The intraday reversal in the markets on Wednesday is of big interest and importance to traders and market technicians. Since the Jon Hilsenrath article, almost two weeks ago, investors have put more weight again on any tapering talk from the Fed. As I mentioned on the radio show last week, Wednesday was going to be a big day because of Bernanke’s testimony before Congress as well as the Fed minutes of the April meeting. Bernanke testified in the morning that the Fed could slow its asset purchases “in the next few meetings” if the economic data is good. At that point, the market reversed direction and ran for short-term support. Let’s look at the technical background and then we’ll look at the technical significance of Wednesday’s reversal.
For starters, the market was extended as of Wednesday. Once second quarter earnings kicked off in earnest and the S&P 500 tested the 50-day moving average, we were blessed with another rally. Once the job numbers helped break 1600 resistance, that rally was extended further as everyone selling on weak economic numbers in April was watching the market move against their strategy – and they quickly reversed course, biding up straggling areas of the market in cyclical sectors. The commodity rally also helped to encourage a risk on mentality, but enough talk about how we got here. Let’s look at the evidence in numbers.
Overbought, Overbought, Overbought
The market was overbought--overbought on momentum--overbought on participation--overbought on bullish sentiment. Let’s examine the indicators here to see that this was the case. For starters, anytime the 14-day RSI gets above 70, the market is considered overbought and extended. The past couple of times the S&P 500 has seen RSI levels above 70 have been significant. In September last year, the stock market had a 7.5 percent correction after the 14-day RSI broached above 70. In February of this year it happened again, but instead of the index correcting, we had a rotational shift from cyclical stocks to non-cyclical stocks in health care, consumer staples, and utilities. This time, it isn’t clear just yet if we’ll have a consolidation or correction, but the 14-day RSI was above 70 until Wednesday.
Besides momentum coming down from a four-month high, the percentage of stocks above the 50-day and 200-day moving average, for the S&P 500, is elevated and in overbought territory. That is to say that participation has been excellent in this rally which portends that any correction is likely to be shallow until we see some divergences. Although the intermediate-term 50-day indicator has rolled over, it will not produce a sell signal until it breaks below 70 percent.
The percentage of stocks above the 200-day moving average indicator never produced a sell signal in April, nor did it even produce an early warning by breaking below support (dashed black line). Just the opposite, the new highs confirmed the breakout in the stock market this month – which suggests that any correction will be shallow until divergence or sell signal can be created. An early sell warning will be registered if the percentage of stocks within the S&P 500 falls under 81% (currently 93%).
Now that we’ve taken a look at momentum and participation, let’s look at sentiment, which too shows that the market is overbought and extended by the small amount of bears. The AAII US Investor Sentiment readings show that the number of bulls is near elevated levels while the number of bears is at depressed levels. This doesn’t always correspond exactly with market tops and bottoms, but it does portend that the probability of a correction is higher with as many investors already bullish on the market – from a contrarian perspective.
Now that we’ve identified that the market is overbought, and we’ve identified that the market is concerned about Fed tapering, the setup was right for a short-term correction. Once the FOMC minutes were released, it was clear that more voting members were considering tapering bond purchases.
At this meeting, a few participants expressed concern that conditions in certain U.S. financial markets were becoming too buoyant, pointing to the elevated issuance of bonds by lower-credit-quality firms or of bonds with fewer restrictions on collateral and payment terms.
A number of participants expressed willingness to adjust the flow (taper) of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong sustained growth; however, views differed about what evidence would be necessary and the likelihood of that outcome.
So essentially, there’s a debate going on as to when to adjust the amount of purchases each month. Recall that Bernanke and the Fed have said they want to see “substantial improvement” in the labor market? Bernanke said Wednesday he’s only seen “some” improvement. As such, most analysts don’t believe there will be any adjustment to bond purchases until September or later. Despite what the Fed hawks say, we all know by now that Bernanke leads.
The market fell Thursday on weak PMI data from China as well as the technical reversal in the Japanese Nikkei, which fell 7.3% on Thursday, the worst day for their market since the tsunami. One of the issues that sparked the selloff in Japan has to do with the spike in Japanese bond yields (sell off in bonds despite Bank of Japan purchases). This worries investors that maybe their borrowing costs are getting away from them. This is definitely an issue that we’ll all have to watch closely. Is Japan having a Greek moment in confidence? I doubt we can answer that now with their stock market up 40% ytd, but if investors are unsatisfied with the BoJ’s reaction to higher yields, that may be the case. The yen rallied nicely versus the U.S. dollar, losing nearly a point.
The market began to rally on Thursday due to Bullard’s dovish comments and a slew of economic results that beat estimates, starting off with the market response to the new home sales, but the bulls didn’t seem to have enough buy-the-dip-juice to turn the market positive at the close.
Source: Bloomberg
It was nice to see the reversal off of key support levels, but it would have been more bullish short-term had the bulls closed the market back into positive territory. As such, we could continue to work off the overly bullish and overbought condition on the market. That can happen with a correction or a consolidation from here. But this isn’t when you start thinking of armageddon scenarios. This is when you look at favorable stocks you’ve been watching and where you identify key support levels to buy them on pullbacks. Don’t chase stocks. Let your patience and discipline in a correction pay off.
As a client of mine mentioned, “The music is still playing, even if the same ‘ol tune is getting old.” The market has been acting bullishly with stocks hitting all-time highs being confirmed by the transports. That’s the 10. The market has been strong without any divergences recently. It’s overbought and over bullish yes, but that just means it’s extended and it’s time for mean regression. Use this time to trim extended positions, raise cash, and buy newly rising stocks. I’m particularly favoring late-stage cyclicals right now. If the economy continues to strengthen, then we will begin to see the resurgence of the reflation trade. This is an area that’s been oversold for some time, especially with the commodity take-down in April.
