When the Inevitable Correction Comes, History Suggests It Won't Amount to Much

One of the basic laws of technical analysis, which I have learned the hard way, is to be very careful about calling counter-cyclical short-term moves. The primary trend dominates everything. For example, if you are in a bear market and you see a short-term oversold condition, do not assume that it has as much power as an oversold condition in a bull market, because nine time out of ten it won't. The reason is because a bull market lifts all boats and surprises have a strong tendency to develop in its direction.

Take a look at Chart 1, which compares the S&P Composite with its 9-day RSI. The green arrows show that the market is very responsive to oversold conditions. There was one exception, in May of last year, when we did not see much of a rally, but, generally speaking, those oversold conditions represented a great opportunity to buy. Now contrast that to the numerous overbought conditions, none of which have so far been followed by weakness.

Chart 1

Chart 2 features my Dow Diffusion indicator, which monitors the percentage of Dow stocks in a positive trend. It's more of an intermediate indicator and has had a bit more luck in calling corrections. It triggered another sell signal a week ago, but, so far, there has not been much of a response. Bringing the current overbought RSI reading into the mix, now might be a good time to anticipate some form of consolidation or digestion of recent gains, but I am not that confident that it would amount to much.

Chart 2

Part of that reason lies in Chart 3, which features the A/D line for all NYSE-listed stocks and NYSE-listed common stocks. There is no sign of negativity here, as both have been in gear with the S&P for quite a while.

Chart 3

"But wait, there's more!", as they say, and that goes to the heart of the net new high data. Charts 4 and 5 are derived from the strongest sector of the market, the NASDAQ. What I have noticed is that important market peaks are typically foreshadowed by negative divergences in the net new high data. These are shown by the diverging red arrows. The length of these divergences differs from peak to peak, but the consistent thing is that the initial thrust is a leading indicator for this weekly new high series. At present, there are no signs of a divergence as the indicator climbs to a 2-year high. Also, note that the pink shading flags periods when the cumulative new high line in the bottom window crosses below its 39-week MA. If we are going to get weakness, this is usually when it takes place. Earlier in the month, it rallied back above the MA again, suggesting the all-clear for the market.

Chart 4

Chart 5 shows similar characteristics using daily NASDAQ data, with the indicator already at a new high for the move.

Chart 5

Over at the NYSE, a similar development is taking place. Net new high data has been making a series of rising peaks since the start of 2019, with not even a hint of a negative divergence. Previous ones have been flagged by the red arrows.

Chart 6

Finally, Chart 7 shows net new high data in histogram format. The thing that impresses me is the fact that there are few signs of weakness, whether you look at the S&P, mid-cap, small-cap, etc.

Chart 7

None of this is to suggest that the market can't come down big time, as it can do whatever it likes. All we can say is that the market is overbought. However, an overbought condition is not sufficient to signal a correction in a bull market. By the same token, the kind of net new high setup that usually precedes an intermediate or greater decline is not currently in place. That means that nailing a counter-cyclical correction is going to be more difficult than usual.

Good luck and good charting,

Martin J. Pring

The views expressed in this article are those of the author and do not necessarily reflect the position or opinion of Pring Turner Capital Groupof Walnut Creek or its affiliates.