We Got The Oversold Rally, But Now What?

By normxxx | 26 December 2007

For the most part, the broad equity indices haven't done anything wrong since the November low— in fact, the price pattern has played out in classic fashion.

By mid-December, stocks had sold off hard. So hard, in fact, that a slew of price-based oversold signals were triggered. I spent a couple of days going over some of them, and all of those "oversold in December" stats argued for higher prices ahead... if we were willing to hold through the first couple of sessions of the new year at the latest.

We didn't have to wait long, though, as stocks quickly turned around and have gone up strongly since then. That's good confirmation of what I saw in the indicators at the time, but it has also begun to trigger a lot of short-term signs of excessive optimism. Typically, when we get those types of readings, even during seasonally positive periods, stocks have trouble holding on to much additional upside.

As for the more intermediate-term indicators, they are mostly neutral. I saw an overwhelming number of historically extreme "excessive pessimism" readings in November, which consistently precede gains of 5% - 10% over a one- to three-month period when they've occurred in the past. We've already satisfied those goals, and sentiment has understandably become more bullish because of it.

Looking at the sentiment conditions as they stand now, it's hard to make a strong case either way. The 'Smart Money Confidence' index is still relatively high, poking around 60%, but the 'Dumb Money' is also relatively high and it won't take much more to push it also over 60%. I'm going to go to 25% Long here, simply based on the idea that the models, indicators and studies I follow no longer provide as strong a bullish edge as earlier in this 'positive season.' But, this still is much more positive than the neutral position I had planned to end the year on.

Coming into this week, we had a number of short-term measures that were pointing to the idea that it was unlikely we'd see more sustained upside until the indices took a breather. ST overbought conditions, on the heels of an options expiration, have tended to precede weakness much more often than not.

The one big wildcard was (and is) seasonality, which is unmistakably positive as we all know at this time of year. Nevertheless, looking at past occurrences of the current kinds of setups heading into the end of the year, I see as much weakness as strength.

That kind of battle is not one I want to fight. It seems I can make a valid argument for being long, and an equally valid one for being short, and that's not the type of situation in which I want to risk capital, so I'm staying mostly neutral (as per plan) for trading positions here.

My thought heading into the week was that we'd have one more opportunity to trade the "oversold in December" phenomenon. The longer we go without pausing, though, the less likely it's going to present itself, simply because the clock is ticking ever closer to year-end.

The Nasdaq 100, in particular, has a very nasty habit of correcting at least 5% within a 10-day window during January, so if I'm to be tempted further to the long side, then we need to see the setup fairly quickly. The past couple of years, the index shot higher to begin the new year, but that was after weak endings to the previous December.

The bottom line is that I'm doing very little here trading-wise. I'd like to see another opportunity for a low-risk long trade heading into the first couple sessions of the new year, but if we just hang around in overbought territory, then my focus will likely shift to the short side after the end of the year.
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Normxxx    
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