Stock prices, as measured by the SPDR S&P 500 (NYSE: SPY) have fallen about 8% in the past two months. Traditional technical indicators now say that SPY and other stock market index exchanged-traded funds (ETFs) are oversold, a condition that could lead to a short-term price rebound. In addition, sentiment has reached a level that is usually seen near short-term market bottoms. We last saw this combination of indicators in July, and a six-week, 10% rally followed.

At the bottom of the chart, the 26-week rate of change (ROC) is being used to measure momentum. Bollinger Bands have been added to highlight extremes. Bollinger Bands are calculated during the last 50 days and use 2.1 standard deviations, the settings recommended for use with indicators by John Bollinger in his book, Bollinger on Bollinger Bands. Oversold levels occur when the ROC drops below the lower Band.

Sentiment is often measured by surveys. The American Association of Individual Investors (AAII) questions individuals every week asking if they are bullish, bearish or neutral on the market. The most recent survey shows that only 28.8% of individuals are bullish and 48.8% are bearish. Long-term averages show we would normally see about 40% bulls and 30% bears.

With bulls at a four-month low and momentum oversold, a rally could be expected and seasonal tendencies reinforce that outlook. The S&P 500 index has been up in December 74% of the time since 1928. This is the strongest performance seen in any month of the year.

The recent sell-off has done some damage to the technical picture for most stocks and sectors. Of the nine major SPDR sector ETFs, only three are above their 200-day moving averages. Among those three, Consumer Discretionary Select Sector SPDR (NYSE: XLY) seems most likely to outperform in the next four to six weeks.

The chart above shows that the two-week RSI has fallen below 15 for XLY. This happens about three times a year on average, and 23 times in total since XLY began trading. One month later, XLY has been higher 61% of the time. The average one-month gain has been about 3%, while the average loss has been about 1%. Additionally, on a seasonal basis, XLY is even stronger than SPY having closed up 77% of the time in December.

Using the 200-day moving average at as a stop, the risk is limited on this trade. The moving average is at $44.58, which is less than 1% from the current price and in line with the historic average risk on this trade. The profit target is $46.25 based on a 3% price move, again using the historic average to find the potential reward of the trade.

Traders willing to accept more risk on a dollar basis can consider options. January $44 call options are trading at about $1.70 and would be worth at least $2.25 if XLY reaches the target price for a 32% gain. A stop-loss level of $1 should be used with the call options. This trade carries higher risk compared with a stock purchase; however, the higher potential percentage gain could make it more attractive to some traders.

Stocks may be in the beginning of a bear market, but this trade could work even if further declines lie ahead for the market, as December is historically a good time to own stocks. Even in the bear market that started in 2008, both SPY and XLY delivered small gains to traders. 

Action to Take –> Buy XLY at $45.25 or less, set the stop-loss at $44.58 and set a profit target at $46.25 for a potential 2.2% gain by year-end. You can also buy XLY Jan 44 Calls at $1.80 or less, set the stop-loss at $1 and set a profit target at $2.25 for a potential 25% gain in two months.