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oversold




A few weeks ago I mentioned that the US dollar and Euro sentiment had gotten lopsided enough to warrant our contrarian oriented attention. The US dollar sentiment had reached extreme bearishness while there was full blown euphoria about the Euro.

Apparently, with the scary headlines about Greek debt receding from front pages everywhere, suddenly everyone is happy to sell the US dollar and hold Euros. Even the Chinese have bid up Greek debt, pushing the 10 year Greek sovereign debt to 9.27%, down significantly from its recent double top at 12%. The crescendo of QE2 (quantitative easing) expectations from the Federal Reserve haven't helped the dollar either.

The most recent Daily Sentiment Index (DSI) reading for the dollar shows an even more extreme bearishness: only 3% of retail traders polled believe that the US dollar will appreciate. This is the level that we saw when the US dollar bottomed out in late 2009: "Anything But Euros" Pushes Dollar Sentiment To Extreme. But less bearishness than it took for the greenback to rally in early 2008 (6%).

US dollar SPX comparison Oct 2010

There are also other clear indications that this move down is over-played. The RSI for the US dollar for instance hit an extremely low of 22 recently. That is the lowest level since March 2008. As well, the US dollar's relative distance from its long term moving average is back to where we last saw it in late 2009 and early 2008 - instances where it rallied strongly. So it is clear that sustaining such a pace of decline is highly improbable since it corresponds to a severe level of gloom and of being technically oversold. I don't know exactly when but a dollar rally is expected to take place soon. And when it does, we shouldn't miss the higher lows that the dollar would carve out on the chart.

But more interesting than that is the relationship of the dollar with the wider US stock market. As you can see from the chart below, the US dollar and the S&P 500 index have been opposite each other for some time. The correlation isn't a perfect -1 but even a cursory perusal will reveal that when the US dollar is rallying, the stock market usually goes down (or at best sideways).

Hedge Fund Sentiment
So we can add the potential for an intermediate US dollar low to the list of cautionary signs for a weaker stock market. As well, the hedge funds who are considered the 'smart money' have been reluctant to jump on the rally bandwagon. According to the latest TrimTabs BarclayHedge survey conducted in early October, only 31% were bullish on the S&P 500 index. Slightly more (37%) were bullish on any other stocks.

While most would feel comfortable calling hedge funds 'smart money', as we saw in the asset correlation grid, they haven't really been able to offer their clients much of a safe haven. Nevertheless, I'm reluctant to interpret their lack of enthusiasm as being a contrarian indicator. Especially when there is ample evidence from other sources suggesting a weaker equity market ahead.

Election Year Cycle
The only positive note - and it is a significant one - is that we are smack dab in the middle of the most intense period within the presidential cycle. Also known as the election cycle. According to Ned Davis Research, since 1900 (till 2009) the Dow Jones Industrial has returned 3.7% in the second year of the presidential term (current year). Next year, as the third year has on average returned a whopping 12.6% and the last year 7.5%.

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While the market has been acting tired this month and the tape looks like it want to head lower, we have some signs that, at least in the very short term, the equity markets are oversold.

For example, take a look at the percentage of stocks above their 10 day moving average. Earlier this week this fell to just 11% which is just a hair's width shy of the 'magical' 10% level:

percentage stocks SPX 10 day moving average june 2009

The medium term breadth measure, percentage of S&P 500 stocks above their 50 day moving average, is not showing any indication of being oversold. As of yesterday about 60% of the 500 component stocks closed above their 50 day moving average.

Since mid April this percentage has been hovering around 90% - signaling an extremely overbought market. But the indexes have been able to move higher in spite of this.

This provides for a potential tell for the health of the market. If we are able to put in a strong bounce (in the short term) here in response to the oversold condition, then there is a higher chance that the market can continue to snake its way higher as it has since March 2009. But if we fall hard in spite of it, then we are looking at a weak market that may retest the previous swing lows.

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The Dow Jones Transportation sector is acting really wonky. At first glance, it might seem to be getting tarred with the same brush as the general market. The wonky part is that it has completely decoupled from the crude oil market.

For example, on October 29th, 2008, West Texas crude oil futures went into free fall, closing the day almost down 10%. On the same day, the Dow Jones Transports went down 5.2%. Huh?

Other than the plausible explanation that people are selling everything, is that the market is starting to discount an economic slowdown which will damage the transport sector more than a decrease in fuel costs.

But in any case, the transport sector has goetten clobbered out of proportion. Take a look at the bullish percent index for the sector to see what I mean:

bullish percent transportation sector oct 2008

The index closed last week at 5% - meaning that only 5% of the components of the Dow Jones Transportation index are trading with a point and figure buy signal. Five percent.

To find a time when the number was this low we'd have to go back to the beginning of the year and then the summer of 2002. The advantage is that such an extreme oversold is occurring right at support (~4100 on the Transports index) where it has found support two other times - summer of 2006 and early 2008.

I don't know if the market is signaling an economic shift with the way this sector is melting down, but I am willing to wager that it won't be straight down. We're about to see a bounce or snap back rally.

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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.

percent spx above 50 MA september 2008

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:

spx 2007 to 2008 chart oversold weak recovery

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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Wednesday's market performance took us down to a seldom seen place: only 10% of S&P 500 Index components closed above their 10 day moving average.

percentage stocks SPX 10 day moving average june 2008
Chart from indexindicators.com

That is oversold but according to Lowry's research, when the market reaches below 10% for this indicator, we have a setup for a powerful snap back rally that most of the time transforms into a full blown bull market rally.

The good news is that the S&P 500 Index (SPX) is approximately 60 points above its March levels here while it has pushed the percentage of stocks above their short term average to these low numbers. The bad news is that technically, we didn't go below 10% but actually reached 10.2% and recovered.

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