S&P 500 — Overbought Conditions Set the Stage for a Short-Term Correction
S&P 500 — Overbought Conditions Set the Stage for a Short-Term Correction For example, three weeks ago, the growth sectors of the market were highly oversold, while the previous lagging defensive sectors were overbought. S&P 500 — Overbought Conditions Set the Stage for a Short-Term Correction
That was not surprising, as the growth sectors of the market were the most exposed to the “Yen Carry Trade. “
We saw much the same in the Risk Range Analysis (Note: both sets of analysis presented are published weekly in the Bull Bear Report).S&P 500 — Overbought Conditions Set the Stage for a Short-Term Correction
As explained in the weekly report:
Two critical points. First, three weeks ago, many sectors and markets were well below their historical risk ranges. The second is that all but three sectors or markets are on long-term bullish “buy signals.”
When most markets are on bullish signals, as they are currently, markets have never suffered severe bear markets. As such, corrective market actions, as witnessed three weeks ago, tend to be buying opportunities.
When the number of “bearish signals” increases, the risk of a more significant drawdown increases.
Flash forward three weeks to Friday’s close, and a very different picture emerges.
Every major market and sector has fully reversed to more extreme overbought conditions, which historically have been a precursor to short-term corrections to reverse such conditions.
However, as noted above, only ONE sector remains on a “bearish” signal. While many sectors and markets, particularly Gold Miners (NYSE:GDX), Real Estate (NYSE:XLRE), and Utilities (NYSE:XLU), are pushing double-digit deviations from their respective long-term means, a correction to reverse those extremes will not likely devolve into a deeper bear market.
In other words, investors should consider taking profits in areas that are highly deviated from their long-term means, as these areas will suffer more significant corrective reversals than those that are not.
But how significant could a correction be?
While the recent rally from the lows has been impressive, it has also been bullish by triggering several signals that historically precede further market gains. As noted this past weekend:
The last sentence is the most important.
While weekly bullish buy signals and improving market breadth certainly portend further market gains, this does not preclude a short-term correction from occurring.
On a very short-term basis, some nearby retracement levels would relieve some of the short-term overbought conditions without triggering larger market concerns. Those levels are as follows:
Between today and the election, these primary levels have the highest probability of containing any near-term market correction that would reverse most overbought conditions.
Such would provide a much better entry opportunity to increase exposure for a potential year-end rally.
What about the potential for a more extensive correction? Yes, such a risk is possible, and we should not ignore it. If we look at a monthly chart, two warnings are immediately noticeable. First, the market’s deviation from the 20, 50, and 100-month moving averages (MMA) is substantial.
Historically, the markets correct such large deviations. However, such a correction, while possible, would require a more severe credit-related event, a deep recession, or a financial crisis of some magnitude.
While such events are possible, these events are ALWAYS exogenous and unanticipated. The technicals tell us that the market is susceptible to an exogenous shock that would lead to a more profound corrective event.
Secondly, the monthly overbought conditions are also at levels (as shown in the bottom chart) that have preceded more extensive corrections, such as in 2022, 2008, and 2000.
Notably, every time the market has been as overbought as it is currently, it has suffered short — to intermediate-term corrective events.
Looking at the longer-term daily chart, should such a more significant correction occur, we can use a Fibonacci sequence to determine the depth of the retracement.
The market’s overbought condition is apparent, and a correction is likely. The only questions are the trigger and the magnitude. However, investors must keep such corrections in perspective.
Given the current technical backdrop, most probabilities are weighted to corrections within 5–10% of current levels. However, we can’t dismiss the smaller possibility of a larger correction.
So, what will cause this correction? As discussed previously, “sellers live higher, buyers live lower.”
In other words, “Sellers live higher. Buyers live lower. “
We can see where the buyers and sellers “live.” The following chart shows where the highest volume occurred. As shown, there are few buyers at current levels. As the old Wall Street axiom states, “If everyone has bought, who is left to buy.”
That leaves the market vulnerable to a correction. When an event occurs, there are “willing buyers” for every transaction — just at much lower prices.
While the “Yen Carry Trade” quickly resolved itself, that risk has not been removed. The Bank of Japan is still intent on hiking interest rates, while the Federal Reserve is lowering them.
At the same time, the Dollar has been declining, and the Yen Has Been increasing. So far, this has not triggered another “margin call” for hedge funds. However, should the underlying dynamics continue, the risk of another “event” clearly increases.
With markets overbought and sentiment bullish, such is a good time to rebalance portfolios and reduce excess risk.
Trade accordingly!
