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Last week’s stock market rally was historic.
The S&P 500 gained almost 6%. The Nasdaq Composite Index blasted 8% higher.
The action was strong enough to cause a lot of financial television talking heads to declare, “The bear market is over. Stocks will go higher from here.”
Maybe…
After all, we are in a seasonally bullish time of the year. The stock market tends to perform well in November and December.
But the problem is last week’s rally used up a lot of energy. There’s not much fuel to propel the market higher from here…
Today, we have a reason to be concerned about the short term.
Just look at this chart of the S&P 500 bullish percent index (BPSPX)…
A bullish percent index measures the percentage of stocks in a sector or an index trading with positive technical patterns.
It’s a percentage. So, it can only drop as low as zero or rally as high as 100.
Most sectors are overbought when the bullish percent index rallies above 80. Most sectors are oversold when the index dips below 20.
But when it comes to broad-based indexes – like the S&P 500 – which hold stocks in multiple sectors, the parameters are a little tighter.
For example, the S&P 500 is overbought when the bullish percent index climbs above 70. It’s oversold when the BPSPX dips below 30.
Trading signals occur when the BPSPX reaches overbought or oversold levels and then reverses.
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On the chart below, the red arrows mark the four times over the past year when the BPSPX turned lower from overbought conditions – thereby generating a sell signal.
Here’s how the S&P 500 performed following the first three of those signals…
In all four cases, the S&P 500 started to decline within just a few days of the BPSPX sell signal.
Last November, the index fell 200 points in one week. In January, it lost 450 points in less than one month. In less than three months, the S&P 500 dropped over 900 points following the sell signal in late March.
And the most recent signal in mid-August – which happened when all sorts of talking heads were declaring the bear market was over – led to a 600-point drop in about six weeks.
This is important because if you take another look at the BPSPX chart, we’re setting up for another sell signal soon.
The BPSPX hasn’t turned lower yet. But it’s above 70. So when it does turn lower, we’ll have a new sell signal for the broad stock market.
That could happen as early as this week.
Yes, it’s possible the market could press even higher in the days ahead.
But with the BPSPX already extended above 70, the gains are limited. Any strength early this week will likely be given back in the weeks ahead.
And if you recall the monthly S&P 500 chart I shared with you on November 4, a decline toward the end of this month could set the stage for a waterfall decline in the months ahead.
Traders should be careful here.
Until the BPSPX works off its current overbought condition, there’s limited upside to the stock market. And the downside could be substantial.
Best regards and good trading,
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Jeff Clark
Reader Mailbag
In today’s mailbag, Rob W. shares his thoughts on Imre Gams’ essay from last Thursday…
I think the Fed will likely pivot in March or April when demand for energy slows and the worries of a cold winter will have abated.
Whether or not there was a cold winter will not matter by that point and the biggest spikes in natural gas and crude typically occur in late January/early February.
If there is a cold winter, then the pivot will most likely happen in April… perhaps even May.
– Rob W.
Thank you, as always, for your thoughtful comments. Keep them coming at [email protected].