Markets Bounce Back Following Elevated Selling: What to Do Now

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“A prediction about the direction of the stock market tells you nothing about where stocks are headed, but a whole lot about the person doing the predicting.” – Warren Buffett

We often see analogies between the ocean’s current and the stock market. When the sea and winds are calm, we can sit back and enjoy the ride. But when the current becomes rough and the wind is blowing, we need to adjust to the dynamic conditions in a rapid manner. If we fail to act quickly, we leave ourselves in a vulnerable state.

The trick is to know when and how to adjust to changing market conditions. Yesterday afternoon brought enhanced selling pressure, resulting in the worst performance for the S&P 500 since October. The Dow and Nasdaq snapped 9-day winning streaks, as overbought conditions sparked increased volatility and profit-taking.

The question now becomes whether we get more of a pullback and if so, when buyers will step back in. Let’s delve a bit deeper and see what we can learn.

Overbought Does Not Mean Over

We’re coming off a historic November rally that saw the S&P 500 gain about 9% during the month. From a longer-term perspective, the outsized monthly return from November bodes well for a continuation of this new bull market. In previous instances where the S&P 500 achieved a greater than 8% return in a single month (30 times dating back to 1950), a year later the index was higher 27/30 times with an average return of 15.8%.

The impressive rally created widespread overbought conditions within the S&P 500; the index hit key resistance within 1% of its previous all-time high. There’s no doubt that by most conventional measures, the major U.S. indices (and most individual stocks) became overbought in the short-term. We can see below that the strong momentum behind the S&P 500 resulted in this condition as measured by its own relative strength index (RSI) figure.

Image Source: StockCharts

Another indication included above is the percent of S&P 500 stocks trading above their respective 50- and 200-day moving average prices. The relatively high percentages show us that market breadth has improved, which is very positive for this new bull market. But when these measures reach an extreme, they can signal that the tide may be turning in the short-term and buying pressure is becoming exhausted.

The volatility (VIX) index has surged nearly 20% over the past few days after hovering near multi-year lows; periods of low volatility are often followed by periods of high volatility, so this is something to watch out for in the months ahead.

But overbought conditions by themselves aren’t a bad thing; in fact, this is what we want to see as more stocks join the rally. From a longer-term standpoint, the recent breadth thrust and overall bullishness bodes well for the future. The percentage of stocks in the S&P 500 that are overbought (as measured by the 14-day RSI above 70) reached 44% recently, the highest level on record. It’s normal to read that and think things are stretched.

And again in the short-term, that may be the case. Yet the 2 other times that percentage reached a similar level were June 2003 and June 2020 – not the worst times to be bullish. It’s the market’s way of telling us to expect higher prices ahead.

Is the Rally Over for Big Tech?

The widely-followed XLK ETF XLK, which represents the technology sector of the S&P 500, hit a new all-time high during yesterday’s session before closing down -1.5%. Heavyweights Apple AAPL and Microsoft MSFT comprise nearly 45% of the overall XLK ETF holdings. Yesterday was the worst performance for an all-time high day in XLK since July 13th 2020. 

Those who know their market history remember that stocks were in the midst of a stimulus-induced rally in July of 2020, when many stocks were similarly overbought. Here’s what the XLK ETF looked like on that date, when it hit a new all-time high before closing down -2.1%:

StockCharts
Image Source: StockCharts

I don’t like to make predictions when it comes to the financial markets because predicting can get us in trouble. When we see a candle like that, it’s normal to try and predict that markets have topped out, and the best of the rally is behind us. That type of thinking would have proven disastrous, as XLK when on to soar in the following year:

StockCharts
Image Source: StockCharts

It’s important to not get too caught up in daily fluctuations; always keep the bigger picture in mind. Let’s also remember that like 2020, we are now seeing the more cyclical and aggressive areas of the market have the highest percentage of overbought stocks. The current market recovery is showing constructive signs and elevated levels of buying pressure overall, which is healthy and speaks to the sustainability of this new bull market run.

What to Do Now

Yesterday’s late-session, quick selloff may have marked a short-term change in market conditions after stocks entered overbought territory. As we know, we need to adjust quickly when the current goes against us. This translates to realizing some profits and reducing exposure, while possibly hedging for those so inclined.

Still, our analysis suggests that any pullback should be relatively contained. As we saw in the XLK ETF historical example, the move off the all-time high within a longer-term uptrend didn’t end up causing too much harm.

Markets appear to be bouncing back today, and historical statistics suggest more strength ahead. Ideally, we want to be targeting stocks that aren’t too extended but are still showing relative strength. Make sure to take advantage of all that Zacks has to offer as markets look to close out the year on a positive note.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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