At least based on the way I measure oversold and overbought conditions, I don’t think the market is as oversold as I keep hearing and reading. You see, when a bottom was set in mid-June, the daily, 3-day, and weekly timeframes were aligned almost perfectly. This doesn’t happen all that often. In other words, all three timeframes bottomed simultaneously and subsequently began to recover from the oversold condition in concert with each other. When the daily timeframe is oversold and begins to emerge from the current condition, a momentous rise should be expected whenever reinforcement is received from higher-degree timeframes such as the 3-day or the weekly. This explains the exhilarating rally that went on unchallenged for three full weeks. Besides, stocks were already severely oversold back then, and companies were expected to report stellar earnings, which they did. Now that earnings season is largely behind us, the focus is not on the backward-looking earnings, but rather on the employment situation and a weakening economy on the verge of falling back into recession.
Even though the stochastic indicator on the daily timeframe is currently attempting to turn up from oversold territory, its counterparts on the 3-day and weekly timeframes are right in the middle of the range (i.e. neither oversold nor overbought) and pointing downward. Therefore, any attempt at a bounce on the daily chart will likely be subdued by the higher-degree forces. One thing that I’ve come to notice on the 60-min chart of the ES is a Fibonacci 4.25 relationship between two waves. This is depicted on chart 1. If I’m correct, the next leg down should carry the index back below the November 2010 in the coming hours. This makes me leery of this overnight rally, leading me to characterize it as a fourth wave that’s probably setting the stage for the fifth.
Chart 1. The ES_F is tracing out a fifth-wave rally. The fifth wave appears to be underway.
Chart 2 depicts the recent price action relative to the head and shoulders pattern. The bulls lost their grip on the market as soon as price breached the green support line that managed to contain the 2009-2011 rally, not to mention the neckline breach that occurred two sessions ago. That’s a big deal. Yesterday morning’s scare, in my opinion, was not capitulation selling. You’ll recognize capitulation selling when it comes. Buyers stepped in and bought the market near the support cluster consisting of monthly S2, the November 2010 high, and the 38.2% retracement relative to the July 2010/May 2011 rally. At least in my opinion, the resulting recovery was nothing more than a technical bounce.
Chart 2. An ominous Head-and-Shoulders top on the chart of SPX.
Chart 3 depicts the price action in the NDX. It too was bought near a support cluster. However, price still has more to go in terms of retracing a healthy portion of the July 2010/May 2 rally.
Chart 3. A broadening top on the chart of NDX.
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