Was Last Week’s Decline a One-Time Thing or the Start of Something More?

For the first time since the fall of ’16 we saw some significant selling pressure in stocks. Granted a great deal of it came on Friday, but last week saw the S&P 500 experience its biggest decline since the first week of ’16.

For some time now I have been cautioning investors about the overbought levels in most of the indices, ETFs and individual stocks. I have also been talking about the sentiment readings being overly optimistic. I have talked about the streak of days without a five-percent correction.

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While I have issued cautious statements, I don’t think we are getting ready to head in to a bearish phase. When we look at the weekly chart of the S&P, we see how minor of a correction we had last week. The index hasn’t breached its 13-week moving average yet and it is still almost nine percent above its 52-week moving average.

We see how overbought the S&P was heading in to last week. In fact it is the most overbought it has ever been based on the 10-week RSI. The RSI did move out of overbought territory thanks to last week’s selloff, but it has a long way to go before it gets anywhere close to oversold. Personally I think a pullback to the 52-week moving average would be a good thing for the market.

I view the market like a pressure cooker and if there isn’t a little steam let out every once in a while, we could see an explosion of sorts. Last week’s selling, for now, appears to be nothing more than letting off a little steam.

The fundamentals of most companies are still pretty good and the majority of earnings reports have been beating estimates. The P/E ratios are terribly high and most fundamental valuations don’t show the market as historically expensive.

The sentiment indicators are the ones I am most interested in seeing. Most of the best sentiment indicators are only calculated once a week and when they are released this week, they will reflect what last week’s selling did to investor confidence. A few sentiment indicators that are available daily have changed dramatically.

One of those sentiment indicators is the CBOE Volatility Index (VIX) and it jumped sharply last week, climbing over 56 percent on the week. The VIX moved above the 17.50 level for the first time since the Presidential Election in November ’16. That is a significant jump and it is up so far again this week.

Another sentiment indicator that I can look at on a daily basis is the SentimenTrader.com Optix for the major index ETFs. The optix on the SPDR S&P 500 went from its highest reading in the last year on January 26, to its lowest reading of the past year last Friday. One week is all it took to go from the highest reading to the lowest reading. This sentiment gauge is influenced greatly from the daily trading action, so it could be overstating the sentiment shift due to the sharp selling last week.

I am far more interested in seeing what happens to the Investors Intelligence report and the AAII sentiment survey. These two indicators shift far more slowly and had been at pretty optimistic levels in recent weeks. The AAII survey had started to show a decline in optimism in the last two weeks, but the Investors Intelligence report was still showing extreme optimism with the ratio of bulls to bears coming in at a ratio of over five to one in each of the last three weeks. That ratio had not been seen since 1987. I am hoping that last week’s selling caused a significant decline in the ratio.

For me the bottom line is this: we needed last week’s selling to remind investors that the market moves in two directions, up and down. We need some more selling in order to bring the sentiment indicators down from the incredibly high optimism levels we have seen lately. Are we heading in to a bearish phase? I don’t think so, at least for now.

If we see the S&P continue down, I will be anxious to see if it gets to its 52-week moving average and where the sentiment readings are at that time. If it breaks below the moving average, I will start getting a little more concerned about a possible bearish cycle. If we see the 13-week moving average make a bearish crossover below the 52-week moving average, that will cause me major concern.

About Rick Pendergraft

Rick has been studying, trading, analyzing and writing about the investment markets for over 30 years. He has worked for some of the largest financial publishers in the world and he has been quoted in the Wall Street Journal, USA Today, the New York Times and the Washington Post. In addition, he has been interviewed on Bloomberg, CNBC and Fox Business News. Rick’s analysis process includes fundamental, sentiment and technical analysis. Rick started college as an education major, wanting to teach economics, but eventually changed to majoring in Economics and received a Bachelor of Science in Economics from Wright State University. His desire to inform and educate people is at the heart of his writing.

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