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Market's Overbought Condition Has Everyone’S Attention.

 January 28, 2013 09:41 AM


After being up 11 of the last 12 days, everyone seems to be aware of the short-term overbought condition above 50-day moving averages. As I've been noting, it's not just the U.S. market, but global markets in general, all tracking together in a typical favorable season rally.

But does everyone being aware of it perhaps mean nothing much will come from it, since the market likes to do whatever it takes to fool the majority?

[Related -Analyzing Performance Histories That Might Have Been]

Yet, the overbought condition seems to have affected enough global markets to have a potential pullback already underway elsewhere.

Lastly, is the tentative upturn the last few days in the Middle East & Africa Index, which was the first to top out from the overbought condition, an indication that the worst to be expected is a quick pullback to the 50-day m.a. to alleviate the overbought condition before the upside resumes?

[Related -Big Prints in VIX Calls]

We'll just continue to follow our technical indicators.

Then there is investor sentiment.

For many years I have preached that investor sentiment cannot be used as a market-timing tool, but only as an indication that it's time to watch actual technical indicators more closely, particularly those that measure conditions like reversals in internal strength.

But I still get messages pointing out that the market can't reverse to the upside because the AAII investor sentiment or the Put/Call ratio, or Investors Intelligence sentiment index, or whatever, is not bearish enough, or can't top out because sentiment isn't bullish enough, or must top out because sentiment is at the level of bullishness where the market topped out in April, or in 2010.

Truth is that even when sentiment reaches levels that have us watching technical indicators more closely for potential signal reversals, sentiment can remain at those levels for a long time, or even move higher.

This week's AAII poll showed the bullish percentage has jumped to 52.3%, and bearishness has dropped to only 24.3%. That's getting close to what our work has shown to be a danger zone when bullishness rises to 55% or above and bearishness drops below 20%, where we need to be watching technical indicators more closely.

But in fact the market has topped out into corrections when AAII bullishness only reached 49%, and at other times it has risen into the 60's. And it has even risen into the 60's and the market has continued to rise. For example, it reached 63.3% bullish and only 16.4% bearish on Dec. 12, 2010.    

And as the chart shows, the favorable season rally continued and did not pull back from an overbought condition until the following February, and the rally then resumed, topping out at a higher high on May 1.

And then there is the VIX Index (aka the Fear Index).

It has been a cause for concern lately, attracted considerable attention in the media.

Since the market top in 2007, the market has been in danger of a rally ending when the VIX showed fear had dropped to low levels (high level of bullishness) compared to its level in 2007. We have often shown you the chart.

So the VIX as a measurement of investor sentiment has been seen as a warning sign since mid-year when it dropped into the low fear (high bullishness) zone, and particularly since it recently dropped down to lows even lower than at the 2007 bull market top.

But perhaps something important is changing from the period the market and sentiment has been in since the the housing bubble burst, the 2008 financial meltdown, and during the hesitant economic recovery.

Because if we back out further, we can see that the current five-year low on the VIX, which some pundits are referring to as a record low, is not at all a record.

It is only at lows that marked each of the rally tops in the type of bull market, surrounded by ‘big picture' fears, that we've been experiencing since 2007.

As the chart shows, in the bull market of the 1990's, and more recently in the bull market of 2003-2007, VIX reached much lower levels of fear. 

So once again I point out that investor sentiment cannot be used to time the market, but only as an indication that it may be time to look more closely at actual technical indicators.

And this time it's also possible that the VIX is signaling a potential fundamental change in the type of bull market being experienced.

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