MarketOwl is a FREE online investment service. We invite you to encourage friends and acquaintances to subscribe by going to www.marketowl.com.

One of the more common topics of interest among market technicians is whether the market (as represented by the major indexes) is overbought or oversold. In fact, there are some analysts who believe the overbought or oversold condition of the market is the major determining factor on market movement. In the midst of a strong market rally that has existed for a year, right now many investors are wondering whether stocks have reached an overbought extreme.

When the market is overbought, that means that the market has been pushed to an extreme level because of a large number of buyers. Oversold is the opposite condition: too many sellers have driven the market to an extreme in the opposite direction. One investment guru I used to work with likened these conditions to a stretched rubber band. He maintained that when the markets reached these extreme conditions, the only alternative was to bounce back in the other direction.

Unfortunately, my experience has shown that financial markets are not as predictable as the behavior of rubber bands.

The analysts who try to identify overbought and oversold market conditions generally use some type of cycle indicator. The theory is that markets move in identifiable and predictable cycles like the ocean tides or heartbeats.  The use of a cycle indicator supposedly allows one to identify where the market is in any given cycle and therefore forecast what its next move is likely to be.

After many years of observing cycle analysis, I can unhesitatingly say that there are periods where it works remarkably well and other times when it is completely wrong.

One of the more commonly used cycle indicators is called a stochastic oscillator. I could devote many pages to explaining how this oscillator works, but that isn’t necessary. All you need to know is that is consists of two moving averages of different durations. When the moving averages cross over each other, that triggers buy or sell signals. The oscillator also includes a scale from 0 to 100. When the oscillator reaches 80 or above, that is an indication that the market is at an overbought extreme and is likely to correct. When it falls below 20, that is an indication that the market is at an oversold extreme and is likely to advance.

Let me illustrate. The chart below shows the daily price activity of Nasdaq over the past six months. The middle portion of the chart with the wavy brown and blue lines is a slow stochastic. I added the red arrows to better show some of the switch points triggered by the stochastic oscillator. One of the first things that becomes obvious is the frequency of the switches. So far in 2007 this stochastic would have produced more than 20 trades. In truth, the oscillator actually did a pretty good job of identifying short-term bottoms and tops. But in most cases it would be impractical for an investor to trade off of this signal because transactions costs would become too cumbersome.

You can also see that the cycles tend to be erratic rather than regular. For example, in April the oscillator climbed above the 80 mark that signifies an overbought market. But instead of correcting and heading downward, the Nasdaq continued to advance and the oscillator generally stayed at an overbought extreme. In the past couple of days the oscillator turned negative again, and the Nasdaq has moved down. But this indicator does not do a good job of forecasting the amplitude or duration of market moves.

Still, it can be a valuable tool for an active money manager, particularly when used in combination with other indicators. The bottom portion of this chart is a moving average convergence divergence (MACD). This is also a tool based on multiple moving averages, but it produces fewer signals than the stochastic oscillator. Right now, it is also turning down, indicating that the market might struggle over the next few sessions.

To get a better idea of what is likely to happen over the short term, let’s take a longer view. The chart below is the same as the one above, except it covers a two-year period. The red arrow is a trendline that I added. My best guess is that the Nasdaq will correct back to that trendline over the next couple of months. That should produce a mostly sideways pattern similar to the period I marked with the blue line. Notice that on the longer-term view this stochastic is too short to be practical as the switch points become almost indistinguishable. The MACD, however, appears to give fairly good trading signals for an intermediate period.

For now the long-term advance by the major indices remains intact. Economic fundamentals remain strong, so it would be difficult for a new bear market to gain a foothold. Although the market appears to be overbought on a short-term basis, any correction here is likely to be sideways and short-lived.

The sharp selling we saw today could well continue Friday ahead of the Memorial Day holiday. But that is likely to reverse next week.

Have a great holiday.

F.S.