Stocks Conundrum: When is ‘oversold’ not ‘oversold’?

Two Wall Street terms that are bandied about with impunity are “overbought” and “oversold.” How many times have we heard a market commentator say something like, “Well, the market has rallied over the past month and it looks ‘overbought.’” Or, “the market has declined toward key support and it looks ‘oversold.’”

While admittedly we also use the terms, hopefully with more precision, what makes the comments even more exasperating is the fact that the basis for the conclusions can be varied. Aside from the specifics of which cycle the analyst might be talking about, the indicators used to arrive at such conclusions can also vary. From simple momentum through oscillators to pure “gut” feelings about the current status of the market, “overbought” and “oversold” suggestions proliferate, albeit with their vagaries.

But the biggest problem with such declaratives is that given the historic perversity of the stock market when it comes to predictions, what is “oversold” at one juncture in a market cycle may be simply an indication of lingering market negativity in another. In other words, in a down market the term “oversold” could prove to be meaningless when used as a timing mechanism.

Since “oversold” is usually a suggestion that the market could be entering into a zone of opportunity, it’s necessary to determine what point in a cycle that measurement is being made. In other words, if the market is in a sustainable longer-term rally, all short- to intermediate-term zones of opportunity, or “oversold” conditions can be used to buy. In a bear trend that is not the case. An “oversold” condition must be used in conjunction with other market tools to suggest first the opportunity and then the reversal. For example, using one timing mechanism, if the market gets “oversold” on the minor cycle we would need to see prices rally up through the upper edge of a defined 10-day price channel to suggest a reversal of the downtrend to positive. .

Inevitably a larger cycle uptrend will reverse to negative and what was previously a point to buy in a larger cycle advance will prove to be nothing but an interim low prior to a reflex rally and then more selling. At that juncture “overbought” becomes actionable to the extent sales should be made while “oversold” remains questionable. Without an understanding of cyclical context the terms “overbought” and “oversold” are meaningless. Without reference points all the uninformed commentator is suggesting is that the market is either up or down.

With that preface we are up to date. The market is currently “oversold” on the minor and intermediate cycles, but it has been that way for the past month, so underscoring our point. With many suggesting that the market is “oversold” we are once again left with the conundrum: is the market in a zone of opportunity or are the measurements simply underscoring what we already know, that the market is weak? We suspect the latter of the two possibilities for a number of reasons.

First, “oversold” conditions have persisted. That observation suggests that something new is going on as compared to the advance in equities that lasted from the March 2009 prices lows to the April highs. The fact that “oversold” has not led to a sustainable rally suggests that the game plan has changed.

Second, many market players remained in denial mode following the May 6 mini crash. While there have been “investigations” aimed at determining the cause of the debacle, we suggested subsequently that aside from any “big fingered” traders or other justifications, the real cause of the little crash was that market internals were weak.

Third, primary indicators like our Most Actives Advance/Decline Line (MAAD) have continued to underscore a lack of participation by Smart Money. We have belabored that point repeatedly over the past several months. It is even more relevant now that MAAD on the minor cycle has fractured its uptrend that stretches back to the March 2009 lows while MAAD on the larger Intermediate trend is poised to follow suit even though both cycles are now deeply “oversold” (there’s that word again).

Fourth, price patterns in the major indexes, S&P 500 and Dow Jones Industrials, have traced out what could be Head and Shoulders distribution tops with downside targets toward 900 in the S&P and 8250 in the Dow 30. If it turns out the H&S scenario is invalid prices could reach for downside targets via “a-b-c” corrections that would put the S&P toward 975 and the Dow 30 near 9100. In either case what is relevant is that neither index has reached either downside goal even though both have remained “oversold.”

In sum, except for the possibility of small reflex bounces within the context of this decline that was initiated after the later April price highs, we suspect that “oversold” will continue to be a useless measurement to the extent it will suggest a buying opportunity unless defined upside buying targets are reached. More apropos of the current market, it’s likely that short-term “overbought” might be the more reliable measurement since that yardstick would be reflecting yet another point to exit equities or to sell short within the context of the intermediate negative.

McCurtain Most Actives Advance/Decline Line (MAAD)

MAAD remained weak last week with cumulative advance/decline data on both the daily and weekly cycles moving down to the lowest levels since the April highs. In fact, daily MAAD data marginally fractured an uptrend line stretching back to the March 2009 lows. The more statistically significant and larger weekly cycle has moved down to its uptrend line but has not yet fractured that line.

If currently “oversold” levels on both cycles lead to buying, we could see both MAAD cycles demonstrate some recovery. But whether or not such action would be good enough to reverse the downtrend until downside targets are reached is doubtful.

On the positive side of the equation, we continue to note that MAAD has yet to decline below its February support lows even though market pricing has terminated supports with new short term selling. That positive MAAD divergence could be an indication market “internals” remain weak, but maybe not quite as weak as eternal prices would have us believe.

Click charts to enlarge

McCurtain Call/Put Dollar Value Flow Line (CPFL)

Unlike MAAD, CPFL actually rose last week during three of the five trading sessions as reflected by net Call Dollar Volume as compared to net Put Dollar Volume and despite overall net weakness in the broad market. Strength in the indicator is a suggestion options players have begun “nibbling” at the market. While such action is not necessarily a sign that index pricing will begin to reverse to the upside, it is nonetheless a positive sign as measured by CPFL.

Also of note is the fact that like MAAD CPFL has not demonstrated the same amount of weakness over the past several weeks as have market prices. CPFL remains modestly above its February support lows to suggest that options traders have not been as bearish on the broad market as have other players.

Click charts to enlarge

Conclusion

Our two key indicators, MAAD and CPFL, were a mixed bag last week to the extent that one indicator (MAAD) weakened further while the other (CPFL) did not. Both indicators, however, remain “oversold” on both the short and intermediate term cycles and both have remained modestly above their February 2010 support lows even though the broad market indexes have not. Those two conditions suggest that at least a decent short-term rally could follow once a minor cycle rally has been put in place, but as we noted in our main commentary above, “oversold” does not necessarily mean that a rally is imminent.

Notice, however, that we use the phrase “short-term rally” rather than “larger cycle rally.” Substantial market and chart damage has occurred over the past several weeks. And despite the proliferation of commentaries suggesting that that the “market is oversold” and therefore primed for a rally, history has suggested repeatedly that downside extremes are ended only when the selling abates. While that statement is no epiphany, an extension of the thought suggests that “oversold” conditions in a downtrend may not always be what they seem. Price is ultimately the determinant.

MAAD data for past 30 Weeks* CPFL data for past 30 Weeks

*Note: All data is for week ending on Friday even though ending date may be a holiday.
Unchanged issues in MAAD calculations are not counted.

MAAD data for past 30 days** CPFL data for past 30 Days

**Note: Unchanged issues are not counted.

Robert McCurtain is a technical analyst, market timer and private investor based in New York City. If you would like to read more about how the CPFL is constructed, read a Futures article on the concept. This will take you to the MAAD article. Robert can be reached at traderbob@nyc.rr.com.