We finally got a proper pullback off the overbought condition. I consider that good news because it means the market is doing what it is supposed to do.
We have spent a great deal of time over the last week discussing the overbought condition on various metrics and indicators, all short-term in nature. Today I want to take a closer look at a more intermediate-term Oscillator. It's the same concept as the Overbought/Oversold Oscillator only it uses the 30-day moving average of the net of the advance/decline line instead of the 10-day moving average (which is what the Oscillator uses).
The concept is that when we look back at the string of numbers we are dropping and we see a lot of red to be dropped, we expect to replace those red numbers with green (or black) making the market oversold. A string of green (or black) numbers to be dropped makes us overbought.
As you can see it doesn't work perfectly (nothing does, unfortunately) but notice the summer months on the chart where the 30-day a/d kept making lower highs while the S&P (lower panel) made higher highs? That is the intermediate term momentum waning in the market. It is what I called a negative divergence in September. You can even see that the 30-day a/d fell off a cliff and plunged almost a week prior to the S&P starting its tumble (blue arrow) in early October.
The 30-day a/d got oversold in late October (green arrows) and kept moving upward until it reached an overbought reading again in early December. (red arrows). It then got oversold right around December 24th, the same time the S&P did (green arrows). You can also see the minor overbought reading last week.
Allow me to take you behind the numbers though. Late this week this indicator will begin dropping that entire December collapse. This means the indicator ought to get back to an oversold condition relatively quickly.
You can see starting Friday of this week the indicator starts to drop a long string of red numbers, making it 'back to oversold' again. This is one reason I believe that the current overbought pullback will lead to another rally, because this particular indicator is going to get oversold in about a week.
My biggest problem is that the shorter term Overbought/Oversold Oscillator shows no such signs of reaching an oversold condition anytime soon. I am not yet sure how it resolves itself on that score but my sense is that we'll get this overbought pullback and rally again because of this more intermediate term indicator.
Perhaps if we do that, then sentiment will turn significantly more bullish sometime in February, just as this intermediate term indicator gets overbought again. But in the meantime, let's see if we can work that shorter-term overbought reading off this week with a proper pullback.