We came into this week looking for a rally, and that’s what we got.

The S&P 500 gained 110 points during the three-day bounce that ended on Wednesday. And, in spite of yesterday’s modest decline, the index is still up 3.5% – just for this week.

That’s the sort of rally that can happen when the proverbial rubber band stretches too far to the downside.

In Monday’s essay, we noted the S&P 500 closed 50 points below its 9-day exponential moving average (EMA) on Friday. That’s an extreme move. The index rarely drifts more than 30 points away from its 9-day EMA before reversing back towards the line.

Combine that extreme condition with extremely bearish investor sentiment, and we have the ingredients for one heck of a bounce.

By Wednesday, though – after a 110-point rally in three days ­– the S&P closed in nearly the exact opposite condition it had on Friday. 

The S&P closed Wednesday 50 points ABOVE its 9-day EMA. And, if the giddiness of the financial TV talking heads is any indication, investor sentiment made a solid rebound this week as well.

So, just as the conditions on Friday suggested the downside potential was limited in the short term, the conditions at the close of trading on Wednesday suggest the upside potential is limited.

That doesn’t mean the market can’t move higher from here. It most certainly can. But, we probably need a day or two of consolidating action, or maybe a pullback to the 9-day EMA (at 2694 and rising) to relieve the current overbought conditions.

From a longer-term perspective, keep this next comment in the back of your mind…

This week’s rally is indicative of the types of oversold rallies we saw in 2008. The market would stretch far into oversold territory. Sentiment would get horribly bearish. Then we’d get a one- to four-day long “wonder rally” that crushed the folks who held short, and got everyone else all “bulled up” for a big move higher.

Then the market would reverse and head lower again.

That’s typical of how bear markets behave.

It’s important – for the longer-term outlook – that the S&P does not dip below last Friday’s closing low of 2632.

Any pullback from here needs to establish a “higher low” on the daily chart. Otherwise, the September high around 2930 may prove to be THE top of the bull market.

Best regards and good trading,

Jeff Clark

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