Perils of the Overbought Market

 | Jan 20, 2012 | 5:00 PM EST
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The only thing I hate more than buying into strength, is buying into an overbought market.

Lately, we've had a lot of both and not much else, so I haven't been buying much. I haven't been selling much either. True, I could have sold some remaining positions at Thursday's close, but I had already cut back to a maximum of about 40% overall exposure (including junk bonds and short Treasuries) and as I still have higher targets outstanding, I am reluctant to lighten my exposure much more.

As for those higher targets, there are now the July 27 gaps looming above. Currently not much of a factor in the daily action, but as the market approaches these gaps -- for example at 1326 in the S&P Futures and Eminis  -- then I'd expect the market to not only take notice of these gaps, but to be pulled toward these gaps as if by a magnetic force.

In the chart of the Emini below (again I've had to take some liberties with the chart to adjust for the prices in the now-expired December and September contracts), you'll see how the market collapsed from the late July highs. In fact, July 27 (my birthday if you want to send an e-card) was a nasty down day with the Dow suffering its sharpest single-day point loss in more than two years and off more than 500 points at the bell. The point is, that was a bad time for the market and, accordingly, lots of folks who were holding long from the close of the July 26 have been patiently awaiting an opportunity to get out at, or near, break-even levels. If you think they won't be eager to sell stocks on a return to those gaps from July 27, think again.

Adding to the attraction to that area is the bearish island reversal from that same day. The island based on the July 21 gap runs 1321.30-1325.50. The orthodox gap from July 27 is a bit wider, exactly 5 points from 1321.20-1326.20. All of this has a basis in the now-expired September contract. Very short term note that Thursday's gap up opening left a little gap at 1302.25 to 1303.50. This morning's low of 1304.75 was pretty close and now it's lifted off that level. On the upside is this morning's gap at 1310.50-1309.50. A move above that gap and, more importantly, above yesterday's high of 1311.50 points higher. 


Emini Futures -- Another Island to Abort
Source: R.J. O'Brien Futures


The chart of the SPX suggests pretty much the same thing, but without the island reversals. Here there is also the gap from July 27 just below the 1332 level. That is the next upside objective once the overbought condition is relieved. Very short term there is a tiny gap of .01 from yesterday's close at 1314.50. A move above it should point higher, though the SPX will also have to take out yesterday's high about a point higher. On the downside, for the very near term there is the gap from yesterday at the 1308 level. That gap was approached this morning within about a point. A return to that gap that holds in that area might represent a short-term spot to buy, but I probably will leave it alone in deference to the market's overbought condition.


SPX -- Gaps to fill in both directions
Source: optionsXpress


Then there is the Russell 2000, which also has a July 27 gap, a long way up from current levels. That gap gets filled at 824.83. So I'm not going to be holding my breath for that one. But it's likely going to happen in the weeks ahead.


Russell 2000 -- A long way from its July 27 gap
Source: optionsXpress

As for the market's overbought condition, yes, it's a real source of concern. The McClellan Oscillator registered a fully overbought +171.5 at yesterday's close. It's clearly time for a breather, but once the overbought condition is relieved, especially if some of the recent downside gaps are filled, I wouldn't mind adding to my bullish positions.

The frothy sentiment is also a big concern. I would like to see the VIX spike back into the 30s, but that's not likely any time soon. Till then, I am a cautious holder up to a maximum of 40% (including junk bonds), but not a buyer of anything.


VIX -- Yesterday's new lows below 20 signal caution
Source: optionsXpress

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