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Market Summary and Forecast 11/16/4


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#1 TTHQ Staff

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Posted 16 November 2004 - 03:09 PM

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There is overbought and then there is OVERBOUGHT. Ordinary overbought readings occur from ordinary rallies. They often occur at or near the peak of the rally. They occur near the end of a counter trend move or in the last leg or wave of a larger move. For example at the early April peak the McClellan oscillator hit a modest overbought +123 a few days before the rally ended. On June 24 it hit a modest +114 at the end of the May-June rally. Another characteristic of an ordinary overbought reading is that the indicator usually turns back down and moves to neutral very quickly. Price sometimes holds up a bit longer but shortly follows suit.

OVERBOUGHT readings, on the other hand are not ordinary at all. The indicators move well past normal overbought levels and often reach extreme readings. In most cases this signals a strong surge in momentum, which in turn leads to higher prices. A good example is the +186 reading on the McClellan oscillator on September 2. The S&P did not peak for another month on October 6. These can occur from two positions. The first and usually the most powerful is when they occur very early in the initial rally following a prolonged decline and move from oversold to overbought quickly. The 1982 kick off saw exactly that as the McClellan oscillator moved from -88 to +158 in nine trading days. There is usually a positive divergence as well from the indicators at the price low. The McClellan oscillator made its low in May of 1982. We saw the same pattern following the October 1998 low. We call them initiation signals as they most often signal the beginning of a strong medium or even long-term move in price.

There are those rare occasions when these signals fail. However, we have seen some common traits on those occasions when they fail. The first is that at the indicator does not have a positive divergence. This occurred in May of this year, July of 2002 and August 1998. Of course the indicators cannot go up for ever and eventually do correct and work off that initial surge. Here lies the second trait and that comes from the averages. During the initial correction of the overbought condition of the indicators price either goes sideways or higher. In 1982 for example the McClellan oscillator peaked on August 26 with the S&P closing at 118.55. The McClellan oscillator moved lower into September 30 while the S&P moved higher. On September 30 with the oscillator at -88 the S&P closed at 120.42 never moving below its August 26 close. In both August 1998 and August 2002 the S&P turned down in conjunction with the oscillator and moved lower. In May of this year the S&P did hold up for a while but when it broke in June in negated the potential signal.

There are times when a strong momentum surge occurs well after a rally has started, usually after an initial correction. These do not occur often but do occur. In fact, we are in the midst of one now. This is actually a second surge as we did see one in late August as well. There are two important points in regards to the current signal. The first is that the breadth related indicators, the McClellan oscillator and the breadth oscillator have not exceeded their September peak. They are close but as of right now we do have a potential divergence. However, the volume oscillator and the McClellan volume oscillator have both moved above their September peaks with the volume oscillator also moving above its May peak. Over the past several years the volume based indicators have lagged the breadth indicators. There were those few times when they kept pace for a bit and those were positive. To us volume is more important than breadth as it represents demand and money flow. To see the volume related indicators not only confirming the breadth indicators but actually stronger is a big plus.

While absolute levels are important to the strength of a signal as is the markets response to the initial correction of the overbought reading, so to is persistency. By that we mean how long the indicators stay overbought. Persistent overbought readings are a sign of strength. These are considerably more rare but have the same implications. The last such persistent overbought condition was seen in March-May 2003. After its initial surge on March 21 the McClellan oscillator held well above zero and has two subsequent moves well above +100 while also moving above its March high in late April. It was not until late May, two months after the initial spike that it moved below zero. This did not occur following the early September surge. It is far too early in this move from October to say one way or the other. But even if it does occur we would not view it in the same light as March-May 2003 as it is coming off a secondary low in all of the averages save the DJIA.

The sentiment indicators are not at the extremes seen in late December and early this year but that was after a nine to ten month rally. But with an exception or two they are bearish and the few that are not at fully bearish levels are also not too far away. The initial rally from August to early October did see some indicators move to modest bearish levels but nothing extreme. Others, such as the put to call ratios and the Rydex ratios actually remained at bullish levels. In fact on October 5, the Nova/Ursa ratio was only slightly higher than where it stood on May 10. The 10-day moving average of both the CBOE and Equity put to call ratios although off their extreme readings of mid August were still at the low end of bullish. This was completely opposite of their behavior during the May-June rally. This was one of the factors that led us to conclude that the early October top was not of the same degree as the late June top. It was obvious that the initial rally from August was being met with some degree of skepticism. This has changed dramatically from the October 25 low. The Nova/Ursa ratio has moved above 1.00 for the first time since June 30 and both the CBOE and equity put to call ratios moved to the same levels seen at the early April and late June tops. The move in the Rydex Nova/Ursa ratio on October 22 was the same as it was on May 20. It took 27 days from the May 20 low to reach its peak on June 30. It has made that same move from October 22 to Friday in only 15 days. However, there is one major difference, and that is the fact that the S&P has moved well above its March peak on Friday while in June it did not. The May June rally was 6.5% while the October 25 rally has so far added 8.6%. The surge in the Rydex ratio from October is bearish, but when looking at it from the perspective of the relative gains in the S&P and the new high it is not as bearish as it was in June. We also need to point out that the ratio is still a little below its January peak while the S&P is 1.8% above its March high.

We are not discounting the message from the sentiment indicators. They are bearish and a concern. However, strong momentum will overcome negative sentiment almost always. We like the fact that the volume measures are stronger than breadth indicators, which shows broad based participation. In addition, we have added confirmation from some priced based indicators such as the 13-day RSI and the 13-day Rate of Change. These have both hit levels that are also consistent with higher prices. We do not think that the current momentum signal has the same implications as say 1998 or even March 2003, in fact we are of the opinion that this rally is the last phase of the cyclical bull market not a new leg up in a new secular bull. Even so, the strength we have seen of late argues strongly that this rally has some staying power and will not end quickly. Short-term we remain bullish and are raising our stop to 1171 from 1162. Medium-term we are neutral but with a positive bias. Long-term we are bearish.


Larry Katz
email me at: LK1618@mta.org
website link: www.marketsummaryandforecast.com


Larry Katz serves as both editor and research director of Market Summary and Forecast. Mr. Katz is a full member in the Market Technicians Association and is both one of the founders and the president of their Southern California Chapter. He also serves on the management committee chairing the membership committee. Mr. Katz is a regular contributor to Top advisors corner on America On Line. He is a regular guest on the Business Channel in Los Angeles with Richard Saxton. He has been a quest speaker of the Market Analysts of Southern California (MASC), the Omega users group of Thousand Oaks, Ca. and Orange County, the Market Technicians Association Atlanta Chapter as well as the Foundation for the Study of Cycles. He also ran a workshop at the Market Technicians Association 1999 Annual Seminar. He has been a regular commentator on the Reuters Financial network, both in the US as well as in Japan, as well as being published in the Market Watch section of Barrons Magazine on a number of occasions. He is currently ranked in the top five for intermediate term gold timing by Timer Digest.

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