Overbought Breather Or Something More?

Yesterday I was asked if the declines that we had seen in major market indices over the past two sessions was a pause after a rally that caused markets to be overbought, or whether the declines were the start of something more significant. Unfortunately, I had to give a pithy 10-second response. I offered the opinion that we were taking a breather from an overbought condition, though we won’t know the real answer for a few days or weeks because investors’ reactions to earnings season would be the main driver. With more time to craft a response, I’ll offer a fuller answer to that question.

Two days does not a trend make. Although yesterday marked the first time in weeks that we sustained two down days in a row, with the second being somewhat significant, all we did was return to levels last seen in the prior week. In the case of the S&P 500 Index (SPX), we reverted to last Wednesday’s value. In other words, we gained last Thursday and Friday, only to give back those gains on Monday and Tuesday. That is neither a trend change nor anything remotely significant. Consider this chart of SPX, which includes today’s bounce:

SPX 2-week chart, 15-minute bars

SPX 2-week chart, 15-minute bars

Source: Interactive Brokers

It is evident that SPX found support yesterday at last week’s lows, which were established on Monday and reaffirmed on Wednesday. For those of you who believe that gaps need to be filled (in the era of nearly 24-hour trading, I find that concept to be obsolete), yesterday’s decline filled Thursday’s gap. I suspect that I will hear from traders who believe that we could be forming a short-term head and shoulders top, but until or unless the index declines to form a neckline by testing support around 4110 over the next day or two, I would dismiss that idea. Quite frankly, I have found that prematurely looking for head and shoulders patterns before they fully develop is a fantastic way to lose money. 

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Disclosure: The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the ...

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