A “Good” Overbought

On Wednesday, the S&P 500 rallied 1.5%. That was its best performance since August 21 and was supported by a breadth ratio in excess of 6:1 and an up/down volume ratio in excess of 5:1. Total volume increased by 10% over Tuesday’s level.

In Tuesday’s blog we suggested that we needed to be alert for an upside acceleration. That acceleration was apparent on Wednesday as the "500" rallied through an important resistance trend line. Thus, if Tuesday’s rally through 1053 invalidated the diagonal triangle (wedge) pattern from July’s low, Wednesday's follow-through above the resistance line would seem to seal the deal.

S&P 500

In addition to the trend line break, the rally has carried some indicators to new recovery highs. For example, the advance-decline lines for the S&P 500, 400, and 600 are all at new highs, as is cumulative NYSE volume (On-Balance Volume). Moreover, the Bullish Percentage Index for the broad-based S&P 1500 is now above its October 2007 level. Finally, the monthly Coppock Curve long term momentum indicator currently has a bullish bias for 23 of the 24 S&P industry groups (the exception is Diversified Consumer Services). There are other examples, but these demonstrate that, while the market is overbought, that condition will likely prove to be a “good” overbought. In other words, a coming correction is expected to be followed by a return to or through whatever highs are being made now. All of this buttresses our view that a second bear market to new lows is unlikely at this time.

That said, a correction is likely sooner rather than later. All good rallies come to an end, and a correction would serve to work off the overbought condition and allow the various indicators to move to a healthier 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. With that in mind, the post-March uptrend line is currently at 986, while the dominant uptrend line from July’s low is now near 1020.

None of this changes our view that the post-March pattern is corrective/counter trend.

First support is indicated at 992-991. A break of that level over the next two days 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.