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On returning from hiatus last week, I promised to give you the broad strokes of the market: then and now. There are a lot of different technical measures I could point to but in trying to keep things simple and provide a context, I found myself returning to one of my favourite market internal measures: the percentage of stocks above their moving average.
The first chart shows the portion of stocks within the S&P 500 Index (SPX) that traded above their respective 50 day moving average. This internal market statistic has gyrated from extremes several times within the past two years. On several occasions it has hit extreme lows, which not by chance, coincide with intermediate swing lows in the market.
But while the market hit extreme oversold areas, the rally that followed was the important litmus test. And if we look closely, we see that each successive oversold level was followed by a weaker and weaker rally. The bears appear to be grinding the bulls down.
Take the first instance in early March of 2007. Only 25% of S&P 500 stocks were above their 50 day moving average when the market stopped going down. The resulting rally took that number to 85% by the end of the next month.
Over at the price chart, by the end of April, the S&P 500 had recovered all the ground it had lost. Then it continued to rally, gaining an equal amount on top of the recovery. This is normal for a healthy bull market:
Now compare this to the next time the market became oversold in late July and mid-August 2007. The percentage of stocks trading above their 50 day moving average temporarily spiked below 10%. A rare feat. And as it usually has historically, this caused a rally.
But the bulls were able to recover the lost ground and a smattering more - before being pushed back in October (green arrow above). This time, the rally didn’t continue.
You can go through the next 3 examples yourself and see how prices recovered less and less with each instance of extreme oversold readings.
Notice especially how in January 2008, although there were again less than 10% of stocks above their medium term moving average, the ensuing rally was so weak that it didn’t even go above the previous swing low. And so, the market had a lower low and a lower high (red dashed line).
Extreme oversold conditions are a great opportunity for the bulls to fight back. The “value” buyer steps in and creates a floor. The momentum trader then steps in and creates a virtuous buying cycle for others.
An oversold extreme is not automatically reason enough to buy. This depends on the tone of the market. Which is only truly revealed when you observe how the market behaves after it gets oversold.
So here we are, heading into the weakest month of the year, with lukewarm sentiment and a market that seems to be looking for any excuse to meander lower.
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