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Overbought Breather or Something More?

By:

Chief Strategist at Interactive Brokers

Yesterday I was asked if the declines that we had seen in major market indices over the past two sessions was a pause after a rally that caused markets to be overbought, or whether the declines were the start of something more significant.  Unfortunately, I had to give a pithy 10 second response.  I offered the opinion that we were taking a breather from an overbought condition, though we won’t know the real answer for a few days or weeks because investors’ reactions to earnings season would be the main driver.  With more time to craft a response, I’ll offer a fuller answer to that question.

Two days does not a trend make.  Although yesterday marked the first time in weeks that we sustained two down days in a row, with the second being somewhat significant, all we did was return to levels last seen in the prior week.  In the case of the S&P 500 Index (SPX), we reverted to last Wednesday’s value.  In other words, we gained last Thursday and Friday, only to give back those gains on Monday and Tuesday.  That is neither a trend change nor anything remotely significant.  Consider this chart of SPX, which includes today’s bounce:

SPX 2-week chart, 15-minute bars

SPX 2-week chart, 15-minute bars

Source: Interactive Brokers

It is evident that SPX found support yesterday at last week’s lows, which were established on Monday and reaffirmed on Wednesday.  For those of you who believe that gaps need to be filled (in the era of nearly 24-hour trading, I find that concept to be obsolete), yesterday’s decline filled Thursday’s gap.  I suspect that I will hear from traders who believe that we could be forming a short-term head and shoulders top, but until or unless the index declines to form a neckline by testing support around 4110 over the next day or two, I would dismiss that idea.  Quite frankly, I have found that prematurely looking for head and shoulders patterns before they fully develop is a fantastic way to lose money. 

The pattern in the NASDAQ 100 Index (NDX) is a bit murkier.  We see a gap open on Monday that was filled on Wednesday, and a similar gap on Thursday that was filled yesterday.   

Source: Interactive Brokers

To the index’s credit, traders have managed to shake off disappointing earnings from Netflix (NFLX) to push NDX higher today, but the rally pales in comparison to NDX.  A saving grace is that the “N” in “FAANG” has been far outpaced by the other letters in that acronym.  The combination of Facebook (FB), Apple (AAPL), Amazon (AMZN) and Alphabet (GOOG, GOOGL) now accounts for about 30% of the market capitalization of NDX, while NFLX accounts for just under 2%.  NFLX occupies a significant amount of tech traders’ mind space, but it is now only the 13th largest holding in NDX.  It is far more important that AAPL, with over 11% of NDX’ market cap, sank modestly on yesterday’s product announcements and is essentially unchanged so far today. 

That is why earnings remain the challenge ahead for markets.  The top ten stocks in NDX represent about half that index’ weight, and they have yet to report.  Those stocks also represent about a quarter of SPX as well.  So far, we have seen about 15% of the constituents of SPX report.  It is fair to say that investors’ responses have been lackluster, despite the vast majority having beaten their estimates.   Investors are only modestly rewarding some earnings beats, while ignoring many others.  The rewards have gone to companies who left virtually no room for complaint, like Goldman Sachs (GS), and those who posted solid results after numerous disappointments, like Wells Fargo (WFC) and IBM.  We have not yet seen how markets might react to the market-leading, mega-cap tech stocks that have either propelled or supported the major indices over the past year.  Until we get a sense of whether investors will be satisfied by earnings reports from the major market components, we can’t really offer much guidance about the direction for markets in the upcoming weeks.

Stay tuned.

Disclosure: Interactive Brokers

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