The market is nearing an overbought reading
The Street.com
March 15
The market is finally nearing an overbought reading. This
means it's going to be more difficult for the market to maintain
its upside momentum in the near term. In addition to the
soon-to-be overbought reading, it's become difficult for
individual stocks which are at new highs to maintain their
upward climb -- thus the drop-off in stocks making new highs.
These indicators say the market is tired and needs a rest.
New Highs and New Lows
These indicators are pure and simple: They tell how many
stocks are making 52-week highs or lows on any given day.
They can be used to show divergences in the market as well.
For instance, if the Dow makes a new low and the number of
stocks making new lows shrinks, then there must be a reason
there was no participation on the downside. In that case, the
market has a positive divergence.
In a bull market, the number of new highs could be expected
to expand as the market rallies. If it does not expand, then
you need to consider the possibility that this represents a
failing rally and be decidedly more cautious on the market.
The Overbought/Oversold Oscillator
There are many ways to calculate an oscillator. The one I use
is a simple 10-day moving average of the net differential of
advancing issues minus declining issues on the New York
Stock Exchange.
Overbought and oversold have to do with momentum and not
necessarily price. This is an important point: Just because a
market has slid in a big way does not necessarily mean it is
oversold -- and vice versa. Since this is a momentum-related
measure, one should be more concerned with the magnitude
rather than the actual level of the move.
For example, a truly weak market can get oversold and stay
oversold by simply gaining downside momentum.
Since it's a simple 10-day moving average, we concentrate on
the string of numbers we are "dropping." Take the following
case using this simple 10-day moving average: Let's say the
market is currently in oversold territory, and 10 days ago, the
market was down and the a/d was poised at a reading of
minus 500.
That would mean that today, 10 days later, we would be
"dropping" this reading of minus 500. If the market is down
today and the a/d gives us a reading of minus 300, then, in
effect, we will be adding the difference between that reading 10
days ago and today, or plus 200.
That shows a lessening of downside momentum. You see, it's
down -- but not as bad as it was 10 days ago. We can now
say the market has reached a short-term trough in its oversold
reading.
However, if instead, today the a/d had a reading of minus 700,
then there would be a loss of another 200 on the oscillator.
That would mean there is still a lot of downside momentum,
and therefore, while the market might be oversold, it has not
yet peaked. Lacking this crucial signal, we would have to
conclude that the market is not yet poised for a decent
bounce.
The Oscillator and Divergences
Since we are concerned with the magnitude of the oscillator,
we use it to judge the strength of the move. A reading of less
overbought (i.e., a lower peak) accompanied by a higher high
in the Dow Jones Industrial Average would be considered a
negative divergence, as the momentum on this move was less
than the previous move.
Therefore, when we get a peak reading in the oscillator in
conjunction with a high in the DJIA or S&P 500, we conclude
the market is overbought. After the market backs off some and
begins to rally again, we will measure the magnitude of that
rally by watching to see if the oscillator can better its previous
reading or not.
If it betters its previous overbought reading, the momentum is
intact. If it turns down shy of the previous peak, we conclude
momentum is waning and label that a negative divergence. It
says be cautious in here.
The best way to use this indicator, though, is for positive and
negative divergences. If the market is rallying and the Dow
peaks around the same time it becomes overbought, then we
must conclude that it is simply overbought and must look for
some weakness to begin buying again.
However, after the oscillator swings back down to oversold
territory and rallies once again toward overbought, we can
once again look for the peak of this rally. If the Dow
subsequently makes a new high and the oscillator does not,
that is a negative divergence. It tells us the momentum on this
rally is not as strong as the previous rally. It says be cautious
in here.
If, on the other hand, the Dow fails to make a new high but the
oscillator surpasses its previous overbought level, we know
that there's still underlying strength and that stocks should be
bought; there is still momentum left in the market.
The same holds true for declining markets, where the
tendency is for a market to become oversold.
Cumulative Advance/Decline Line
Also known as market breadth. This is the cumulative total of
advancing issues minus declining issues on the New York
Stock Exchange each day. It is a good guide to what
individual stocks are doing. If this indicator is making new
highs each day, then we say the rally is widespread and
consider that a positive. If this indicator is lagging, then we
say that the rally is narrow and would consider that a negative
for the market.
This indicator is not to be used as a timing tool, as it can peak
many, many months prior to the rest of the market.
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