What does “oversold” really mean? – The Wagner Daily
Driven by growing fear in the markets, recent downside momentum kicked into high gear yesterday. The main stock market indexes gapped sharply lower on the open, chopped around in a range throughout most of the day, then closed at their dead lows of the day. The Dow Jones Industrial Average nosedived 3.6%, the S&P 500 3.9%, and the Nasdaq Composite 4.1%. The small-cap Russell 2000 tumbled 5.1%, as the S&P Midcap 400 Index also showed relative weakness with a 4.3% loss. It was the largest average percentage decline in the major indices since late 2008.
Panic selling started kicking in yesterday, causing turnover to soar across the board. Total volume in the NYSE jumped 29%, while volume in the Nasdaq swelled 32% above the previous day’s level. It was the third straight day of higher volume losses in the S&P 500, but volume levels were still lighter than during the declines of May 6 and 7. While the sharp decline of two weeks ago was likely dominated by institutional selling, lower volume on this second leg down indicates the sell-off is probably the result of retail selling amongst individual investors who were late to the party in taking profits. The numerous “distribution days” near the April highs warned us to stay away from the long side of the market, which saved us a lot of capital over the past few weeks, but many investors either didn’t know or chose to ignore the early warning signs we discussed every day in this newsletter.
In our May 7 commentary, one day after the major indices crashed approximately 10% intraday, then recovered about two-thirds of their losses into the close, we said the following, “The popular financial media outlets have been abuzz with speculation regarding the cause of yesterday’s incredible afternoon collapse that briefly caused the Dow to register its second largest intraday decline in history (more than 9%, surpassed only during the 1987 crash). Reports of the culprit have ranged from the erroneous input of a large institutional sell order in the futures markets to computerized trading that led to a lack of liquidity. But although some thick individual stocks (such as PG and ACN) obviously showed evidence of something gone horribly haywire, we believe yesterday’s action was nothing more than a long overdue “shakeout” from the rally off the March 2009 lows, albeit an overly vicious one. Both the NYSE and Nasdaq reported no system malfunctions at any time during yesterday’s session, and computerized “program trading” is nothing new and has been going on for years.” Simply put, we were of the unpopular belief the intraday plunge was for real; simply the result of a market that’s been trending higher for way too long without a substantial correction.
Now, fast forwarding two weeks later, the S&P and Nasdaq have actually closed just above their intraday lows of May 6. This time, the sell-off took one week to do its damage, not just an hour. As such, the popular financial media cannot blame the current round of losses on a “computer glitch” of some sort. With the wild session of May 6 no longer looking like an aberration that should be ignored, the technical implication of yesterday’s slide is the S&P 500 has finally entered into an intermediate-term downtrend because it has formed a significant “lower high” and now a “lower low” by closing below its prior “swing low” (the May 7 closing price). We say “finally” because it is the first time since the primary uptrend began in March of 2009 that the major indices have confirmed a reversal of intermediate-term trend. Other pullbacks of the past 14 months reversed the short-term trends, but failed to decline enough to convincingly reverse the intermediate-term trends. This time is different.
With the broad-based indexes down 8 to 10% over the past week, it’s definitely fair to say stocks are “oversold” on a near-term basis. But what exactly does “oversold” really mean? We merely use the term to indicate the market is vaguely extended a greater percentage than usual beyond common short-term trend indicators such as the 20-day exponential moving average (EMA). Right now, for example, the Nasdaq is trading 7% lower than its 20-day EMA. On most days in any given year, the index is probably less than 4% away from that short-term indicator of trend. Since the 20-day EMA acts like a leash, the price eventually snaps back closer to the 20-day EMA when it gets too far away from it (just as a leashed dog gets yanked back to its owner if it tries to wander too far away). Nevertheless, one thing “oversold”certainly does not mean is that it’s automatically safe to blindly buy stocks. Rather, it tells us the reward-risk ratio of short positions is no longer very positive, tight trailing stops should be kept on short positions, and market participants should be on the lookout for an impending bounce from a near-term “oversold” condition. When that bounce eventually comes, ultra short-term traders could attempt to profit on the long side, but the better play (with stocks now in a new intermediate-term downtrend) may be to initiate new short positions into the next major bounce into resistance.
So far this month, the portfolio of The Wagner Daily has closed just two trades (IYM short and IWM short). IYM netted the a portfolio gain of approximately 2.5%, while IWM was a scratch. Obviously, it’s nice that the model ETF portfolio is showing a month-to-date gain of more than 2% while the S&P 500 is down nearly 10%. But even if you missed our IYM short trade, the most important factor in the long run is we have preserved capital by successfully avoiding losses on the long side market. Despite their supposed low correlation to the direction of the broad market, both of our current open positions (SLV and UNG) are presently showing an unrealized loss and trading just above their stop prices. Yet, even if they hit their stops, we’re still looking at a breakeven month, at a time when many long-term “buy and pray” investors have given back a large chunk of profits and may understandably be getting worried. If nothing else, this extremely bearish month is a healthy reminder that markets indeed still go both up and down — that’s when being a technical, short-term trader really shines.
| Open ETF positions:
Long – SLV, UNG |
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Deron Wagner is the Founder and Head Portfolio Manager of Morpheus Trading Group, a capital management and trader education firm launched in 2001. Wagner is the author of the best-selling book, Trading ETFs: Gaining An Edge With Technical Analysis (Bloomberg Press, August 2008), and also appears in the popular DVD video, Sector Trading Strategies (Marketplace Books, June 2002). He is also co-author of both The Long-Term Day Trader (Career Press, April 2000) and The After-Hours Trader (McGraw Hill, August 2000). Past television appearances include CNBC, ABC, and Yahoo! FinanceVision. Wagner is a frequent guest speaker at various trading and financial conferences around the world, and can be reached by sending e-mail to deron@morpheustrading.com.
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