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From Oversold To Overbought In The Blink Of An Eye at Trader’s Narrative

Last month, we looked at the NYSE McClellan Oscillator (Ratio Adjusted) as it plumbed multi-decade lows to see if it would help us to find capitulation. The Nasdaq McClellan Oscillator didn’t hit a record low but it almost reached levels last seen in October 2008 - indicating an extremely oversold market condition.

In mid-May, the analysis that this meant that the market would find a floor - but not for a few weeks - turned out to be accurate. Fast forward to today and we see this breadth indicator suddenly at the other extreme (for both Nasdaq and NYSE versions), indicating an overbought market.

Click to see larger chart in a new tab:
McClellan RA Oscillator chart Jun 20101

As you can see from this long term chart of the NYSE McClellan Oscillator, it is very rare for this indicator to reach such low levels. But it is even more rare for it to then turn around and hit the upside extreme within a short time:

McClellan RA Oscillator chart Jun 2010
Source: The McClellan Market Report

Historically, a spike up to these levels has not been the end of a rally (see above chart for past year and a half). Such an abrupt change of pace has in fact usually been generally favorable 6 months ahead. According to Tom McClellan, interpreting the meaning of the recent Oscillator’s behavior depends on where the market is in its current cycle:

What we can say is that the meaning of an extreme low reading like this differs based on the context in which it happens. If an extreme negative reading occurs during a protracted downtrend, like what we saw in 2008, it may mark an oversold extreme but it does not usually mark the end of the downtrend. But when a reading like the recent one comes during a correction within an otherwise healthy uptrend, it marks a terminal point for that correction.

A good example was the dip in April 1994, seen at the left end of the chart. The DJIA had made what was then a new all-time high on January 31, 1994, and then by April 4, 1994, the McClellan Oscillator had dropped to an extremely low level. It was an extremely focused selling event, helped by a Fed rate hike, and a sharp reversal from the gentle uptrend. But it got over and done at the moment when the Oscillator made its extreme low. But being done going down did not mean that the market was ready to start upward right away, and it does not have that meaning now either.

Interestingly, 1994 was the second year of President Clinton’s first term, and the second year is usually when bear markets arrive. We are now in a second year, and seeing a focused selling event in the spring time. It will not be too much of a surprise if the market takes until after the mid-term elections in November to start higher, which is what happened back in 1994.

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