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Working Off the Overbought



• The market has already gone through the process of working off the very near-term excesses

• End of quarter influences trump the Fed decision

• In order to mount anything more than a retest of recent highs, more intermediate-term consolidation is needed

When everyone is talking consolidation, they are likely positioned for it. Over the course of the last few sessions, I have been listening to and reading that it should be no great surprise that the market is pulling back and consolidating the extraordinary gains. When everyone announces that, they have likely positioned for it by becoming more defensive by raising cash or rotating to the lower beta areas of the market - especially given the proximity to quarter-end.

In reality, the market has been working off the overbought condition for more than a couple sessions internally. I track the percentage of stocks within the S&P 100 (OEX) and Nasdaq 100 (NDX) that are either overbought or oversold using a 14-period stochastic. While the various indices have only pulled back over recent sessions, the action underneath has been pausing for a while now. In fact, only 35% and 16% of the OEX and NDX are overbought, respectively (below). Given the strength of the rally, even if the indices pull back a bit more, the rotation has been evident...especially in the higher beta names (NDX).

OEX % Overbought

NDX % Overbought

Now that the internals have corrected the excesses, the major market indices are doing the same as evidenced by the same 14-period stochastic (below). Not only is the market, as defined by the S&P 500 (SPX), no longer overbought, but it is approaching a level that generated a bounce last May.

Daily SPX With a 14-period Stochastic

Source: Baseline

End of Quarter Influences

With only four days of the quarter remaining, traders and portfolio managers likely have one or two thoughts: "How can I make up for underperformance without getting too hurt over the next few days," or "How can I make sure I don't get hurt and lose outperformance over next few days?" The answer to those two questions is much more important than whether the thirteenth Fed rate cut of a whopping 25 basis points is going to save the economic day.

Judging by my own performance off the low (I missed the initial part of the rally), my best guess is that most folks are underperforming the major market indices -- especially the Nasdaq. In addition, the main reasons to not be a buyer were that the market was up on a spike, was severely overbought and lacked news. On any further retrenchment, those three reasons are not valid for the near-term.

As shown above, the market is no longer up on a spike, is in the process of consolidating, has worked off the overbought condition and could hopefully see better guidance out of Corporate America for the second half. According to Chris Low, FTN Financial's Chief Economist, the recovery should gather steam at a gradual pace. That means the perception of pending economic, and therefore earnings, improvement can last longer than normal, thus postponing the "prove me" stage for stocks and leading to a trading range environment marked by fits and starts.

Intermediate-term Needs More Work -- and evidence

Let's face it -- this market has run up more on the improvement in the corporate debt market than a demand-led improvement in earnings, coupled with low valuations. "Not going to zero" is a great reason to be a buyer when the market is down for the year or even up slightly, but over the next few months, there needs to be some REAL improvement.

The perception in the equity market is the economy should improve dramatically now that (a) rates have collapsed, (b) the drop in the dollar makes US goods more competitive, (c) there is no pending war, (d) news on corporate malfeasance should slow and (e) capital spending should improve due to all the above.

That is the perception... now what happens if the economy doesn't improve given a resolution (or abatement) to the major issues of the past two years, especially given the greater than 20% gains off the March low? As indicated earlier, the market is in the comfort zone for the very near-term as the "fear of missing" trumps the "fear of being trapped long." That can last while the perception of good forthcoming news is entrenched. My concern is over what happens as we end the quarterly reporting season when the expectations were for "dramatic improvement," but investors get the reality of "stabilization" commentary.

A Process, Not an Event

Typically, important market tops show themselves with negative divergences, signs of institutional distribution and poor rallies, and don't come as a single event. So far this pull back shows none of the signs that are typical before a sustainable decline. If all goes well, the major market indices should work off the intermediate-term (weekly) overbought condition by going sideways, giving the fundamentals time to catch up to the valuations. If all doesn't go well... ahhhhh, we can deal with that when some negative signs show up.

How the market works off this overbought condition will be the key. We believe the S&P 500 could enter a range between 950-1000 for a while, which allows for trading opportunities while the overbought condition is cleared up, but also limits moves in either direction until either major support is broken (945-950) or the severe overbought condition is resolved successfully. As you can see below, over the past few years, intermediate-term overbought conditions have led to some fairly nasty legs down, but this rally has been much more powerful than prior rallies. The strength of the rally prevents outright market sales, while the precedent of the weekly overbought condition likely prevents a runaway market from current levels.

Weekly SPX Chart With 14-period Stochastic

Source: Baseline

No positions in stocks mentioned.
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