Market volatility has been high over the past couple of months, but in spite of that there has been a decent recovery. Now the key is trying to figure out whether this recovery has enough strength to become a new uptrend or if it will soon fizzle as the bears maintain control.

Market technicians like to measure extremes in the belief that if they can determine when the pendulum has reached its widest arc, a change in direction is inevitable. Market professionals refer to these extreme conditions as “overbought” or “oversold.” In other words, when a buying cycle peaks because of pent up demand (or irrational exuberance) then the market is considered to be overbought and a downward correction is likely. Conversely, when an abundance of selling pressure has driven the market to the bottom of a cycle, analysts describe that situation as oversold and start looking for a rebound.

The chart below shows the Nasdaq over the past three years. It is easy to see the significant downturn that began in October and the recent rally. Since bottoming at the beginning of March, the Nasdaq has gained about 9%. In other words, it has recovered about a fourth of the loss it incurred from the peak to the bottom.

The red line highlights the nice upward trend that began in August 2006. Notice that the recent downturn easily took out that trend and erased most of the gains made in the ensuring 15 months. You can also clearly see the corrections that occurred in the midst of the uptrend. They tended to last just two or three months. These fairly regular market patterns are intermediate cycles.

The gold line is a simple 50-day moving average of the Nasdaq. You can see that the index finally broke solidly above the average again earlier this month.

The bottom portion of the chart is a moving average convergence divergence (MACD). This tool is specifically created to identify the overbought and oversold market periods. In February it was showing that the Nasdaq was very oversold and due for a rebound, which began a couple of week later. Based on the MACD, this latest upward move has another week or two to go before the Nasdaq is again overbought.

In this instance, the most recent corrective cycle has been much longer and steeper than any others we see on the chart. If a new bear market is in place, then we will likely see another downleg begin in the next two to four weeks.

Of course, as I’ve explained many times in the past, I certainly don’t claim to have any special abilities to predict market movement and I am regularly surprised by how the market behaves. But the combination of current negative economic and fundamental factors make it seem that the start of a new bull market is unlikely right now.
F.S.

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