The Numbers That Say the Market Is Overbought
02/15/2011 7:00 am EST
The market has had an appetite for S&P 500 bears for several months now. Every time the bears think they are going to get away withtheir short trades, Mr. Market draws up his high-powered rifle and drops the bears just before they can comfortably close their positions and return to the cave. Just when the bears think they have escaped and are home free, Mr. Market reminds them who is in charge.
However, the appetite for oil has diminished tremendously over the past week as the US dollar and geopolitical news out of Egypt pushed oil prices lower. Mr. Market’s appetite is always changing it would seem, but right now, he’s enamored with S&P 500 bear meat and isn’t really interested in the oily bear meat. The question remains whether his tastes will change in the near term, or if he will continue to turn S&P 500 bears into fodder and steak.
With all metaphors and short stories aside, the price action in the S&P 500 for the past several months has been devastating for the bears. Going back to November 2010, every key resistance level ended up being taken out by the bulls, and prices pushed higher and continue to do so. Last Friday’s close pushed prices to new recent highs, and in time, prices may challenge long-term overhead resistance levels. The table below shows just how extended the equity market is:
As can be seen above, 82.73% of all stocks are currently trading above their 200-period moving averages, and over 68% of all equities are above the 20- and 50-period moving averages. While this certainly does not mean that prices are going to roll over, it is hard to refute the conclusion that prices in the equity market are overbought.
A quick glance at the SPX daily chart reveals the recent price action:
It is obvious when looking at the SPX daily chart that prices are extended to the upside in this bull market run. However, the distance between current price action and the 200-period moving average is significant. There is a total of 167.79 SPX points between Friday’s close at 1329.15 and the 200-period moving average at 1161.36. Based on Friday’s closing price, a reversion to the mean (200-period moving average) would produce a decline of around 12.62%.
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The SPX weekly chart is shown below:
It is noteworthy that the May 2008 swing high of 1,440 coincides with the upper band of the rising channel that is obvious when looking at the weekly chart of SPX. While price action may or may not get to SPX 1,440 during this bullish run higher, it is likely not coincidental that both key trend lines coincide at the same price point. The intersection of the long-term rising trend lines corresponding with the upper band of the current rising channel and the 1,440 swing high may be something of importance, or it may turn out to be nothing. However, it certainly is an eerie coincidence on the chart …if you believe in coincidences.
I am still convinced that stocks need to pull back at some point if they are to continue higher. Consolidation or a 5%-10% correction would likely be healthy for the market and might prove to be a launching pad for another thrust higher in price. From the underlying strength in the domestic market, a correction or pullback will likely be an opportunity to get long, barring price breaking down through the lower level of the rising channel located on the weekly chart.
I am not sure that I am going to get involved on the short side if we see bearish price action in the coming weeks. Instead, I will likely be looking for opportunities to get long equities at more attractive prices. Right now, risk to the downside appears to be increasing as the S&P 500 continues to probe higher.
Light Sweet Crude Oil
Oil prices surged when Egyptian protests intensified and have sold off recently now that President Mubarak has stepped down and demonstrations have turned into nationwide celebrations. In addition, the US dollar has strengthened considerably the past few days, which has also put price pressure on oil. The daily chart of light sweet crude oil futures is illustrated below:
Oil prices are hanging on to a key support level by a thread, and price action in the coming week could see prices push lower through the support area and an eventual test of the 200-period moving average. I am not considering a short in oil, but I am looking at lower prices as a solid risk/reward long entry. I am going to be patient, but envision building a longer-term trade using options to profit from a possible rally after putting in a clear bottom.
Right now, price could hold above current support levels and bounce higher, but I think the more likely scenario is a brief bounce early this week and then a flush out lower, running stops and reaching panic level selling. As is customary for my trading methodology, I will be looking to buy into panic selling should that take place, however, at this point, I am not interested in getting involved just yet. I intend to remain cautious and will patiently wait for a low-risk, high-probability trading set-up to emerge. Until then, I will be watching the price action from the sidelines, letting others do the heavy lifting.
While it may open season on bears in the equity markets, the oil futures market has produced a new home and a new river for eager bears to feed. The question continues to remain how long will Mr. Market punish the short traders in equities while rewarding them in the oil futures pits. Mr. Market may be losing his appetite for bear meat in equities and might just decide to feast on some bears covered in oil. As usual, time will be the final arbiter, but for right now, I’m sitting on the sidelines and waiting for Mr. Market to tell me his next order.
By J.W. Jones of OptionsTradingSignals.com