Tuesday's Action Is a Big Test for the Overbought/Oversold Oscillator

 | Sep 05, 2017 | 6:00 AM EDT
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Everything seems so compressed these days. Patterns that used to take months to unfold now unfold in a matter of weeks or days.

Since early August, when the indexes first took their initial spill downward, I have talked about a repeat of the March/April pattern set to unfold again. The pattern -- what I term a W -- unfolded in the spring over the course of six weeks. This time, it was three weeks.

Perhaps because the move was so compressed this time rather than elongated as it was in the spring, we have a different short-term situation. The market has moved to an extreme overbought reading in a hurry. The Overbought/Oversold Oscillator is grossly overbought, back to levels it hasn't seen since late July.

Tuesday's action will be a big test for this indicator. Right now, it has not made a higher high (vs. July). It has a chance to do so on Tuesday (I don't think it can do it on Wednesday, just based on the math). A higher high would be bullish, not bearish.

In any case, the market's breadth has been green for eight of the last 10 days, and that makes this overbought. If we want to look at the overbought situation differently, we can look at the McClellan Summation Index. It finally turned up last week (quite late in my view, but it did turn up). And just like that, it will now take a net differential of about -2600 advancers minus decliners on Nasdaq to turn it back down.

As you can see on the chart, that's quite extreme. Once it gets to the point where it needs more than -2000 to turn, I consider the market overbought. In the last few years, it has mattered more to the Russell 2000 than it has to the larger-cap indexes.

Point A took the Russell down quite a bit. Point B arrived in the post-Brexit vote era, and all it did was send us into a long sideways digestion. Point C came post the election. The market was so pent up, it didn't matter. Point D arrived in early December, and we now know that the Russell essentially topped out then and has been weak/sideways for the last nine to 10 months.

Point E is perhaps a decent comparison. That arrived in late April this year and took the Russell down from 1420 to 1350 (-5%). It also arrived off that March/April W pattern, so there is a comparable situation again. The overbought reading should stall out the rally or should see it correct downward. I do not believe the market looks similar to the way it did post-election, so I am ruling out November for now.

On the sentiment side of things, the 10-day moving average of the equity put/call ratio has taken a dive down under 60%, typically meaning sentiment has gotten "overbought" in the near term (calls for a pullback or sideways chopfest).

Then there is the put/call ratio of the VIX. Last Tuesday, it chimed in at 19%, indicating far too many bets placed on a higher VIX (lower stock market). Friday once again saw it dip under 20%. It is possible it was the long weekend effect, but when we get two such readings so close together, I consider it too persistent to be short-term bullish.

Couple that with the put/call ratio for ETFs sinking under 100% on Friday -- something that hasn't occurred since late July (the recent high in the market) -- and I think the best we can do is chop or correct the recent rally. It seems we've run a bit too far, too fast.

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