A Fall Rally Is in the Cards

08/26/2011 9:30 am EST

Focus: MARKETS

James Stack

President, Stack Financial Management

A couple of  key proprietary indicators are pointing toward a healthy rally from these levels in the next few months, writes Jim Stack of InvesTech Research.

My Pressure Factor indicator is designed to gauge overbought/oversold market conditions. During the past few weeks, this short-term indicator hit several oversold readings that were lower than negative-100, with the lowest at minus-169 on August 4.

When the Pressure Factor is deeply oversold —as it is now— the odds of a sharp rebound dramatically increase.

Digging a little deeper, we found that since 1950, the Pressure Factor has seen only six readings lower than negative-160. Each of these instances occurred during a global crisis, and this time is no exception. Debt problems here at home and in Europe have pushed global markets down in tandem to extraordinary oversold levels.

The good news is, however, that one and three months after these psychological extremes, the market was up an average of 5.4% and 7.6%, respectively. And if a relief rally appears on the horizon, investors would have a better opportunity to gauge technical health of the market and adjust allocation accordingly, after the initial panic and fear have dissipated.

Even in the face of the US debt downgrade by Standard & Poor’s, investors are still loading up on US Treasuries. At the close on Wednesday, the yield of the bellwether 30-year Treasury bond was 3.63%, well below our 5% danger threshold and near the best (most stimulative) levels in over 50 years.

Additionally, the Fed’s commitment to hold interest rates low through mid-2013 has reduced uncertainties regarding future borrowing costs for businesses.

Commodity prices have also moved down alongside global equity markets. Since its all-time high in April, the CRB Spot Commodity Price Index has fallen 10.5%. This could help to keep a lid on inflationary pressures while stabilizing profit margins at the same time.

At the height of the political crisis in Libya, crude oil peaked at $114 per barrel, and is now down 25% to $85. When oil prices are rising, they act like a tax increase for consumers; and when falling they can help stimulate the economy by putting cash back in consumers’ wallets.

Bottom line, when we look at the volatile overreactions in early Augustand August 9 was a perfect example, with a 230-point gain, followed by a 400-point retreat, and then a 600-point rally, all in one daywe find it encouraging, if not ironic, that short-term traders have literally destroyed each other in that week.

Hopefully, that will put some of this nonsense (and fears) on the back burner, and allow some of the positive developments to emerge.

It is perhaps early to say this—but if this is a correction rather than a protracted bear market (as we believe), then we feel the correction lows are most likely behind us. But only time will tell, and we’ll be watching both breadth and leadership gauges closely…

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