Are We Oversold Yet?

In the past few weeks we've seen the markets come down quite a bit and rallies struggle to make any headway. We have built a head-and-shoulders pattern in the major averages (three successive peaks, which may indicate the reversal of an uptrend), and we've seen sentiment grow more bearish as this has transpired.

Losing momentum

If we look at a very short-term momentum indicator, what I call the overbought/oversold oscillator, we can see that it peaked in late March, shortly after the low in the market. However, notice how every single rally in the market after that initial momentum peak has shown a lower high in momentum. That loss of momentum has been evident since just a few weeks after the low.

Source: Helene Meisler, as of July 10, 2009.

If we look at a more intermediate-term momentum indicator, in this case the 30-day moving average of the advance/decline line, we can see that this indicator has been losing momentum since late April.

Source: Helene Meisler, as of July 10, 2009.

Then there's the McClellan Summation Index, which measures market breadth by comparing the number of advancing stocks with the number of declining stocks. This indicator is quite slow-moving and does not oscillate very much. It peaked in early May and has been heading lower ever since.

As a result, the late May rally, where the S&P 500® Index climbed to a higher high in early June, saw a lower high in this indicator. However, you can see that the late June rally barely saw an uptick in this indicator. By then the market was so weak that the best this indicator could do was go sideways for a few days.

Source: Helene Meisler, as of July 10, 2009.

Expansion of new lows

If we turn away from momentum and focus more on what individual stocks are doing, we can see that the number of stocks making new lows has started to expand. The Nasdaq now has more new lows than it has had since the March lows. The NYSE is in the same situation: Stocks at new 52-week lows are expanding, not contracting.

Source: Helene Meisler, as of July 10, 2009.

If we choose to smooth out the new highs and new lows using a "high-low" indicator, we see once again the loss of momentum. In the chart below, note the Nasdaq's high-low indicator compared to the NYSE, since many market participants seem to think the Nasdaq has not been rocked by this correction as much as the S&P 500 has. Under the surface, the indexes are not in much better shape. The Nasdaq is now making a lower low versus just a few weeks ago.

Source: Helene Meisler, as of July 10, 2009.

Recapturing the neckline

If we get back to the aforementioned head (H) and shoulders top (LS, RS) in the S&P 500 as shown below, we can see that we have broken the neckline (the lows following each peak can be connected to form a neckline or support level) but have so far failed to recapture it. It's my view that the more obvious something is in the market, the more likely it will NOT occur, since well-known information tends to be already priced in.

Source: Helene Meisler, as of July 10, 2009.

I would not be surprised to see the market rally in the coming days and recapture that neckline. That would have the effect of making folks second-guess the head-and-shoulders top that is now evident. However, it's said that head-and-shoulders tops that are "saved" (that is, those that don't break down) are a warning that even though there may be some life left in the chart, a genuine turn may be near. In my view, the next time the market reverses, it may be the final "rally" in the pattern.

I believe the market may rally sometime in late July. But because the market is losing momentum and individual stocks are underperforming the averages, I think rallies should be used for lightening up positions rather than adding to them.