Oversold Bounce Or Return to Risk On?

Is this the end of market weakness and the start of the next significant rally?

That’s the question on Traders’ minds in the wake of the Spanish €100 billion Euro bank bailout.

A few factors make assessing this action especially challenging. The bailout in Europe and added liquidity should add some fuel, but its offset by a slowing global economy. China, India and Europe all have seen noticeably weaker economic data the past month.

The US data has softened, but much of that is giveback for the stronger employment and retail sales data from Q1. The unusually mild winter weather likely pulled sales forwards in autos, clothing, construction and elsewhere; softer data in Q2 is the makeup for that.

Complicating this is the question of if and when the Fed will unleash QE3. As the chart below shows, the prior two QEs as well as Operation Twist all came about from much deeper oversold levels, with markets down ~20% or more.

It seems the QE drug requires greater doses administered ever more frequently, yielding an increasingly weaker liquidity high. All addicts experience this. Every subsequent hit of that sweet, sweet junk yields a less intense high. It takes more and more stuff to achieve the same effect, leading to an increasingly strong addiction to substances that are very bad for the overall health of the body, but damn, that shit feels good! At least, until the withdrawal pains kick in, followed by hallucinations. (And the dry mouth, I really hate that).

Perhaps it might be instructive to look at recent history to see how this market swing compares to others. Last week, a low put was made on Monday (June 4) culminating an 11% slide since April 2nd. European markets are up strongly, with US futures following suit. Sentiment has been rather negative, but not at the extremes that typically give way to lasting rallies.

Do not forget that Q1 was a smoking hot 12% move in the SPX. If you think of April as a consolidation of that strength, then this move up could be the continuation of that rally. The market had two 90% down days since then (May 30th and June 1st) which tend to exhaust the supply of stock for sale, at least for the short term.

What would make us more constructive on equities for the near term? Right now, the move off of the June 4th lows has the appearance of an oversold bounce. What we would want to see is greater appetite for equities beyond HFT and Swing Traders. Greater participation from institutional buyers and longer term stock accumulators like pension funds and 401ks would be a strong positive.

How can we tell if that is occurring? The data would reflect it in several significant ways: Broad buying should show strong breadth — meaning lots of stocks are  participating, with many more advancers over decliners. Given the low volume this rally has had over the past year, any notable improvement should be easy to spot. Third, we would prefer to see strength in high quality names, not merely the most oversold junk that gotten beaten up in May.

Until the S&P clears 1365 with good internals — and that’s less than 4% from here — it is difficult to look at this as anything but an oversold bounce.

Source: The Chart Store