Get Ready for a (Weak) Oversold Bounce

By Dr. Duru written for One-Twenty

July 9, 2009

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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 market 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.

S&P 500

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.

DR. DURU®, 2009