If you click here, you will see that the McCellan Oscillator finished Monday’s session well above 70. Generally speaking, over 50 denotes an overbought broad stock market, while below minus-50 indicates oversold conditions (If you are not familiar with the McClellan, it basically is as simple as that).
The terms “overbought” and “oversold” are highly controversial in the trading community, and rightly so. Too often, traders find themselves in losing trades because they fail to either comprehend or respect the fact that overbought markets can often become much more overbought, and oversold markets can become much more oversold. As we saw earlier this summer, the McClellan stayed dramatically oversold for over two full trading weeks. Thus, you should always remember that price is what matters most, and trading largely off of indicators entails significant risk of trapping yourself on precisely the wrong side of the trade for a much longer period of time than you can imagine. That said, certain indicators, such as The PPT broad market hybrid score, have worked unbelievably well during these summer months.
I would like to lay out a few situations where I think you should distinguish the nature of overbought market condition. Here is my take:
I. WHEN OVERBOUGHT IS BEARISHÂ
- When we are in a bear market, and enjoy a sharp relief rally that quickly flags overbought on a variety of indicators, and then begins to sell-off in a violent way.
- When we are in a bull market, but in the process of a correction, and see a brief rally off of said correction that flags overbought as the rally stalls out.
- When in either a bear or bull market, the underlying participation of stocks making new 20-day highs (as just one example of a metric to watch) is weak and indicates that only a few stocks are seeing sharp moves higher despite the broad market flagging overbought.
II. WHEN OVERBOUGHT IS BULLISHÂ
- Overbought markets tend to be most bullish when they STAY overbought for an extended period of time–The market fights off a correction with such ferocity that traders start to actually doubt whether we will ever see another correction again. Stocks push higher, and then simply drift sideways for a day or two before continuing higher, as traders try to short the market all the way up because it is “overbought” according to a variety of metrics.
- Overbought markets are most bullish in the early stages of a fresh uptrend (off of a bear market low, or a correction low in a bull market) when the majority of traders acknowledge the power of the move but still largely consider it a bear market rally.
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Applied to the current market, we know that a bunch of indicators have flagged the market overbought as a whole. In the coming days, we are looking to see whether the market can stay overbought and fight off any semblance of a rollover. They key is working off the overbought condition by going dead for a day or two and then continuing higher, as opposed to seeing another down 200-400 daily dip in the Dow. It will only be then that we can look at the early-August lows as a durable, bonafide bottom.
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