Hyper-Oversold Markets

By: Adam Hamilton | Fri, Oct 7, 2011
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The recent sharp selloffs in stocks and commodities have fueled an incessant drumbeat of pessimism plaguing the financial markets. Greece is doomed, Europe is fracturing, China is slowing, the US faces a recession, the sky is falling! You've heard all the popular bearish arguments countless times. But as usual at major turning points, popular consensus is dead wrong. Oversold markets are very bullish!

As a battle-hardened contrarian forged by decades of trading, I relish oversold markets. They spawn some of the best entry prices ever seen, the ideal time to buy low (a necessary prerequisite to selling high later). The word "oversold" simply means a price has fallen too far too fast to be sustainable. It happens when traders' collective fear grows excessive, flaring up brilliantly before rapidly burning itself out.

Both stocks and commodities are seriously oversold today, their prices battered down to silly levels. And as always when oversoldness runs rampant, traders think it is totally righteous. All the endless bearish arguments justifying the super-low prices seem valid and perfectly logical in real-time. But they are just rationalizations, scared traders desperately latching on to anything to justify their own irrational fears.

While the tyranny of the present obscures oversoldness when it is happening, in hindsight it is crystal-clear to all. You certainly remember the brutal stock panic of late 2008, when virtually everyone was utterly convinced the world was being engulfed by the second Great Depression. Everything was sold with reckless abandon, driving stocks and commodities to depths unimaginable a few months earlier.

But we, along with other contrarians and students of the markets, aggressively snatched up extreme bargains in the dark heart of that epic fear storm. Buying when everyone else wanted to sell led to enormous realized profits. So many times in 2009, traders asked me how we knew the markets were going to soar dramatically when everyone else was crazy-bearish. Simple, they were hyper-oversold!

Oversoldness returned in the summer of 2010, although nowhere near as extreme as seen during the stock panic. The stock markets had just plummeted in the infamous Flash Crash, Greece's sovereign-debt problems led to overwhelming Europe pessimism, the euro was plunging, and weak Chinese stock markets threatened a hard landing in Asia. Global stock markets and commodities were utterly crushed.

Sound familiar? The bears claimed the sky was falling, and everyone was terrified. So we bought aggressively once again, seizing the incredible bargains that oversoldness drove. Just 6 to 9 months later, many of our trades had more than doubled! While buying stocks when no one else wants to is very challenging psychologically, the huge rewards are well worth the pain. And now, oversoldness is back.

After enough years of trading, you learn to intuitively recognize this sentiment phenomenon. It is evident in popular fear, the bearish consensus outlook, and overwhelming resignation that the markets are doomed to spiral much lower. But oversoldness can also be objectively measured by technical indicators. My favorite is one I created many years ago to hone my timing, and I called this simple system Relativity.

For trading, absolute price levels aren't important. But relative ones sure are. A price that has rallied too far too fast is overbought (the time to sell high), and a price that has fallen too far too fast is oversold (the time to buy low). Relativity looks at a price relative to an objective-yet-slowly-evolving baseline, its own 200-day moving average. It expresses a price as a multiple of its 200dma, and then charts this over time.

These multiples readily reveal overbought and oversold conditions. They are perfectly comparable over time in percentage terms even as the underlying price levels change. And they usually form well-defined horizontal trading ranges in trending markets, defining clear entry and exit levels. This powerful system helped our 591 newsletter stock trades since 2001 achieve stellar annualized realized gains of +51%!

While Relativity principles can be applied to anything in any market, today I'm most interested in the hyper-oversold conditions in stocks and commodities. The best proxy for the stock markets as a whole is the flagship S&P 500 stock index (SPX). This benchmark market-capitalization-weighted index reflects the fortunes of the 500 biggest and best companies in America. And it is now radically oversold.

Relative SPX

Relativity charts look complex at first glance, but in reality they are quite simple. The SPX along with its key technicals are slaved to the right axis for reference. If you divide the blue SPX line by its black 200dma line, the result is the red Relative SPX (rSPX) line rendered off the left axis. Imagine taking the black 200dma line, flattening it to horizontal, and showing where the SPX trades relative to it in perfectly-comparable percentage terms.

Today's cyclical stock bull was born out of those horrendous secondary panic lows back in March 2009, a time when everyone was certain a new depression was upon us. Except contrarians like us, who fight to suppress their own greed and fear to instead trade on market history. Since then the mighty SPX has enjoyed a couple powerful uplegs and weathered a couple sharp corrections. These are labeled above.

This bull's first correction unfolded in the summer of 2010, a major 16.0% selloff in 2.3 months. Back then there was widespread fear too, fanned by the same headlines we see today. Greece was going to default, Europe was in danger of fracturing, China was slowing, a US recession loomed, the sky was falling. And the SPX was oversold, trading under the lower support of its long-term relative trading range.

At Zeal we use the latest 5 calendar years of price action to define these relative ranges. Our subscribers can log in to our website and see the large high-resolution charts (updated weekly) from which they were born. And in the SPX's case, it tends to trade between 0.95x to 1.10x relative (or 95% to 110% of its 200dma). By its own historical standards, over 1.10x is overbought and under 0.95x is oversold.

Starting in early June 2010, the SPX traded under 0.95x its 200dma on several different occasions over 12 weeks. While that bottoming process was long, messy, and painful, it was still prudent to aggressively buy stocks over that whole span. The SPX's subsequent powerful 33.3% upleg over 9.9 months led to massive leveraged gains in high-potential stocks, including the commodities stocks we specialize in.

It was funny, as back in mid-2010 during the correction when we were aggressively buying commodities stocks we got a lot of flak. If trades bought in oversold conditions don't soar instantly, weak-willed traders freak out and sell in disgust. But by early this year when many of those same trades had more than doubled, I heard from many traders expressing regret that they didn't have the courage and fortitude to buy mid-2010's rampant oversoldness.

Fast-forward to today. The SPX has just weathered the second correction of its cyclical bull, a major 19.4% decline over 5.2 months. Traders are utterly terrified, once again convinced that a Greek default will usher in a financial apocalypse. Europe will fracture, Chinese growth will crash in a hard landing, the US will plunge into a double-dip recession, and the sky is falling. Same fears, different day.

This has not only driven the SPX to oversold levels, but to extreme oversoldness as this chart shows. The rSPX didn't bottom near 0.95x as usual, it plunged all the way down near 0.85x! Traders are so scared that they think the flagship US stock index trading around 85% of its 200dma is justified in a cyclical bull! It is insane. The SPX hasn't been this oversold since early 2009's brutal secondary stock-panic lows!

But Adam, are you blind? Maybe just stupid? Don't you know Greece is going to default, Europe is imploding, China is collapsing, the US is nosing over into a recession, and the sky is falling? Only a fool would buy stocks during so much uncertainty! What if they continue plunging? What if we're on the verge of a new panic? What if a new cyclical bear market is being born before our very eyes?

Serious traders determined to thrive in the stock markets study history for very good reason. Comparing today's markets to similar past conditions greatly improves our odds of correctly gaming near-future market action. And contrary to all the wailing and gnashing of teeth today, the stock-market action since the SPX's latest interim high in late April looks nothing like a bear market. The price action is all wrong.

I've written about this extensively in recent essays if you want to understand why. In a nutshell, the last cyclical bull was both too young and too low compared to historical precedent of mid-secular-bear cyclical bulls to have likely topped in late April. And the sharp SPX selloff in early August was way too early relative to cyclical-bear precedent if a new bear is upon us. Big fear spikes soon after major tops are a signature bull-market-correction behavior.

And if a new bear market is very unlikely based on bull-bear cycles and how intense this latest selloff has been, it is silly to worry about one. On top of all this, back in early August and again this week stock fear slammed into its effective ceiling. Historically this has marked the best times to aggressively buy super-oversold stocks in bull and bear markets alike. And the odds of a new panic are vanishingly-small.

Stock panics are exceedingly-rare events, on the order of once a century. Before 2008's, the last one was 1907's! Panics are 20%+ stock-market plunges in less than 2 weeks. And they only occur at one time in the bull-bear cycles, cascading out of bear-market lows late in a mature bear market. Since the SPX's latest interim high was so recent in late April, any new bear market can only be 5 months old at best.

This is far too young to spawn another stock panic. In addition, these extreme selling events are so rare because it takes decades to build up enough popular complacency and greed to fuel one. Expecting another stock panic merely 3 years after the last one is like expecting another epic wildfire just 3 years after a massive once-in-a-century conflagration thoroughly burned out the same area. There hasn't been anywhere near enough time yet for new fuel to grow back in!

With a new bear market highly unlikely, and a new panic nearly impossible so soon, the extreme oversoldness we've seen in recent months must be aggressively bought. It is the only high-probability-for-success trade that speculators and investors can make. Today they are presented with a rare and valuable opportunity to buy incredible bargains, and prove their mettle as contrarians. Will they seize it?

And it is not just the stock markets that are hyper-oversold, commodities just got crushed too after the Fed failed to launch a third quantitative-easing campaign as some expected. The best proxy for commodities as a group is the Continuous Commodity Index (CCI), today's version of the celebrated classic CRB. The CCI tracks 17 equally-weighted component commodities, including all the major ones crucial to traders.

Relative CCI

Just like the SPX, the CCI has experienced a pair of mighty uplegs and a pair of sharp corrections since those dark secondary stock-panic lows in early 2009. Unlike the stock markets, the commodities were fairly resilient in early August. But right after that latest Fed decision, they utterly collapsed. This hammered the rCCI down near 0.87x, far under its usual Relativity support of 1.00x. Traders are terrified today.

Just like they were back in the summer of 2010, when fears of a Greek default, a spreading European sovereign-debt crisis, a slowing Chinese economy, weak US jobs growth, and a falling sky dominated popular sentiment. Yet somehow the world managed to muddle through, and the subsequent upleg in commodities was massive. The CCI soared 53.3% which dwarfed the SPX's 33.3%, helping explain why commodities stocks skyrocketed so fast after those oversold conditions.

Once again fast-forward to today. Now the CCI is not only oversold, but extremely so. Over the past couple weeks since the Fed spooked commodities traders, the rCCI was pummeled down to its lowest levels since early 2009! Commodities as a group have not been anywhere close to this oversold since emerging out of the stock panic's secondary lows! And obviously that was an epic buying opportunity.

Every time there is a meaningful commodities selloff, it is blamed on economic fears. But just like in the stock markets, these are usually rationalizations for selling rather than the causes. The truth is commodities prices are highly correlated with the general stock markets. When stock markets are rallying, traders assume the global economy is improving so they buy commodities. And vice versa, of course.

Rather than being a legitimate fundamental response to economic fears out of Europe or China, the latest CCI plunge was a product of the SPX weakness and all the fear it spawned. This same thing happened in the summer of 2010, and back during the stock panic too. But the sheer degree of selling in commodities when stock markets are oversold is never justified fundamentally. There is no way the world economy can slow fast enough to drive commodities like oil and copper down by a third in a month or two!

Unfortunately when markets are oversold so fear reigns, traders forget what the economy truly is. An economy is simply the sum total of all the goods and services bought and sold by everyone. And since we all need to work and buy stuff to live, the economy marches on even during scary financial crises. Think about this carefully, and you can transcend the irrational fears plaguing commodities today.

When Greece defaults on its sovereign debt, some French banks will have to report bigger-than-expected quarterly losses on write-offs. How will this affect you personally? Will you quit your job and stay home cowering in fear because a French bank made a bad bet? Will you stop buying food for your family? Will you really pull back your spending on anything? Will the average European who is not a French banker? Will the average Chinese worker despair and suddenly give up bettering his family's fortunes?

Of course not! Traders make bad bets all the time, and debt investors face defaults when they lend their money to risky borrowers who might not be able to pay it back. The whole world has known that Greece's profligate spending spree wasn't sustainable for years now, and it was always likely to end in a default. But this is not going to stop the world's working people from working hard and spending to provide for their families. They will continue buying products, consuming commodities, driving profits for business.

Despite the fear, life goes on as it always has. Hyper-oversold levels in the stock markets and commodities are so darned irrational because they implicitly assume that life won't go on. Traders who can transcend the tyranny of the present to see the big picture can aggressively buy some of the best bargains ever seen in the stock markets. It isn't easy buying low, but the resulting profits are enormous.

At Zeal we've been aggressively buying extremely-oversold commodities stocks throughout the last couple months' bottoming process. We always layer in new positions gradually during oversold conditions, as no mere mortal can know the exact bottom in real-time. Sometimes the markets fall even farther, driving considerable initial losses in our young trades. This sure happened in the past couple weeks, as the Fed unexpectedly hammering commodities just crushed our stocks.

But the subsequent massive rallies out of oversold conditions are so huge that early losses soon turn into big gains. If you are interested in commodities stocks, the buying opportunities out there today are epic. From precious metals to base metals to rare earths to energy, commodities stocks are mind-blowingly cheap today. We just spent 4 months deeply researching oil stocks to find our dozen fundamental favorites. They are each profiled in depth in a fascinating new 36-page report available for just $95. Buy yours today, while these stocks are still dirt-cheap!

We also publish acclaimed weekly and monthly subscription newsletters. In them I draw on our vast experience, knowledge, wisdom, and ongoing research to explain what the markets are doing, why, and how to trade them with specific stock trades as opportunities arise. Our track record is stellar, since 2001 all 591 stock trades recommended in our newsletters have averaged annualized realized gains of +51%! Learn how to thrive in the markets, buying low and selling high like a contrarian. Subscribe today!

The bottom line is the stock markets and commodities are hyper-oversold today. Paralyzed by the same fears that dominated the markets near other lows in recent years, traders are again convinced the sky is falling. But oversoldness is a psychological phenomenon, not a fundamental one. Traders are scared so they are using global economic news as a rationalization to justify their own foolish selling near lows.

Market history is crystal-clear in showing that oversold conditions are the best buying opportunities ever seen. And the more oversold the markets, the greater the fear and anxiety, the better the resulting bargains. It isn't easy being brave when everyone else is afraid, buying low during intense uncertainty. But taking this prudent contrarian approach is the easiest and surest way to earn big money in stocks.

 


 

Adam Hamilton

Author: Adam Hamilton

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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