Relieving the Oversold Condition

The market’s plunge since the bombing in Madrid, coming on top of the slow slide which began late January, brought us to very oversold levels. After a nearly year long uninterrupted rally, this may not be a bad thing. Bull markets need the occasional corrections to keep them healthy and to reduce enthusiastic excesses. While this correction looks to be of that nature, it also has signs that it is not quite finished. Lets look at the reasons why.

We start by noting that Breadth remains strong, even if has eased somewhat recently. Our working premise is that this is a correction, and not the beginning of the end. Indeed, Breadth remains the single best insight into whether the Bull remains intact, or is rolling over into a new Bear.

That needs to be put into the context of how far the markets have come, and how little they have retraced. Over the past 12 months, Nasdaq has had a nearly 70% gain, while the Dow and S&P gained almost 45%. Since peaking in late January, the Dow and S&P have each given back 6%, while the Nasdaq lost about 10%. All things considered, these are actually rather minor retracements.

In late January, most of our Sentiment Indicators were deep into the exuberance zone: Bull Bear surveys, Put/Call ratio, and the VIX had alerted us on January 22nd that the market was flashing a Yellow Caution light.

The following six weeks worked off some of those excesses, but it was the post-Madrid sell off that moved most of these signals deeper into fear territory. The sell off produced enough fear that several markets experienced meaningful oversold conditions setting them up for a bounce. In particular, the Investor Surveys are now way off their highs, dropping from 70% Bulls to about 45%. The Arms index spiked, breaching 2.35 for 3 consecutive days, and the Put Call ratio moved up significantly.

We note, however, two factors make us suspect that this is the 7th inning of the correction, and not the end of it: The first is the low Volume during rallies, and heavier volume during sell offs. This reflects a lack of conviction on the part of buyers. Until that changes, the correction will likely continue.

Secondly, we note that the major indices are in a “No Man’s Land,” significantly above major support, yet far below the true resistance spots above present levels. Our support levels remain ~1875 on the Nasdaq, 9900 on the Dow, and 1070 on the SPX. Purchases can be made as we approach those levels.