Almost (but not quite) Oversold

After 4 down — and one up — days, the markets were set to try to reassert themselves, when a terrorist strike in Turkey sent futures much lower. After a fairly hard gap down, the market has been trying to climb back all morning. As mentioned Monday, the markets have been moving from overbought towards an oversold condition – but haven’t quite gotten there yet.

As the nearby McClellan Oscillator chart shows, the Nasdaq is nearing an oversold condition. The Nasdaq Oscillator is the chart of choice, if only because that market has been the leader throughout the rally. As such, its action sets the overall tone. Until rotation away from tech – and into Insurance, Non-cyclicals, Energy, Diversified Financials and Banking – can establish new market leadership, Nasdaq remains the key “tell” for all indices.

The markets have not had a 5% pullback since the rally began in March 2003. Ned Davis Research notes that this is the longest the markets have gone without a corrective drop since 1996. That in turn may be contributing to the lack of a substantially oversold condition and the lower volatility we have been seeing for the past few months.

Other technical data also reflect the not-quite-oversold-enough conditions The Arms Index 10 day moving average is nearing 1.5. That’s a critical reading typical of buying junctures. It is getting close, but not quite there yet.

If major terrorism cannot bring the markets to an oversold condition, what can? We are watching several factors:

Dollar: It dropped to its lowest level ever against the euro. But for massive Japanese central bank intervention, further losses versus the yen were inevitable. While positive for exporters, this is very negative for US deficit funding.

Deficits: The US has two huge and growing deficits – the federal budget, and balance of trade both approaching record levels. The risk is that if we may be unable to attract investors to fund these deficits, then U.S. interest rates will rise. This can choke off the nascent economic recovery.

Foreign Investors: A major decrease in international fund flows suggests a vote of no confidence in U.S. securities by the global investors: Net purchases of dollar denominated stocks and bonds have collapsed 90% – from $49.9 billion in August, to $4.19 billion recently.

As these three issues evolve, they may create the oversold conditions necessary for a bounce.

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