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Writer's picturePeter Lee

Overbought Correction or Something More?

Prior to the escalation of the Coronavirus there were technical divergences that warn of a stock market correction including the following:


(1) the 10-year US Treasury yields (TNX – 1.60%) struggled to breakout above key resistance at 1.95-1.97% and declined into the year-end 2019/early-2020 stock market rally; (2) US Dollar Index (USD – 97.77) declined to a low of 96.02 successfully finding a bottom near its 2-year uptrend channel and began to rally into the New Year (2020); (3) SPX implied volatility (VIX Index – 18.23) fell to a 2-year low (10-11.5) and began to reverse direction; (4) near-term overbought conditions were developing in key stock market indexes as technical indicators such as Bollinger Bands and MACD price momentum peaked; (5) leadership sectors including S&P Technology and Healthcare were trading at overbought levels and former leadership sector, Financial, began to weaken; (6) defensive sectors such as S&P Utilities (XLU), Real Estate (XLRE), Consumer Staples (XLP) began to outperform peers over peers in the past few weeks; and (7) gold futures (GOLD – 1,577.40) broke out of a major cup and handle bottom pattern.


So, did the escalation of the Coronavirus triggered the start of the corrective phase? Is this the much-needed correction that many have been calling for that will alleviate an overbought market condition allowing for the resumption of the bull rally or is this the start of something more?


A brief review of key domestic and international equity markets, macro markets as well as of key market internals we believe this is yet another correction within the context of a bullish primary uptrend. This would then imply the stock market was ahead itself (overbought) and needed to consolidate before it can resume its primary and prevailing uptrend.


Given the sharp rally over the past 4-months (from Oct 2019 lows) there are two possible scenarios: (1) a normal correction (3-5% decline from its recent highs) or (2) a deeper correction (7-10% or more). Typically, a normal correction would result in major equity markets finding key supports near its 50-day moving average and its 38.2% retracement from its recent rally (Oct 2019 low to Jan 2020 high). Violation of these key support zones warn of the start of much deeper correction leading to a retest of the 61.8% retracement level and its 200-day moving average.


Enclosed below are 3 major US stock market indexes including S&P 500 Index (SPX), Dow Jones Industrial Average (INDU), and NASDAQ Composite Index (COMPQ). Included are key technical support zones that will likely be tested in the days and weeks ahead.


Source: Courtesy of StockCharts.com

Source: Courtesy of StockCharts.com

Source: Courtesy of StockCharts.com

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