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Why a Relief Rally Is Likely


It will be driven by oversold conditions.


Expectation is the root of all heartache.
-William Shakespeare

Recap and Set-Up

As the S&P 500 Index weakens to approach the area I'd outlined in the Bull Market Timer weekly update on October 25, let us again evaluate the market outlook. Here's the updated chart with the near-term support levels identified:

Click to enlarge

Over on the Buzz & Banter, we've been getting increasingly concerned about the health of many sectors over the course of the past few trading days. Last week, we took a look at the deteriorating internals of the following indexes:

  • Russell 2000
  • Semis
  • Housing Index
  • Bank Index
  • Dow Transports

Sector wise, on October 22 and 23, we noted deterioration in the Restaurants sector with stocks as Darden (DRI) and PF Chang's China Bistro (PFCB), and Semi space with stocks such as FormFactor (FORM), Marvell Technology Group (MRVL), MEMC Electronic Materials (WFR), Semtech Corp (SMTC), Intersil Corp (ISIL) and TriQuint Semiconductor (TQNT). We also traded good short set-ups in Broadcam Corp (BRCM) and Research in Motion (RIMM).

This week, this dismal contagion has spread to many more stocks and sectors, such as Education: Apollo Group (APOL), ITT Educational Services (ESI), New Oriental Education and Technology Group (EDU); Solar: First Solar (FSLR), Sunpower (SPWRA); Retail: Polo Ralph Lauren (RL), Limited Brands (LTD), Gymboree (GYMB); and many other stocks such as Manpower (MAN), Flowserve (FLS) and so forth.

An important takeaway is that this is very different behavior from last earnings season. In July, most stocks came out with great earnings and were appropriately rewarded by the market with a strong advance and good follow-through. This time, the reaction is decidedly different, and many stocks are being punished for their weak guidance. Others which gapped up on good guidance have either filled the gap or retraced more than the gap and headed lower.

Additionally, we have menacing double-top formations in the Semis and Dow-Transports, the presence of which might signal the threat of a deeper correction in the intermediate term.

Short-Term Market Outlook

On a very short-term level, however, two of the short-term market indicators that I follow are in deeply oversold territory. This might indicate that a rally might be close at hand. Here are the two indicators that I'm watching that might spur a relief bounce:

1. Percentage of stocks above their 10-day moving average is at five, implying that 95% of the stocks are below their 10-day moving average. This should not come as a surprise since all of the above sectors (Russell, Semis, Housing Index, Bank Index, Dow-Transports) breached their October 1 lows and are at new lows for the month.

2. Secondly, McClellan Oscillator is at a level it's not seen in the past 22 years (my database on this indicator goes back that far). At a deeply oversold -381.49, it might be signaling that a relief bounce is on its way.

Click to enlarge

Intermediate-Term Market Outlook

It will be critical to assess the quality of any rally that might develop from these oversold conditions since we have some dueling forces coming into play for the intermediate-term trend.

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Position in AMZN, AAPL.

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