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Oversold Markets Can Stay Oversold

01/24/08 08:54:18 AM
by Mike Carr, CMT

With momentum indicators oversold, isn't the market due for a bounce?

Security:   DJIA
Position:   N/A

With the market down so much, so quickly, many traders will look for a long entry point. They rationalize that the market is oversold and is due for a bounce. Even if it turns out to be a dead-cat bounce, they are certain that the market should offer a relatively low-risk long trade after a rapid decline. But the charts show that right now, stochastics and the relative strength index (RSI) are reaching lower lows along with price and pointing toward lower prices (Figure 1).

FIGURE 1: DJIA, DAILY. Currently, stochastics and RSI are reaching lower lows along with price and pointing toward lower prices.
Graphic provided by:
History shows that the market can remain oversold for an extended period of time. While momentum indicators have been oversold for nearly three weeks now, in bear markets, it is not uncommon to see this level sustained for a month or longer. In the 1972–74 bear market, momentum remained oversold for a month or more on several occasions (Figure 2).

FIGURE 2: DJIA, DAILY. In the 1972–74 bear market, momentum remained oversold for a month or more on several occasions.
Graphic provided by:
Reaching further back in history, we see month-long periods of oversold conditions occur several times in the 1929–32 bear market (Figure 3).

FIGURE 3: DJIA, DAILY. Further back, there were month-long periods of oversold conditions occurred in the 1929–32 bear market.
Graphic provided by:
While prices may be due for a bounce, traders should await price confirmation of that higher prices are more likely than lower prices before initiating new long positions. John Maynard Keynes was fond of saying that markets can remain irrational far longer than traders can remain solvent. This wisdom is usually applied on the upside, but is just as meaningful in bear markets.

Mike Carr, CMT

Mike Carr, CMT, is a member of the Market Technicians Association, and editor of the MTA's newsletter, Technically Speaking. He is also the author of "Smarter Investing in Any Economy: The Definitive Guide to Relative Strength Investing," and "Conquering the Divide: How to Use Economic Indicators to Catch Stock Market Trends."

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