Tuesday, June 12, 2007

Market Momentum Indicating Overbought Levels

Four straight record closes for the SP 500 and six consecutive days of gains leaves us at a point in the market that things have started to diverge. As the SP posts new highs, the yield on the ten-year note has approached its yearly high and sits near 5% for the first time since last June. Interest rates are not a problem until they are. Has the market overlooked this fact?
Today, the market has seen some selling activity mainly because of three factors. First, there are no catalysts to push the market higher and second, the ten-year note approaching 5% has some investors acting a little finicky. Ben Bernanke spoke this morning from South Africa and effectively reiterated the FOMC minutes from last week. He sees economic growth picking up to more normal levels in the coming quarters and although inflation has moderated, the risks are still to the upside. And last, but not least, the market momentum indicators are showing some overbought conditions that need to be relieved.

In this chart of the SP e-mini futures contract I want to take a look at two momentum indicators; Stochastic Oscillator & the Relative Strength Indicator (RSI). First, notice that the market has made a considerably steep rally over the past several months to reach new all-time highs on May 30th. The green circles highlight the market’s buying pressure. The red lines point to “relief” points when the market dropped and relieved an overbought level only to continue moving higher and into overbought territory again.
Another highlighted region is the negative divergence of the RSI line and the market. Eventually, the RSI line will begin to level out when buyers and sellers meet the supply and demand for each other. With the current overbought conditions, there is a chance the market would begin to follow the RSI. Remember, this is not the first time we have seen a negative divergence as the market climbed higher. Just look at December 2006 through early February and you will see similar action.

It is not uncommon for a bull market to be in overbought territory for long periods of time; however, eventually the market needs to rest. One of the things to watch here is how the markets close each day. Yesterday, the market closed near its highs for the day (flat), but it is the buying pressure into the close that is keeping the markets near these overbought levels. Personally, I don’t believe the buying pressure at the end of the day will continue for much longer. We would like to keep an eye on any sharp moves downward that end on high selling pressure. This could lead to the 3-5% correction we are looking for over the next week or two and an interesting summer of trading. Enjoy!

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