Selling Exhaustion or a Falling Knife?

What defines selling exhaustion? Selling exhaustion occurs when most market participants trading in a market have already sold. With very few sellers left the price begins to stabilize. Although residual selling can still occur, the decline takes place at a slower and weaker pace as the sellers dwindles and buyers begin to emerge. Exhaustion is more of a state or a condition. However, blow-off market bottoms are extreme conditions of exhaustion. Under this extreme scenario the sellers overwhelm the buyers on excessive rising volume as the price fall precipitously and individual stocks within the index aso fall indiscriminately. This tends to be the easiest of major market bottoms to detect and often signals an impending reversal. Nonetheless, most bottoms have a common characteristics, the existing downtrend with a series of lower-lows and a series of lower swing highs begins to reverse direction and is replaced by a higher-lows and higher-highs uptrend.

Calling a major market bottom is extremely difficult. Many will deploy complex technical indicators, utilize proprietary quant models, run statistical formulas, conduct sentiment surveys, and others to try to identify the bottom. However, by relying on too many technical tools this can confuse and dilute the results. Paralysis by analysis of over-analyzing (or over-thinking) a situation so that a decision or action is never taken. In effect, one is paralyzed and hence lose focus of the outcome.

Remember that a major market bottom occurs as the direct result of visible and often dramatic changes in the state or condition of the selling pressure (i.e., magnitude and severity). When the strong and severe selling abates or subsides this mark one phase of the overall bottoming process. An equally important phase to achieving a major market bottom is the quality of the subsequent recovery.

Over the past few weeks, we have studied many internal technical indicators, performed numerous volume analysis, reviewed important sentiment indicators and conducted a host of other technical studies. As with many of our peers we may also be over analyzing the market to identify the bottom. As we have alluded to before, a major bottom occurs only when you have exhausted the sellers and the buyers begin to return. On the charts the magnitude and pace of the downtrend often slows and abates.

The Zig Zag indicator is a popular swing trading technique deployed by many currency and futures trading professionals. The indicator plots points on the charts whenever prices reverse by a specified variable (i.e., 5%, 7%, 10% etc.). The objective is to isolate and identify major price trends. Like moving averages, it eliminates random price fluctuations and focus on the primary or important trend changes. Although this is a viable strategy for swing traders it may be an equally important indicator to utilize in today’s volatile market conditions. After all, a major market develops when selling pressures are exhausted and this is reflected with the downtrend also slowing and abating.

Attached below is a brief analysis of the Zig Zag indicator applied to the S&P 500 Index (SPX). Since 2/19/20 market top (3,393.52) SPX has experienced 4 distinct waves of selling pressures including: Wave 1 from 2/19/20 to 2/28/20 or -15.8% in 7-days, Wave 2 from 3/3/20 to 3/12/20 or -20.9% in 7 days, Wave 3 from 3/13/20 to 3/18/20 or -15.9% in 3-days, and Wave 4 from 3/19/20 to 3/23/20 or -11.2% in 2-days.

As you can see on the charts with each wave of selling the trend of the selling pressure becomes shorter in duration and the magnitude of the selling declines. Also, each subsequent bottom (i.e., 3/28, 3/12, 3/18, and 3/23) were associated with very heavy volume. In addition, three important technical indicators (VIX, MACD, and Market Breadth) recorded extreme readings during the bear decline. VIX recorded a potential extreme closing high of 82.69 on 3/16/20. The price momentum MACD indicator recorded a potential extreme momentum low of -237.02 on 3/23/20 and the advancing issues minus declining issues market breadth indicator also established a potential extreme low of 6,030.90 on 3/23/20.

In summary, an internal low may have developed on 3/23/20 (2,191.16). The four waves of selling pressure, each less severe than the prior ones, coupled with key technical indicators achieving extreme readings and volume peaking during the respective four price lows fit the definition of a selling exhaustion. Although the above technical conditions are encouraging, a market bottom is still a process. One half of the bottoming process may have developed via a selling exhaustion phase. However, to reaffirm the 3/23/20 low at 2,191.16 as a major bottom a technical basing effort preferably via a series of higher-lows and higher-highs need to occur. To confirm a higher-low SPX must maintain above its 3/23/20 low of 2,191.86 on any subsequent pullbacks. To establish a higher-high pattern SPX needs to clear above 2,637.01-2,641.39 (3/26/20 and 3/31/20 highs), 38.2% retracement (2,650.89) from 2/19/20 to 3/23/20 rally, and preferably above 2,711.33 (3/13/20 high).

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