At the Crossroads

We are at an interesting and telling inflection point for the market. The market is generating overbought signals in our short- and intermediate-term indicators. The next moves the indices make will tell us a lot about the nature of this market. If the indices can rally from the current overbought levels, we may be at the start of a significant rally. If we see a breakdown from here, we can expect more of the same bear-market action we have been living with for the last year.

A rally from overbought levels would create a "good overbought" market condition. We only see this type of market condition at the start of new bull-market rallies. It's a sign of a strong, impulsive, bullish move.

The reason we are paying close attention to this issue now is that we have a convergence of several interesting signals. The 10- and 40-day SARSI charts are at overbought levels and show us that the market has made a one-sided push to the upside.

Zweig Breadth Thrust

The Zweig Breadth Thrust indicator has also generated a continuation signal. A "breadth thrust" occurs when this indicator moves from below 40% to over 61.5%. We have made such a move, but it wasn't very quick. That the signal took longer than 10 days to occur makes it slightly less bullish.

10- and 40-Day SARSI Charts; Contracting Bollinger Bands

Lastly, we noticed a contraction of the 21-day Bollinger Bands in the S&P 500. A contraction like this suggests that a higher-volatility move is on the way.

We would be on the lookout for a market break one way or the other. An upside break against the current backdrop would be significant and would signal a real bullish change for this market. A break to the downside would be a simple continuation and suggest we're ready to form another leg down and work off the overbought conditions that are in place.

The action in the first two weeks of January could be more telling than many traders are expecting. A breakout over 930 would signal a bullish change and have us looking for an impulsive move against a "good overbought" backdrop. A break below 860 would have us looking for a retest of the November lows.

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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.