SARSI Suggests a Bounce Is Near

The market has weaved its way through the worst June in recent memory with an 8% decline in the major indices for the month. The price action has obviously been very bearish, as traders simply ran for the exits with a variety of concerns on their minds.

Surging oil prices and the continuing financial meltdown, led by the regional banks this time, have topped the list of problems. Technically, the market is in distress, but once again, the market is at oversold levels on our 40-day SARSI indicator. Oversold readings in this indicator suggest a one-sided bearish environment which should lead to a countertrend rally in the broad market indexes.

Russell 1000 40-day SARSI

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We've highlighted oversold readings in this indicator in January and March. Each time this indicator reaches oversold levels, we have seen some sort of rally develop in the market. The oversold reading in January produced a counter-trend rally which led up to the March retest. The retest in March produced another oversold reading, which led to a more substantial and profitable rally through May. The June decline has been swift, and once again, we are deeply oversold and in a position to produce a counter-trend rally.

Once oversold readings are reached, it typically takes 10 to 14 days to develop a rally. Oversold readings in the intermediate-term SARSI shows one-sided bearish sentiment and price action. Getting long the market into this type of oversold environment is cutting across the grain and moving contrary to a "super" majority of traders.

We would like to see a spike in the VIX over the 26 level to confirm the oversold reading in the 40-day SARSI and show real fear. This decline has been marked by a certain amount of complacency from traders. Our experience suggests that we need to see a minimum amount of fear generated before a significant rally can develop.

Traders should look at the oversold readings in our internal indicators and simply know that the market has moved too far too fast and the odds now favor the development of a counter-trend rally. A spike in the VIX over 26 would show the minimal amount of fear required to generate a bullish signal and would confirm the oversold reading in the 40-day SARSI. We would suggest traders tighten stops on the short side and start putting out trades on the long side. Traders can start looking for a broad-based counter-trend move to develop within the next 10 trading days.

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At the time of publication, John Hughes and Scott Maragioglio had no positions in the stocks mentioned. Hughes and Maragioglio co-founded Epiphany Equity Research, which has developed and utilizes proprietary tools to identify and track liquidity changes in the market indices and sectors. Hughes advises numerous asset managers, hedge funds and institutions managing in excess of $30 billion. Maragioglio is a member of the market technicians association (MTA) as well as The American Association of Professional Technical Analysts (AAPTA) and holds a Chartered Market Technician (CMT) designation. Maragioglio has also served on the board of directors of the AAPTA.