VARIOUS MARKET MEASURES SHOW AN OVERBOUGHT STOCK MARKET
BOLLINGER BANDS SHOW OVER-EXTENDED MARKET... There are several ways to measure when a market has moved into overbought territory and is vulnerable to some profi-taking. One way is to use longer-range Bollinger bands. I've written in the past about converting weekly and monthly signals into daily ones. That helps show where major support and resistance levels are located. In Chart 1, the lower dotted line is the 400-day moving average. I get that number by combining a 20-month average into days (20 months x 20 days). The 20-month (or 400-day moving average) acted as major support over the summer and has done so for the last three years. The upper line is the Bollinger band for the 400-day average. It's much wider than the standard 20-day line and gives us a better read on when the market has gotten ahead of itself. The circles in Chart 1 show the market correcting downward each time it exceeded the upper band during the first half of 2006. Chart 2 converts the numbers to a weekly chart. The circles show instances over the last three years when the S&P moved over the upper band. Each instance was followed by some profit-taking. The two down arrows show where the upper band acted as a resistance barrier. The chart isn't necessarily a sign of a market top. It just means that the S&P has come too far too fast and is in overbought territory. Other indicators show essentially the same situation.
Chart 1
Chart 2
THE S&P MAY BE TOO FAR ABOVE ITS 200-DAY MOVING AVERAGE ... Another sign that the market may be over-extended is the distance it's travelled over its 200-day moving average. The red line in Chart 3 is the 200-day moving average for the S&P 500. The market tends to stall when it's moved too far over that long-term support line. One way we can tell when that's happening is by plotting the spread between the two. That's what the black line in Chart 3 does. The black line (the S&P minus its 200-day line) has reached the same level that coincided with downside corrections throughout 2006 and 2005 which puts it in a potential resistance area (red line). Chart 4 compares the spread (black line) between the S&P and the 200-day average to the index for the last three years. It shows that the spread did move much higher at the start of 2004 in an earlier stage of the bull market. Over the last two years, however, the spread has tended to narrow (down arrows). Right now, the spread between the S&P and its 200-day line is at a level that interrupted rallies during 2005 and 2006. Here again, that's doesn't mean the uptrend is ending. It does suggest, however, that it may be in need of a breather.
Chart 3
Chart 4
COMBINING BANDS AND AVERAGES ... Chart 5 uses the standard 20-day Bollinger bands to show where underlying support levels exist. First, an acknowledgement that the 9-day RSI line (top of chart) has reached overbought territory over 70. If a short-term pullback does occur, the first line of potential support would be the 20-day moving average (dashed green line) which currently sits at 1334 (and rising). There's also potential chart support at 1326 which is the May peak. If a deeper correction were to occur, more substantial support is likely at the lower Bollinger band (green line) and the 50-day average (blue line). There's no convincing evidence to indicate a major decline at this point. All we're warning about here is an over-extended market condition at current levels, and the possibility for a short-term pullback or a period of consolidation within the market's ongoing uptrend.
Chart 5
