The S&P 500 has sold off 5.58% from its April 2nd high of 1422 to its low on May 9th of 1343 and conditions are in place for the market to put in an intermediate low. Whether the market rallies from present levels or not will tell us a lot about the market’s current strength. Failure to rally when intermediate oversold levels have been met indicates a weak market as prices are not low enough to bring buyers into the market. If the market does rally but breadth is weak and the indexes do not reclaim their 50 day moving averages this would also indicate a weak market that is simply working off oversold conditions before resuming its decline. What the bulls need to see is the market advance from here on strong volume and breadth, while also reclaiming their 50 day moving averages. What the market does over the next week will shed a lot of light on how strong or weak the market’s internals are.
Technical Indicators Reach Intermediate Oversold Conditions
After the 5% decline since the April peak many intermediate-term indicators are reaching oversold conditions where the market has staged rallies in the past. The percent of S&P 500 advancing issues and the percent of S&P 500 up volume are near two standard deviations below the mean as is investor sentiment measured by the American Association of Individual Investor’s survey, and the McClellan Oscillator is one standard deviation below its mean.
Source: Bloomberg
Conditions are in place for the market to rally and what the market does from here will tell us if we are in store for a larger correction or if the market wants to continue its advance off the October lows. If the market fails to rally when the conditions are ripe for its advance, then we are dealing with a weak stock market that is likely headed lower and a move down to the 200 day moving average is a likely target. This would equate to a 6.3% decline from present levels and a 10.2% decline from the April highs. Given the market’s oversold condition, another scenario we could see is a weak bounce in which the market doesn’t really gain any ground and simply works off its oversold condition before heading lower again as the bears recharge their resolve. For the bulls to maintain control we will need to see the major indexes reclaim their 50 day moving averages and also see the cyclical sectors and small cap stocks display leadership on any advance.
Europe, A Surprise Catalyst for the Bulls?
One of the things weighing on U.S. markets has been renewed flare ups in Europe and for a quick overview of recent European events readers can catch up with Ryan Puplava’s article from yesterday, “Unraveling This Week’s Euro Drama.” Given all of the volatility in Europe and the selloff in their equity markets, one would think that this renewed concern would also be evident in their credit markets but this is not the case. Since the late March to early April peak in U.S. and European equity markets, the Bloomberg European Financial Conditions Index (red, lower panel below) which is a composite of credit spreads has remained flat in contrast to the summer 2011 correction in which BOTH equity and credit markets deteriorated. There has clearly been a disconnect between European equity and credit markets and this disconnect will need to be resolved. If it’s the equity market that is overreacting we may see a recovery rally in European equities that is likely to be a bullish catalyst for U.S. stock markets.
Source: Bloomberg
The converse is also possible that if the European credit markets are simply being complacent they may catch up with the equity markets and provide further fodder for the bears on both sides of the Atlantic. Obviously watching how this disconnect plays out could be a key tell for which way the market’s next move will go.
Summary
With the decline off the April highs the U.S. stock market has reached intermediate oversold levels which typically see a rally ensue. Failure to rally from here or a weak rally that sputters will indicate how weak the equity markets are and will likely lead to a new leg lower in the markets with a test of the 200 day moving average as a potential target. One surprising catalyst for the U.S. equity bulls may be the European equity markets if the disconnect between European equity and credit markets resolves to the upside. Next week’s action in U.S. and European equity markets should shed light on the market’s internal health and provide clues as to which direction the next big move in equity markets will go.
