A Good Overbought "Ahead of the Fundamentals"

On Thursday, the S&P 500 fell 0.3%; this was only the second setback in 10 days. Breadth was negative by a 7:4 ratio, but the up/dn volume ratio was negative by only a 5:4 margin. Moreover, total volume was lower and the S&P recorded both a higher high and a higher low relative to Wednesday’s action. All post-March trends remain up.

We have pointed out that one has to go back to the early 1930s to find a time when the S&P rallied by as large a percentage in as short a time as it has since March. Friend and former colleague David Rosenberg, the Chief Economist at Gluskin Sheff in Toronto, put another spin on things this morning. We thought we would share it with you.

”Never before have we seen the stock market rise so much off a low over such a short time period, and usually at this state, the economy has already created over one million new jobs — during this extremely flashy move, the U.S. has shed 2.5 million jobs (as many as were lost in the entire 2001 recession). … By the time the U.S. stock market rallied 60% off the October 2002 lows, we were into July 2005. We were into the third year of the expansion. Go back to the onset of the prior bull market in October 1990 — by the time we were up 60%, it was January 1994! It took almost a year to accomplish this feat coming off the 1982 lows too and back then, we had lower interest rates, lower inflation, lower tax rates, lower regulation and an eight-year uninterrupted economic expansion to sink our teeth into.”

Without putting words in Dave’s mouth (he feels the market is “way ahead” of the fundamentals), we think his comments are another way of saying something we have been highlighting, i.e., the technical condition of the market is overbought, but it is a “good overbought.” Those examples were confirmed rallies, and higher highs followed (intervening corrections notwithstanding). Like those examples, the current evidence suggests that a coming correction will be followed by a return to or through whatever highs are made now. A second bear market to new lows is unlikely at this time.

S&P 1500 Sector Sum Indicator

But overbought is overbought, and a tradable correction could occur at any time. Such a correction should serve to work off the overbought condition and allow the various indicators to move to a healthier oversold condition. Our expectation is that such a correction will be a Fibonacci retrace of – at worst – the post-March rally and it may only be a Fibonacci retracement of the post-July gain. To put that into perspective, long time readers know that our usual expectation is for a correction to retrace at least 38.2% of the prior trend; such a retracement of the post-March uptrend would imply a 15% decline.

For trend reference, the pencil and ruler indicator shows that the post-March uptrend line is currently at 988, while the dominant uptrend from July’s low is now near 1023.

First support is indicated at 992-991. A break of that level would be the first lower low on the weekly chart since the July low. The July low (869) is tactical support and is likely to remain so for some time.

On an arithmetic scale a 50% retracement of the decline from the 2007 high to the 2009 low implies a challenge of 1121. Meanwhile, 1159 is the point at which the post-July rally will equal the March-June uptrend. Chart resistance (from the September 2009 reaction low is apparent in the 1155-1156 area. Thus, the 1121-1156 range is a potentially significant range.