Overbought, With Nary a Decline in Sight

 | Dec 08, 2011 | 7:08 AM EST
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Just about a month ago I took an informal poll on Real Money, when the S&P 500 was still showing a triangle pattern, asking folks whether they believed that formation would end in a break to the upside or to the downside. The vast majority of respondents were looking for a breakout to the upside. As we now know, the market underwent its usual routine of doing the unexpected, and broke down instead.

With Friday's European Union summit looming, I conducted another poll Wednesday, inquiring whether folks believed the EU would bring the bazooka or, instead, disappoint the markets. The results of this poll were pretty clear, with 65% of respondents looking for the EU to disappoint.

This is not a scientific poll, but it makes a lot of sense, doesn't it? After all, the EU hasn't brought the bazooka yet. They have in fact continually disappointed the markets. Why should this time be different?

Yet it seems every talking head on television says we should rally into year end. It's that old "chase for performance" mantra, or expectations for a "Santa Claus rally." I realize this is anecdotal, but this sort of sentiment does not sound nearly as one-sided as it did in November.

Since the market is reading as overbought, let's take a look at the last time the indices reached a maximum-overbought reading, on Oct. 18. Following this, the S&P did not make its high until Oct. 28. As you'll notice, the oscillator chopped around for several days before it headed south in a hurry. It took the stock market time to catch up, as well (red box on the chart).

Overbought/Oversold Oscillator -- NYSE

The first thing I must point out is that we don't know how high the oscillator will rise in the next two sessions. If it gets up above plus 600, you can see that will become an extreme overbought reading. If the market sees an up day Thursday because, say, the European Central Bank cuts rates, then we can expect the oscillator to scoot all the way up into that zone.

Now, note that once we see that sort of overbought reading, the market tends to back off and rally again. Since the market took off to the upside last week, we haven't really seen a down day thus far. All we have seen is five straight trading days of chopping.

If the market does rally Thursday, I would expect it to follow that by pulling back from the overbought reading, then rallying again, perhaps if the Federal Reserve pulls another rabbit out of its hat next week.

The real problem will come if the market rallies and the number of stocks making new highs continue to falter. So far this figure has lagged. If that continues to be the case, and we couple that with the overbought reading, we'll have a problem in the market. For now, it's toying with resistance and heading toward an overbought reading.


Overbought/Oversold Oscillator -- Nasdaq



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