Overbought Stock Market is Not a Sell Signal

By: Jack_Steiman

In the face of some deeper selling last week, we saw some strong positive divergences on the 60-minute charts set up on the MACD from well below the zero line on Friday. That was a signal that said it was time to go long into the teeth of the down side.

It felt bad, but then again it always feels bad when the market is selling. If the divergence had set up above the zero line, then it would be more risky going in and believing the market would turn things around. The masses were getting pretty bearish by Friday afternoon. Still, lots of fear out there that this market is going to simply give it up on a moment's notice. Folks are trained to go short or not believe in this process that's been ongoing since March, and this gives the market the opportunity to trend its way higher still. Why anyone would fight positive divergences that are at the right place technically with oscillators unwound is beyond me, but many do. It's good news for the bulls that the bears don't really believe.

On Monday we saw this rally get started early and gain energy all day in what was a clear trend up day. The bears could not muster up any energy to bring this rally down. Whenever the market sold off a bit the bulls came in and squashed the idea of taking this down. We closed on the highs with some very important levels of resistance being taken out along the way. What makes it all the more impressive is the fact that we did that without a gap above those levels. It normally takes a big gap up above critical resistance to get through them, but that was not the case on Monday. We opened below, churned at those levels and then ran right through. The levels of importance we took out were Nasdaq 1697 or that gap down below the neck line of 1700 last week. 1701 was the 50 day exponential moving average on the 60 minute time frame chart and 900 was gap on the S&P 500. Super action overall that the bulls have to be very happy about. The bears have no excuses here. Being unable to defend important support on lighter volume tells you they are in the market here. The sentiment remains bearish thus positive for the bears.

We now turn our attention to the place where the real story is written about this market. The financials, of course, were the culprit on the way down and we are watching them closely here -- i.e., the Financial Select Sector (XLF) -- to decipher whether the market has legs for further upside in the midst of all that's going on in the economy. They are acting as if the worst is behind them, but that can be a lure before the bottom falls out. We don't know yet, but for now they are acting in a fashion that suggests further upside in those stocks and, therefore, further upside in the overall market.

The other place we check for strength is the Nasdaq or the true market leader, i.e., the PowerShares QQQ Trust (QQQQ). Higher beta with faster growth potential. Is the buying come in there as well? We can see the answer to that question is a resounding yes. The leaders in those leading sectors are doing well and that's the key. As long as that continues on you have to keep a more bullish bias. We watch those charts to make sure they're still on their buy signal, and it's hard to find many, if any, that are not still on a buy signal. Keep in mind that overbought is NOT A SELL SIGNAL. A pause signal sure, but not a sell signal. Overbought is a sign of overall strength.

The breakdown on the Vix is a close below 30 and we are getting very close to that. Should that 30 level break, we could see a very sharp move higher in equities. We hit 30.00 during the day with the close at 30.22. The bears need to watch that level closely for if it goes they will be forced to start covering quickly. With the S&P 500 heading back towards the recent high near 930, this could be setting up for a breakout in the market and a breakdown in the VIX. Very interesting times.

The market has done what it needs to do thus far. It took many attempts by the bulls to take out that 875 level, if you remember. It was a level of great frustration for quite some time. We'd get up there and breach, but we just couldn't get through on a closing basis. Finally we did and when we did the market continued to race higher. When we got very overbought we warned of a test back to that 875 level over time. We got down to 878 and held as we should. At the same time the RSI's and stochastics unwound perfectly and then we set up those nice positive divergences on the 60-minute charts. The market is acting in a fashion that says it wants more. Don't worry about whether it's about a new bull or a bear market rally. That's all irrelevant. We only care about getting the signals right as they present themselves. For now we are on a clear buy signal that was never broken although it felt like it was when we pulled back. careful about the distinction between feeling and knowing. Emotion makes you feel. Calm allows you to know. Until thesis is broken, the benefit of the doubt goes to the bulls. 875 is strong support all the way down to 854 or the 50 day exponential moving average. One day at a time. Holding longs.

Peace

Jack

By Jack Steiman

Jack Steiman is author of SwingTradeOnline.com ( www.swingtradeonline.com ). Former columnist for TheStreet.com, Jack is renowned for calling major shifts in the market, including the market bottom in mid-2002 and the market top in October 2007.

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