The Unfortunate Truth About an Overbought Stock Market

Writing about financial markets is probably the most challenging endeavor I have ever immersed myself into. I am a trader first and a writer second, but I have really come to enjoy scribing missives about financial markets because it really forces me to concentrate on my analysis.

Writing for the general public has really enhanced my perception of the market and forced me to dig deeper and learn new forms of analysis. I find myself learning more and more every day and the beauty of trading is that even for the most experienced of traders there is always an opportunity to learn more. As members of my service know, I strive to be different than most of my peers as my focus is on education and being completely transparent and honest.

I want readers to know that I was wrong about my recent expectations regarding the European sovereign debt summit. I was expecting the Dollar to rally based on the recent price action and quite frankly I expected stocks to falter after running up nearly 15% into the announcement. My expectations could not have been more untimely and incorrect.

I share this with you because as I read and listen to market pundits discussing financial markets I find that too many writers and commentators flip flop their positions to always have the appearance of accuracy. In some cases, there have been television pundits that stated we were possibly going to revisit a depression in 2012 no more than 5 weeks ago. These so called experts have now changed their positions stating that we have started a new bull market in recent weeks. How can anyone take these people seriously?

Financial markets are dynamic and consistently fool the best minds and most experienced traders out there. Financial markets do not reward hubris. If a trader does not remain humble, Mr. Market will happily handle the humbling process for him. I was humbled this week. I was reminded yet again that  financial markets do not take prisoners and they show no mercy. I am sharing this with readers because I want you to know that I refuse to flip flop my position without first declaring that I was wrong.

When I am wrong, I will own up to it purely out of sense of responsibility. My word and my name actually mean something to me, and while I strive to present accurate analysis I am fallible and I will make mistakes. The key however to the mistakes that I make is my ability to learn from them and the past week was a great learning opportunity.

After regrouping and stepping back after the price action on Thursday, a few key elements really stood out to me regarding recent price action. First of all, in the short term we are extremely overbought. The chart below illustrates the number of stocks in domestic equity markets trading above their 20 period moving averages over the past 5 years:

Overbought Stock Momentum

What is apparent from the chart above is that prices are almost as overbought right now as they have been anytime in the past 5 years. The number of domestic equities trading above their 50 period moving average over the past 5 years is also nearing the highest levels seen during the same period as the chart below illustrates:

Trading Stock Market Momentum

Equities trading above the 100, 150, and 200 period moving averages are somewhat subdued by comparison meaning in the short run a possible correction appears likely. The longer term time frames are no longer oversold, but they have considerable upside to work with before we could declare that they are overbought.

Additionally, the details of the European Union’s supposed solution have not yet been released raising questions going forward. Every move that is made will create unintended consequences. As an example, since Greece had 50% of their debt written down why would Ireland or Portugal refuse to pay their debts in full?

The Irish and Portuguese governments are going to come under pressure from their constituents to renegotiate the terms of their debt based on the agreement that was made with Greece recently. Spain politicians will likely be under pressure as well. The decisions made in these so called bailouts reverberate across the geopolitical spectrum. Moral hazard still exists, it just evolves over time.

The risk premium of sovereign debt has to be adjusted since credit default swaps did not trigger payment as the write downs were considered “voluntary.” Thus credit default swaps are not the answer to hedge sovereign debt as it would appear that governments have the ability to write down debt without triggering a default based on the status of the write down. The long term unintended consequences could be severe and are unknown at this point in time.

In addition to the unknown factors impacting the European “solution”, next week the Federal Reserve will have their regular FOMC meeting and statement. There has been a lot of chatter regarding the potential for QE III to come out of this meeting. While I could be wrong, initiating QE III right after the Operation Twist announcement would lead many to believe that Operation Twist was a failure.

With interest rates at or near all time lows and the recent rally we have seen in the stock market, it does not make sense that QE III would be initiated during this meeting. It is possible that if QE III is not announced the U.S. Dollar could rally and put pressure on risk assets such as the S&P 500 in the short to intermediate term. If this sequence of events played out, a correction would be likely. The following is a daily chart of the S&P 500 with possible correction targets in place:

SPY Overbought Stock Market

Right now it is a toss up in the financial blogosphere as to the expectations of where price action will head. Are we near a top? Is this the beginning of a new bull market? I scanned through several charts Friday evening and Saturday morning and came to this realization. If the market is going to breakout and this is not a top but the beginning of a major bullish wave higher, then the Nasdaq 100 Index (NDX) has to breakout over the 2011 highs.

The Nasdaq 100 Index is comprised of stocks such as AAPL, GOOG, INTC, and YHOO. In order for a new leg higher to transpire, hyper beta names like AAPL and GOOG have to breakout higher and show continuation with strong supporting volume. If the NDX does not breakout over the 2011 highs, a top could potentially be forming. The daily chart of the Nasdaq 100 Index is shown below:

QQQ Overbought Market

In conclusion, the short term looks like a possible correction could play out. However, it is critical to note that the longer term time frames are more neutral at this time. Furthermore, if price action cannot penetrate the 2011 highs for the Nasdaq 100 Index, I do not believe that a new bull market will have begun. If the Nasdaq 100 Index cannot breakout above the 2011 highs, we could be putting in a potential top going into the holiday season.

In closing, I will leave you with the thoughtful muse of famed writer and minister Hugh Prather, “Almost any difficulty will move in the face of honesty. When I am honest I never feel stupid. And when I am honest I am automatically humble.”

Subscribers of OTS have pocketed more than 150% return in the past few months. If you’d like to stay ahead of the market using My Low Risk Option Strategies and Trades check out OTS at Options Trading Signals.Com and take advantage of our free occasional trade ideas or a 66% coupon to sign up for daily market analysis, videos and Option Trades each week.

J.W. Jones

Just click here to check out J.W.s latest articles.

Evidence Supports the Bears’ Case for the S&P 500

I am not one to discuss fundamentals or macro views, but this situation in Europe is beginning to morph into a media frenzy. Price action in the marketplace is changing rapidly in short periods of time based on the latest press releases coming from the Eurozone summit.

I cannot help but comment on the seemingly arbitrary actions coming from this high profile meeting. Nothing has happened that market participants were not already privy too. The European Union is going to strengthen their EFSF fund by levering it up roughly 4 : 1. I have yet to hear how exactly they plan on doing this, but this action was no surprise to anyone that has read an article about the sovereign debt crisis in the past month.

There was also discussion about backstopping European banks’ capital position. Since European banks are holding billions (Euros) of risky sovereign debt instruments, it would make sense that their capitalization is a primary concern of Eurozone leaders based on current fiscal conditions. I would argue that the banks should be well capitalized regardless of economic or fiscal conditions in order for a nation to have a strong, vibrant economy that has the potential to grow organically.

The final piece of this week’s political nonsense involves write-downs on Greek debt in the neighborhood of 50% – 60% in order to stabilize Greece’s debt to GDP ratio. Apparently Eurozone leaders want to structure the write down so as to avoid payouts by credit default swaps which act as insurance against default. How does a bond take a 50% – 60% valuation mark down without a creating an event that would trigger the payout of CDS swaps?

If a write down of that magnitude does not trigger the CDS swaps, then I would argue they are useless as a tool to hedge against the default risk carried by sovereign debt instruments. If the CDS swaps do not payout as projected by European politicians, the risk assumed by those purchasing government debt obligations around the world would be altered immediately.

The impact this might have on the future pricing of risk for government debt instruments could be extremely detrimental to their ability to raise funds in the private market. Additionally, the write downs would hurt European banks’ capital positions immediately. If the CDS swaps were to pay out, bank capital ratios would suffer as those who took on counter party risk would be forced to cover their obligations thereby straining capital positions even further potentially.

Price action today suggested that the equity markets approved of the package that European leaders were working on. However, the biggest push higher came when news was released that China was interested in purchasing high quality debt instruments as a means to help prop up poorly capitalized banks and sovereign nations in the Eurozone through an IMF facility.

The market did an immediate about face which saw the Dollar selloff while the S&P 500 rallied higher into the close reversing a great deal of Tuesday’s losses. Inquiring minds wish to know where we go from here? I would be lying if I said I knew for sure which direction Mr. Market favored, however that did not stop me from looking for possible clues.

It has been a while since I checked out the short-term momentum charts that are focused on the number of stocks in U.S. domestic equity markets that are trading above their 20 & 50 period moving averages. The charts below illustrate the current market momentum:

Equities Trading Above the 20 Period Moving Average

It is rather obvious that when we look at the number of stocks trading above their 20 period moving average that momentum is running quite high presently. This chart would indicate that in the short-term time frames equities are currently overbought.

Equities Trading Above the 50 Period Moving Average

A similar conclusion can be drawn when we look at the number of stocks trading above their 50 period moving averages. It is rather obvious at this point in time that in the short to intermediate term time frames, stocks are currently at overbought levels. This is not to say that stocks will not continue to work higher, but a pullback is becoming more and more likely.

Additional evidence that would support the possibility that a pullback is likely would be the  recent bottom being carved out in the price action of the U.S. Dollar Index. The U.S. Dollar has been under selling pressure since the beginning of October, but has recently started to show signs that it could be stabilizing and setting up to rally higher.

The daily chart of the U.S. Dollar Index is shown below:

The U.S. Dollar Index is sitting right at major support and is oversold based on historical price action. If the Dollar begins to push higher in coming days and weeks it is going to push equity prices considerably lower. Other risk assets such as gold, silver, and oil would also be negatively impacted by higher Dollar prices.

Members of my service know that I focus on several sectors to help give me a better idea about the broader equity markets. I regularly look at the financial sector (XLF), the Dow Jones Transportation Index (IYT), emerging markets (EEM), and the Russell 2000 Index (IWM) for clues about future price action in the S&P 500.

During my regular evening scan I noticed that all 4 sector/index ETF’s are trading at or near major overhead resistance. With the exception of the Dow Jones Transportation Index (IYT), the other 3 underlying assets have yet to breakout over their August 31^st highs. The significance of August 31^st is that is the date when the S&P 500 Index put in a major reversal right at the 1,230 price level before turning lower. It took nearly two months to regain the 1,230 level and its significance continues to hold sway.

The daily chart of IWM is shown below illustrating its failure to breakout over the August 31^st highs:

The chart above illustrates clearly that IWM has failed to breakout above the August 31^st highs. I am going to be watching IWM, XLF, & EEM closely in coming days to see if they are able to breakout similarly to the S&P 500. If they start to rollover, it will not be long before the S&P 500 likely follows suit.

Currently the underlying signals are arguing for lower prices in the short to intermediate term. While it is entirely possible that the S&P 500 rallies higher from here, it is without question that current market conditions are overbought in the short to intermediate terms.

Key sectors and indices are not showing follow through to the upside to help solidify the S&P 500′s recent break above the key 1,230 price level. Additionally, the U.S. Dollar Index is currently trading right at key support in addition to being oversold. At this time I am not playing the S&P 500 in either direction, but I will be watching the underlying price action in the U.S. Dollar Index closely. I will be watching for additional clues in the days ahead.

Market and headline risk is high presently.

Subscribers of OTS have pocketed more than 150% return in the past two months. If you’d like to stay ahead of the market using My Low Risk Option Strategies and Trades check out OTS at Options Trading Signals.com and take advantage of our free occasional trade ideas or a 66% coupon to sign up for daily market analysis, videos and Option Trades each week.

Chris Vermeulen & J.W. Jones

Currency Market Summary For Tuesday October 25th

The December Euro currency closed down 20 points at 1.3920 today. Prices closed nearer the session high today and hit another fresh seven week high. Bulls have the slight near term technical advantage as prices are in a four week old uptrend on the daily bar chart.

The December Japanese yen closed up 24 points at 1.3182 today. Prices closed nearer the session high today and closed at a fresh contract high close. Prices have seen a bullish upside “breakout” from a sideways trading range at higher price levels. Bulls have the solid overall near term technical advantage.

The December Swiss franc closed up 27 points at 1.1399 today. Prices closed near the session high today and hit a fresh six week high. Bears still have the overall near term technical advantage. However, a bullish “rounding bottom” reversal pattern may be forming on the daily bar chart.

The December Canadian dollar closed down 85 points at .9852 today. Prices closed nearer the session low today and hit a fresh five week high early on. Prices also scored a big and bearish “outside day” down on the daily bar chart today as the bulls faded a bit.

The December British pound closed up 18 points at 1.6009 today. Prices closed nearer the session high today and hit another fresh six week high. The bulls have upside near term technical momentum. A steep three week old uptrend is in place on the daily bar chart.

The December U.S. dollar index closed up 7 points at 76.34 today. Prices closed near mid range today and hit another fresh six week low early on. Some near term chart damage has occurred recently. Prices are in a three week old downtrend on the daily bar chart.

Just click here for your FREE trend analysis of the U.S. Dollar ETF UUP

SP500 Poised For A Sharp Pullback Near Term says Dr. Copper

Back on October 3^rd I wrote a public article forecasting a major market bottom at around 1088 on the SP 500 index.  I surmised we were about to complete a 5 wave move to the downside that commenced with the Bin Laden highs of 1370 in early May of this year.  The following day we bottomed at 1074 intraday and closed over my 1088 pivot and continued higher as we all know.  That brings us to the recent highs of 1233 intraday this week, a strong 159 point rally off the 1074 lows in just a few weeks.

Markets I contend move based on human behavioral patterns, mostly because the crowd reacts to good or bad news in different ways depending on the collective psychology of the masses.  There are times when seemingly bad news is ignored and the markets keep going higher, and there are times when very good news is also ignored and the markets go lower. This is why I largely ignore the day to day economic headlines and talking heads on CNBC, as they are not much help in forecasting markets at all.

Using my methods, I was able to forecast the top in Gold from 1862-1907 while everyone was screaming to buy.  I was able to forecast the April 2010 top in the SP 500 well in advance, the bottom last summer, and recent pivot tops at 1231 and 1220 amongst others.  All of this is done using crowd behavioral theory and a bit of my own recipes.  

That brings us forward to this recent rally from 1074 to 1233, which as it turns out is not all that random.

The rally to 1233 will have taken place within a 13 Fibonacci trading day window which ends today.  In addition, the rally is leading into the end of Options Expiration week which tends to mark pivot highs and pivot lows nearly every single month.  Also, at 1233 we have a 61% Fibonacci retracement level of the 1010 lows of July 2010 and the 1370 highs of May 2011.  1233 was my “Bear line in the sand” I gave out a few months ago to my subscribers as a likely bull back breaker.  

In essence, the market is having trouble breaking the glass ceiling at 1233 for a reason; it’s a psychological barrier for investors now.

Near term, I expect the market to have another sharp correction to work off the near 160 point SP 500 rally that has taken hold in just over two weeks and again on 13 Fibonacci trading days as of today.  In addition to that, we should follow copper as it tends to be an extremely good indicator for the SP 500 index long and short term.

Right now, Copper has dropped 8% this week while the SP 500 levitates on a magic carpet ride within a 30 point range.  Copper looks like it has begun a 5^th wave down, which will likely take it to the $2.70’s per pound from $3.46 last week on its recent bounce from $2.99.  Below I offer a few charts showing the projected copper pattern and also one showing the SP 500 relating to Copper.

In any event, we are due for what I call a “B wave” correction of sentiment in the SP 500 and market indices, which should take the SP 500 to the 1149-1167 ranges minimally, and perhaps set up another entry for a C wave to the upside.  Caution is warranted near term is my point.  If you’d like to receive these types of regular updates during the week covering Gold, Silver, and SP 500 and more, check us out for a coupon or free weekly update at Market Trend Forecast.Com

David Banister

Get David Banisters Free Weekly Index & Commodity Forecast

Is the Market A Buy or Short Sale?

Is the market a buy or short sale? That’s the question that is going through many trader’s minds this week. Should I buy this market, or should I go short this market? At the moment, this market is being driven by perception and sentiment. Eventually that will change and the market will become driven by the direction of the major trend.

Our major trend indicators remain negative on the equity markets. We are also looking at the S&P 500 at the top of the Donchian trading channel. I believe that was the reason for yesterday’s sharp move down.

In order for this market to really get going on the upside it needs to clear the highs of 1230 on the S&P 500 in a convincing fashion.

There is so much confusion in the marketplace right now.....Interest rates, mortgage foreclosures, contagion in Europe and the occupation of Wall Street. The markets always have numerous conflicting thoughts, but eventually the market figures it out and goes the way it wants to go. Our job here at MarketClub is to recognize those changes and alert you to what we are witnessing.

Let's look at todays action in the U.S. Dollar........

The dollar index moved to a five day high today before succumbing to selling pressure. We would not be surprised to see a rally back to the 78.50 area. We continue to be friendly to this index and want to hold long positions with money management stops. The Dollar index is coming from a large energy field that is capable of carrying it much higher. Long term traders should maintain long positions with the appropriate stops in place.

The December U.S. dollar index closed down 31 points at 77.11 today. Prices closed nearer the session low today. Significant near term chart damage has occurred recently to suggest a near-term market top is in place.

Monthly Trade Triangles for Long Term Trends = Positive
Weekly Trade Triangles for Intermediate Term Trends = Negative
Daily Trade Triangles for Short Term Trends = Positive
Combined Strength of Trend Score = – 55

Now, let’s go to today's video and look at the 6 major markets we track every day.

Adam Hewison


Check out Today’s MarketClub Trading Triangles

Adam Hewison: Here’s the Bottom Line, Nothing Has Really Changed

The light volume rally that exceeded everyone’s expectations in the equity markets has finally come to an end. We were surprised, like many traders, just how far this rally extended. The major trends always win out in the end, and the major trend for the equity markets, the oil market, the silver market, and the Reuters Jefferies CRB index are all still negative longer term. The long term trends came into play and proved how important they are in the scope of trading.

This morning I saw that Wall Street insider Raj Rayaratnam was sentenced to 11 years in prison for his insider trading. I’m all for putting people behind bars that break the security laws of the United States. The security markets have no place for individuals like this.

I’m also for putting incompetent politicians who waste our money behind bars. There should be consequences for their actions. When you have Senator Dick Durbin go on the Senate floor and say to everybody to pull their money out of Bank of America, it is an irresponsible statement and very dangerous for our fragile economy.

The reason Senator Durbin said what he did on the Senate floor, is because he cannot be prosecuted. Had he made that statement in a town hall meeting or any kind of public meeting, Bank of America could and should sue him. You can’t have politicians denigrating businesses who are elected officials. Unfortunately, most of these officials have zero shame and certainly would not resign over something like this.

Here’s the bottom line, nothing has really changed, the country and the world is in a heap of trouble and that just can’t be swept under the rug and forgotten about.

Let's look at the action in the U.S. Dollar for Thursday.....

The dollar index is at the lower levels of the Donchian trading channel and is also in an oversold condition. Given the fact that the Chart Analysis Score is +55, we expect to see a rally and recovery most likely to the 78.50 level. We continue to be friendly to this index and want to hold long positions with money management stops. This index is coming from a large energy field that is capable of carrying it much higher. Intermediate and Long Term traders should maintain long positions with the appropriate money management stops in place.

The December U.S. dollar index closed down 4 points at 77.22 today. Prices closed nearer the session low again today and hit another fresh three-week low. Significant near-term chart damage has occurred recently to now suggest a near-term market top is in place.

Monthly Trade Triangles for Long Term Trends = Positive
Weekly Trade Triangles for Intermediate Term Trends = Positive
Daily Trade Triangles for Short Term Trends = Negative
Combined Strength of Trend Score = + 55

Is The SP 500 About to Stage a Multi Month Rally?

J.W. Jones of Options Trading Signals tells us where he sees this market headed...... 

The S&P 500 must have taken notice of the multitude of headlines coming at market participants and proceeded on a path of pure chaos. Since October 4th, the S&P 500 Index (SPX) managed to trade in a range that spanned from 1,074 to as high as 1,171 in 4 days. To put the past 4 days price action into perspective, the S&P 500 Index rallied 97 points or 9% in less than 96 hours.

Since late July, market participants have been dealing with a whipsaw that has been wrought with headline risk coming from Europe and huge swings in the price action of the volatility index. A few short days ago I was calling for a bounce higher in the SPX as every time frame was oversold. After the jobs number came out Friday morning domestic equities rallied sharply higher and in the short term prices were excessively overbought prompting some profit taking.

Around lunch time the news wires broke that Spain and Italy had their sovereign debt downgraded by Fitch Ratings. The downgrade put U.S. banks under pressure quickly and the price action started to rollover. By the end of the day price action was starting to work higher but a sharp selloff played out in the final 30 minutes of the session putting the major indices back into the red at the closing bell. So the real question that lies ahead is where do we go from here?

There is no easy answer to that question as the headline risk coming out of Europe over the weekend could have a dramatic impact on prices on Monday. Just as a reminder, U.S. bond markets will be closed on Monday for Columbus Day, but equities markets will be open as usual. At this point in time my short term bias is to the downside.

It would be healthy to see the S&P 500 roll over here and find a key support level where buyers step in and support prices. A higher low would be constructive and could lead to a more prolonged intermediate term rally which could last into the holiday season. However, before we can see any sort of rally we need to see a bottom form. While I do believe we have initiated that process, until I see a higher low carved out on the daily chart I will consider the current price structure to remain bearish.

In order to break to new lows, the SPX would have to push through several layers of support. I am of the opinion that we are unlikely to see the recent lows broken, but the chart below illustrates the key support levels going forward. A test of the 1,040 – 1,050 price range remains possible, but the price action the past week makes it seem less likely. Within the context of a hyper volatile period of time, just about any possible outcome remains feasible. The daily chart of the SPX below illustrates key support levels for the index:

In addition to the weak price action into the close on Friday, several other clues are pointing to potentially lower prices in the near future. Members of my service know that I focus daily on several underlying ETF’s which help me get a grasp of the overall market conditions. On Friday, the financials (XLF), the Dow Jones Transportation Index (IYT), and the Russell 2000 Index (IWM) all showed relative weakness against the S&P 500. The chart below illustrates the relative performance on Friday:

The financials and the Dow Jones Transportation Index are excellent sectors to monitor when trying to determine the future price action of the S&P 500. Most of the trading session on Friday the financials (XLF) were exhibiting relative weakness versus the S&P 500 Index. Later in the session, the Dow Jones Transportation Index (IYT) started to roll over as well and once both ETF’s were under pressure it was not long before the S&P 500 Index flipped the switch to the downside.

The financials (XLF), the Russell 2000 (IWM), and the Dow Jones Transports (IYT) all put in large reversal candlesticks on the daily chart by the close of business on Friday. This is an ominous signal that lower prices for domestic equities may be forthcoming. The fact that key sectors are showing signs of weakness is a negative omen for the S&P 500 and the early part of next week. However, there is a bright side to this scenario.

If support levels can hold up prices next week and we see a higher low on the daily chart form, the bottoming process could be underway which could lead to a strong rally into year end. Obviously a probe to new lows is possible, but I believe that we are in the beginning stages of forming a bottom and a base for a rally to take shape.

If support levels hold up prices, a bottoming formation will likely get carved out on the daily chart of the SPX. The chart below illustrates two potential outcomes that could cause prices to rally sharply. In one case, a higher low is formed and we see prices take off to the upside. The other scenario involves an intraday selloff down to the 1,040 – 1,050 price level that gets snapped back up and a huge reversal candlestick would be formed. These scenarios are common during bottoming processes. The daily chart of the S&P 500 Index is shown below with the two scenarios highlighted:

The other scenarios would involve prices blowing through support and possibly knifing down to test the S&P 500 1,000 – 1,008 support area. While I find this scenario to be less likely at this time, anything could happen in this trading environment.

The key in the short run is the utilization of defined risk through the use of stop orders. In addition, a trading plan with stop orders and profit taking levels planned ahead will help remove emotion in a volatile tape. The price action is wild, but from my perch the likely scenarios all involve some short term selling pressure. If my analysis is right, this could be a huge turning point for price action the rest of the year.

The next few weeks are going to provide us with clues about the rest of 2011. 

The question traders should really be asking is whether support will hold, or will we break below the recent lows? Right now, the upside looks limited, but in this trading environment the best thought out plans can turn out to be useless if price action does not cooperate. Be nimble and define your risk, as volatility is not likely to subside anytime soon.

Subscribers of OTS have pocketed more than 150% return in the past two months. If you’d like to stay ahead of the market using My Low Risk Option Strategies and Trades check out OTS at Options Trading Signals.com and take advantage of our free occasional trade ideas or a 66% coupon to sign up for daily market analysis, videos and Option Trades each week.

The Latest Options Trading Signals Articles