Market Overbought but Sentiment Still Favors Bulls
by Carl Swenlin

The S&P 500 Index is approaching new 52-week highs, but there is short-term overhead resistance immediately ahead, and our primary medium-term indicators are becoming modestly overbought. Does this spell trouble for the bulls? Probably not. Overbought conditions are not necessarily a problem in a bull market, and there are still way too many bears for an important top.

Our first chart shows the S&P 500 Index with our three primary medium-term indicators (oscillators) -- one each for price, breadth, and volume. As you can see they are approaching the overbought side of their range, but they are far short of being at their extreme limits, and they still allow for higher prices before they make a final top. Another thing to remember is that oscillators oscillate within a fixed horizontal range, prices normally do not. This means that, even though the oscillators top and begin to trend down, prices don't necessarily have to follow. In fact, you can see a few instances on the chart where prices continued higher even after the oscillators topped.

Our next chart is of the Rydex Cash Flow Ratio*, which I featured in an article two weeks ago. Note that the Ratio remains oversold (reflecting strong bearish sentiment), in spite of the fact that prices have continued higher. The condition of the Ratio is caused by a combination of aggressive buying of bear funds and timid acquisition of bull funds. This situation is extremely unusual, and I believe it must be relieved before we can expect a significant price decline. Relief will come when the bears give up and the bulls become more aggressive, ultimately causing the Ratio to move back up toward the top its trading range.

Bottom Line: The significant aspect of the market being overbought is that it is probably not a good time to be adding new long positions. Also, more caution is appropriate while the overbought condition is being worked off. Otherwise, I think the Rydex Cash Flow Ratio strongly suggests that prices will move higher, even after internals begin to correct downward. In other words, I think that people need to become more bullish before the rally will end.

Technical analysis is a windsock, not a crystal ball. Be prepared to adjust your tactics if conditions change.

*RYDEX CASH FLOW RATIO: The Rydex Cash Flow Ratio gives an improved view of sentiment extremes by using cumulative cash flow (CCFL) into Rydex mutual funds rather than using the totals of assets in those funds (which we use for the Rydex Asset Ratio). It is calculated by dividing Money Market plus Bear Funds CCFL by Bull Funds plus Sector Funds CCFL.

BIO: Carl Swenlin is a self-taught technical analyst, who has been involved in market analysis since 1981. A pioneer in the creation of online technical resources, he is president and founder of DecisionPoint.com, a premier technical analysis website specializing in stock market indicators, charting, and focused research reports. Mr. Swenlin is a Member of the Market Technicians Association.