Prof. Sadana,

I'm surprised at the recent market weakness. Given the magnitude of the oversold condition, wasn’t there a good chance that the market would rally harder than it did?

-Minyan A

MA,

I've talked about the recent lack of leadership in the market (see the Buzz & Banter). Many recent leaders such as agricultural chemicals (Monsanto (MON), Potash (POT), Agrium (AGU)), energy (USO, UNG, Transocean (RIG)) steel (United Steel (X), Arcelor Mittal (MT)), and select techs (Apple (AAPL), Research in Motion (RIMM), Google (GOOG)) have shown uncharacteristic weakness. And the financials, in their newfound euphoria, led a short covering rally and managed to exhaust their strength by gaining over 30% in five trading days. This chart captures the giddy move in XLF.


Click to enlarge

As we've been discussing, I've been concerned by the magnitude of recent oversold conditions. To illustrate this point, the percentage of stocks below their 40 day moving average consistently stayed below 20 for 16 trading days (6/2608 to 7/18/08).

This long streak was an indication of the oversold nature of this market. There have been only two similar precedents in the last 21 years. Both those times, the market stayed choppy and difficult in the weeks ahead. Here’s how the S&P fared back in 1990, when we spent about 33 days in deeply oversold territory.


Click to enlarge
All charts courtesy of TeleChart®, www.worden.com 

Given the recent market action following the short covering rally led by financials, the odds favor continued market weakness and the potential to retest July lows. The rally in financials from their July lows rescued the market from being seriously oversold, evidenced by the lack of capitulation and high readings on the VIX.

What the market will do next will depend upon the quality of the retest, the breadth of the market, and the enthusiasm/buying interest in the bounce that ensues. I would not be too eager to put money to work in the market, unless the retest is successful. Until then the jury is still out.

Sincerely,
Prof. Sadana

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