On Friday the US stock market enjoyed a bounce because of an extremely oversold technical market condition. These market conditions often happen when there are extreme emotions in the market. It may seem obvious, but excessive greed leads to overbought conditions and fear leads to oversold conditions, such as the one we recently experienced.
The above chart of the NYSE index (a broad US stock-based composite) depicts the rally and the recent selling.
This chart illustrates levels that are considered overbought or oversold on the NYSE McClellan Oscillator.
The condition, illustrated by the red arrow in the chart, has not been fully worked out so there is still room for more buying. On a technical basis, oversold conditions typically occur after waves of selling that knock an asset out of balance with supply and demand creating a void that must be filled. They are measured by various technical indicators. I prefer the NYSE McClellan Oscillator.
As you can see in the above charts when there is an oversold or overbought condition that reaches an extreme, it is typically corrected and often with violent reverberations throughout the markets.
Downtrend to continue?
Even as the oversold condition resets, it is unlikely that we have seen the last of the selling. Global market conditions are worsening. Sovereign debt defaults, EU stability and China’s perceived slowdown are at the forefront of concerns by market participants.
Typically there is a large bounce that resets the oversold condition to neutral or even overbought and then the downward volatility will continue, assuming that the market is going to continue to keep its eye on the powerful headwinds a global recovery faces.
Fundamentals failing
So far the rally since March of 2009 has priced in what economists call a “V-shaped recovery”. That is to say, a powerful drop and an equally powerful recovery. In order for this theory to play out there must be improving macroeconomic fundamentals, but instead the exact opposite is occurring as the fundamentals deteriorate.
This chart shows US government debt is climbing fast and already at multiples of our GDP.
Western government debt is soaring much faster than any GDP growth. The GDP growth projections are just as unrealistic as the expectation that a debt crisis can be solved with more debt.
A pronounced fear is building up that this surge in global stock prices we’ve seen for the last year may have been nothing more than a mirage without a basis in reality. It’s likely that massive tax increases and spending cuts across many governments are going to be inevitable. Such actions will crush the economies of those countries and create more problems for the global economy.
Unemployment continues to stay at high levels. In the US unemployment as measured by the Department of Labor U6 survey is at 17%, meaning over 1/6 people cannot find enough work, if any. U3, a more conservative measure is close to 10%.
These levels of unemployment are devastating to everyone trying to support themselves financially. Another effect is that it creates a vacuum of sustainable durable or discretionary spending now and in the future hurting businesses everywhere.
The coming correction
At some point there is going to be an even more significant correction than what we’ve seen so far. One that brings asset prices back in to parity with fundamentals.
While zero percent interest rates and government bailouts may have buoyed the markets, they have not improved the economy. Some would say these actions actually damaged the economy because the failing companies were not allowed to dissolve.
As the flight to safety occurs we may see an appreciation in US Treasuries, US Dollars and perhaps even gold. The Japanese Yen will probably also appreciate, damaging the nation’s ability to be competitive with its export prices.