downside positions. Although I am still intermediate-term bearish on the market, not expecting the low for this second year of the Four-Year Presidential Cycle until October or November, this short-term rally might have longer legs than the last three oversold rally attempts that have taken place since the market topped out in April.
The market’s last oversold rally began in early June. I recommended holding downside positions through it, as I expected the S&P 500 would run into trouble at the overhead resistance at its 20-week moving average, and that the intermediate-term correction would then resume very quickly. That is just what happened. The rally ended precisely when the major indexes reached the overhead resistance at their 20-week moving averages, the rally lasting just nine trading days, and amounting to a gain of only 5% on the Dow.
However, for several reasons the rally this time could amount to more.
To begin with, the market was more oversold on Tuesday when the rally began than it was in June. So if this rally is to also reach the overhead resistance at the 20-week moving averages of the major indexes, that would be a rally from Tuesday’s low of 10% for the S&P 500.
We are also in the period of July into August when summer rallies of 10% to 12% often take place.
And investor sentiment is mixed but may also support a better oversold rally this time.
As most investors know, investor sentiment is a ‘contrary’ indicator. That is, sentiment is at a high level of optimism and bullishness at market tops, and high levels of fear and bearishness at market lows. That is only natural. When a market correction is underway, investors naturally become increasingly pessimistic and bearish as their losses mount, so that by the time corrections end investor sentiment is usually at an extreme of bearishness.
While some methods of measuring sentiment, such as the Investors Intelligence Sentiment Index, and the VIX Index (also known as the Fear Index), are not at the high level of fear or bearishness they usually reach at market lows, the poll of its members by the American Association of Individual Investors (AAII) did spike up to a level of bearishness this week that is often associated with market lows. We consider that level to be when the poll reaches 55% bearish, and bullishness drops below 21.
The poll’s bullishness had been holding up surprisingly well until recently. While showing less confidence and bullishness as the market correction that began in April became more serious, three weeks ago the poll showed 34% were still bullish, and only 32% were bearish (the rest neutral).
However, over the last two weeks of further market decline, bearishness increased to 42% last week, and spiked up to 57% this week, while bullishness fell to 24.7% last week, and only 20.9% this week. Those are in the range supportive of the market being at a low, not necessarily the low, but a low.
That said, the AAII poll is not as reliable when it spikes up suddenly, as it did this week, often dropping back down the next week. And while 55% bearish is the level most often associated with market lows, the poll reached a record of 70.3% bearish at the market’s panic low in March of last year.
However, if the market can ignore the negatives continuing to pour out in the economic reports, and the earnings reports next week don’t spook it, a summer rally is likely underway.
Disclosure: No positions