Interactive Investor

Bull market in danger or oversold?

17th October 2016 12:31

Lance Roberts from ii contributor

Over the last couple of months, I have been discussing the importance of the bullish trend line that began this past February. As I stated just this past Tuesday:

"However, a major decision point is rapidly approaching which will decide the fate of the market for the rest of the year.

"In the daily price chart below [top] the tightening consolidation of the market is evident."

"Notice in the bottom part of the chart the market currently remains on a sell signal. That sell signal is problematic for two reasons:

"1) 'Sell signals' combined with overbought conditions tend to lead to at least short-term corrections.

"2) 'Sell signals' formed at very high levels, such as currently, suggests limited upside and larger correction probabilities."

Importantly, the market broke that bullish trend line this past week with the market remaining overbought and on a "sell signal". These combined events put further downside pressure on the markets into next week.

If we zoom in, we can get a slightly clearer picture about the breakdown.

The two dashed red lines show the tightening consolidation pattern more clearly. As I stated on Tuesday:

With the pattern becoming much more compressed, it is quite likely a breakout is going to occur within the next few days. The direction of that breakout will be most important.

Currently, the market has been able to defend crucial support at the level where the markets broke out to new highs earlier this year. However, the market now finds itself "trapped" between that very crucial support and a now declining 50-day moving average (DMA) and the previous bull trend support line.

David Larew (@ThinkTankCharts on Twitter) had a very good chart on this on Friday. This down-trending top, combined with falling moving averages, provide significant overhead resistance keeping downward pressure on stock prices.

It is important, as an investor, is not to "panic" and make emotionally driven decisions in the short-term. All that has happened currently is a "warning" that you should start paying attention to your investments.

As I have written many times in the past, by the time an event occurs where a potential signal is issued, the market is generally either overbought or oversold. Rather than immediately acting on the signal when it occurs, it is often better to wait for some correction of that overbought or oversold condition before taking action.

The chart below shows this a bit more clearly.

As shown, the number of stocks trading below their 50-DMA is pushing levels more normally associated with short-term trading bottoms. This does not mean it is a "BTFD" (buy the f***ing dip) moment.

What it does suggest is that the market is oversold enough on the short-term for a trading bounce back towards previously broken support which now acts as new resistance. Such a reflexive bounce will provide investors the opportunity to proactively rebalance portfolio risk and raise some cash.

As noted in David's chart above, it is very likely we will get a small reprieve in selling pressure temporarily allowing for a bounce next week to rebalance risk into.

However, as shown in the weekly chart below, there is ample evidence we are currently working through a bigger correction process that is not yet complete. This should keep portfolio allocations tilted to a more conservative posture.

This is particularly the case given the two confirming "sell signals" in the lower part of the chart. While it is currently very early, previously when both signals have been triggered further corrective action followed. Given the high levels at which both signals are currently triggered, it pushes the risk of a deeper correction higher than many would likely suspect.

For now, particularly as we enter into earnings season, caution is advised.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of "The Lance Roberts Show" and Chief Editor of the "Real Investment Advice" website and author of The "Real Investment Daily" blog and the "Real Investment Report". Follow Lance on Facebook, Twitter and Linked-In.

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