There are many ways to determine whether a market is overbought or oversold, writes Helene Meisler. Some traders use oscillators while others create their own models. There are those who use time, those who use price, and some who use both.
I create my own overbought-oversold oscillator. It’s based on market breadth, by which I mean the Advance Decline line. I use a 10 day moving average of net width. The theory is that a long series of negative latitude readings indicates a market is oversold and vice versa when readings are overbought.
The following chart of the Nasdaq Composite overbought-oversold oscillator shows how oversold the market is. The index is back to where it was at the end of January this year. While the rally may not seem large, it was a respectable 10% gain.
Even the 30-day moving average of net breadth for the Nasdaq suggests that the market is oversold – in the same range it was in when it was oversold in May. While once again this may not seem big on the chart, this rally had also seen a 10% surge. Also, when the Nasdaq made a lower low in June, this oscillator made a higher low. That is, a positive deviation.
A positive divergence in the market, such as that which occurred in June, can be a helpful indicator in itself. June saw fewer stocks making new lows as the Nasdaq made a lower low.
On Friday 23rd September we saw more new lows than June but fewer than May. Thereafter, Monday, September 26’s decline showed nearly 250 fewer new lows (as indicated by the green circle in the chart below) than Friday.
Why sentiment is an important indicator
Mood is also a very useful indicator. Recent polls show that sentiment is extremely tilted towards the bearish side. My favorite sentiment indicator is the rarely used Investors’ Intelligence survey [US Advisors’ sentiment report].
I like it because it’s been around since the 1960’s and its methodology is scientific in its approach. It aggregates about 100 newsletters and enumerates their authors’ views on the market. Importantly, there are newsletter writers who sell subscriptions where readers pay for their insights.
It’s not about pointing at bulls or bears or clicking up or down. Note that the direction of the bulls is up when the price is rising and down when the price is falling. In mid-August, when the indices were at their peak, this poll showed that 45% of respondents were bulls. At the spring lows, the poll showed bullish sentiment had dropped to 26%. The current measured value is just under 30% again. I’ve never seen a reading below the 22% mark occur in the depths of the 2008 market.
Finally, I like to use the Daily Sentiment Index (DSI). This is another subscription-based service that is not widely used. On a scale of 0-100, readings under 10 or over 90 are extreme. It takes a lot of price action to get to this point. At the time of writing, the DSI for both the S&P and Nasdaq Composite is five.
I think we can all agree that we are in a bear market right now. As shown above, there are trading opportunities on the long side even in bear markets. I expect an oversold rally in early October if not sooner.
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