Generally speaking, overbought or oversold extremes in sentiment are consistent with inflections in equity prices. Both Jason Goepfert (of Sundial Capital) and Bob Prechter (of Elliott Wave International) have each noted recently that the inability of prices to reverse course following extremes in sentiment is indicative of the strength of the tendency underway. Follow through, rather than a reversal is more likely under this circumstance. The Exhibit below highlights two occasions this year that illustrate this phenomenon.
The two periods featured in yellow on the chart show that for both the July decline and the October rally, the extremes in sentiment confirmed the strength of the moves already in process rather than signaling that these streaks had more-or-less run their course. In fact, the vast majority of the steep July-August decline low took place after short-term sentiment began arguing for an advance. Similarly, more than half of October’s gains accrued after short-term sentiment reached overbought levels.
Interestingly, the SentimenTrader.com Short-Term Indicator Score registered an oversold reading after the November 19th session. The index lost almost 3% during the week that followed. Thus, there appears to be another disconnect developing between short-term sentiment and price action. If the past provides any prologue, the implication is that there is yet unfinished business to the downside.