A Cap on the Upside

 | Oct 18, 2011 | 6:15 AM EDT
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Remember all those folks who turned bullish late last week and said they wanted to buy the dip? Here's the overbought pullback, and folks did not seem very interested in buying it.

The market is overbought, and it's pulling back. The question should be when it ought to get oversold again, and the answer is: sometime later next week, as we head into the end of the month. This doesn't mean stocks must go down every day between now and then, but it does mean the market won't be back to an oversold condition until then. That, in turn, should keep the upside limited.

If you would like a positive takeaway from Monday's action, we can cite one or two. Volume was just as light on the decline as it was on the rally last week. Also -- and this one caught my eye -- on Friday the S&P 500 gained 21 points with breadth on the NYSE  at plus 2000. On Monday the S&P lost nearly 24 points and breadth lost only 1900. This is not a big deal but, considering the Russell 2000 was hit so hard, I found it interesting that breadth was not horrible.

Many continue to ask about the potential for that head-and-shoulders bottom I keep suggesting might appear. Bearing in mind I do not believe the market will go down in a straight line for the next week or so (until it's back toward oversold), here is a general picture of what might transpire to set up that head-and-shoulders bottom.

S&P 500

I can hear the questions now: Will the S&P come all the way back to 1150, or will 1120 perhaps make it more symmetrical? What about the 50-day moving average, which is now flattening out and resides around 1170? All are possible. But I can tell you that, if the index gets to 1170 before it gets oversold, then it might not stop at 1170. It's easier to pick the level when stocks are closer to being oversold. It's like inviting someone over for dinner then asking what time they intend to leave. The market didn't get overbought in a day, and it's unlikely to get oversold in a day.

As I was thumbing through my charts Monday, I came across that analogy I had made to 1987 back in August. I discovered it is still somewhat intact. The Crash of 1987 came during the third week of October, and the retest came during the first week of December (boxed in red on the chart). The Crash of 2011 came during the first two weeks of August, and the retest came in early October. Each time, therefore, the period was roughly six to eight weeks.

Dow Jones Industrial Average -- Current

Dow Jones Industrial Average -- 1987

Notice how the Dow broke out across that downtrend line in 1987 and then immediately pulled back toward it. Also notice that it did not pull back and immediately ramp back up -- instead, it bounced some. Then it hung around testing and retesting that line before another rally ensued.

The other thing to notice is that stocks didn't blast off even after all of that testing. 1988 brought us plenty of fits and starts. If you were paying attention then, you might recall 1989 wasn't exactly a stellar year in the markets, either. I believe the analogy will likely break down some time in the coming months, but for now it seems the market is reacting the way it ought to after a crash: highly emotional with plenty of wild swings. This looks like the overbought pullback (point A) on the chart.



Overbought/Oversold Oscillator -- NYSE

Overbought/Oversold Oscillator -- Nasdaq

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