Technically Speaking: Oversold Bounce Or Return Of The Bull?

In this past weekend’s missive, “Markets Go On Alert,” I stated that due to the oversold condition of the market on a very short-term basis, a rally was due this week. To wit:

“IMPORTANT: By the time weekly signals are issued on an intermediate-term basis, the market is generally oversold, with ‘bearish’ sentiment increasing, on a short-term (daily) basis. Given those short-term conditions, it is quite likely the markets will rally next week.”

Chart updated through Monday’s close.

“IMPORTANT: It is the success or failure of that rally attempt that will dictate what happens next.

If the market can reverse course next week, and move back above the 50-dma AND break the declining price trend from the March highs, then an attempt at all time highs is quite likely. (Probability Guess = 30%)

However, a rally back to the 50-dma that fails will likely result in a continuation of the correction to the 200-dma as seen previously. From current levels that would suggest a roughly -5% drawdown. However, as shown below, those drawdowns under similar conditions could approach -15%. (Probability Guess = 70%)”

I have denoted both setups in the chart above. The downtrend resistance from the March highs is quite evident as well as the 50-dma resistance at 2353 currently. Furthermore, as noted, the oversold condition has provided the “fuel” for a reflexive, “oversold,” bounce.

The chart below is the ratio between the 3-Month Volatility Index and the Volatility Index (VIX). As shown, when this ratio declines to 1.00, or less, it has generally coincided with short-term bottoms in the market.

It is worth noting that in several cases, these “oversold” conditions were generally precursors to a future decline.

But how can we tell the difference?

This is where we have to step away from a very short-term view and move to an intermediate-term perspective. The chart below is essentially the same as above but the data is weekly, versus daily, which reduces some of the “noise.”