As
several market technicians have pointed out recently, price oscillators and
sentiment indicators for the U.S. stock market point to an excessively
“overbought” condition, both technically and psychologically. To take
just one instance of how overstretched the market has become, take a look at
the following chart which shows the SPX in relation to its 200-day moving
average. The 200-day MA is widely followed by small investors and big
money managers alike.
While
most participants prefer seeing the SPX trading above the 200-day MA, whenever
the S&P has gotten over-extended from the trend line it has set up a period
of (temporary) under performance. The last such instance of an
overstretched SPX occurred in the weeks leading up to the autumn decline.
Another
important indicator which highlights the current sentiment profile of
individual investors is the American Association of Individual Investors (AAII)
bull/bear survey. The AAII bull/bear ratio last week reached its most
pronounced level of investor optimism in years with 60 percent of respondents
bullish versus only 19 percent bearish on the stock market’s interim
prospects. With so many bulls and so few bears the question that begs to
be asked is: “What will happen when the buyers finally stop buying and there is
no new buying power to boost the major averages?”
It’s
easy to see that investors are almost uniformly bullish with hardly any bears
to be found, and that’s a condition that normally doesn’t long persist without
a market pullback. Whether the next market “correction” takes the form of
a short, sharp decline or a lateral consolidation (i.e. trading range) is open
for debate, though. Internal momentum is still running strong, though,
which should prevent a sell-off of the magnitude we saw in late September/early
October. Instead, the market’s next correction phase could be
surprisingly shallow or perhaps even take the form of an internal correction
where a few high-profile stocks get shot down while the major averages remain
buoyant.
The
one group of investors (other than the perma-bears) that haven’t bought into
this rally is value investors. They’re licking their chops as they wait
for what they think will be a major market decline so they can jump in and
scoop up shares at a relative bargain. They may well be disappointed,
however, especially if the next market correction is as shallow as I think it
will be.
By
the same token, the bears will be even more disappointed if the big decline
they’re expecting either doesn’t materialize or is much less severe than
they’re expecting. This in turn would provide the backdrop for another
major short-covering rally. Although the market has been very overbought lately
the market’s overbought condition followed close on the heels of a record
“oversold” condition. Normally when the market goes quickly from oversold
to overbought it tends to be net bullish for the intermediate-term outlook.
Short-term
internal momentum on the NYSE continues to strengthen, which explains why the
major indices aren’t pulling back despite stocks being overbought. Below
is the chart showing the NYSE short-term momentum bias indicator, an important
gauge of the market’s near-term path of least resistance. With this
indicator rising as consistently as it has in recent weeks it has acted as a
prod to the bulls and a thorn in the side of the bears.
The
sub-dominant and dominant intermediate-term internal momentum indicators
haven’t been as lively, however. The blue line in the following graph
represents the former while the red line represents the latter.
As
you can see in the above chart, these two components of the NYSE internal
momentum index could use some improvement. The stock market clearly
hasn’t been firing on all cylinders, which explains why the rally hasn’t been
quite as vigorous as it was a few weeks ago.
If
nothing else, the next market correction phase should work out some of the
internal kinks within the NYSE broad market and allow the internal momentum
indicators to get back in synch as the bull market continues.
