After eight consecutive weeks of gains, it is time to consider when strength becomes exhaustion in the stock market.
Overbought Eventually Means Overbought
SPDR S&P 500 (NYSE: SPY) closed up 0.11% in a holiday-shortened trading week. This was the eighth time in a row SPY posted a weekly gain. It was also the smallest weekly gain in the winning streak and the second week in a row the rate of change has declined.
The concept of overbought is a challenging one, and traders have spent countless hours trying to understand it. Many indicators, such as stochastics and Relative Strength Index (RSI), are used to define an overbought market, but they all share a common flaw. At the beginning of a very strong up move, markets become overbought and stay overbought.
The chart below demonstrates the challenge of defining when a market is overbought. SPY is shown with the stochastics indicator. The monthly chart is used to decrease the sensitivity of the indicator, but similar patterns can be seen on weekly and daily charts.
Stochastics became overbought in 2003 and remained overbought until the end of 2007. Bollinger Bands(r) confirm that SPY was overbought throughout that time as prices stayed close to the upper Band throughout the advance.
In the current market, stochastics are once again overbought and have been since early 2012. Prices are near the upper Bollinger Band. But the only potential warning sign of lower prices is the extended winning streak we have seen in SPY.
Overbought market conditions only become a problem when there is an absence of buyers. Once again, I am using an oversimplification to illustrate an idea. There will always be buyers and sellers in any market, but when the sellers are acting with more conviction, prices will fall.
As we enter December, SPY is up about 30% year to date. Now is the time when we will start seeing studies about how markets have delivered below-average gains in the year after such a large return. These reports could influence some investors to hold cash while waiting for a better buying opportunity. This could be an example of how we run out of buyers in this stock market.
Eventually, an overbought market falls, and the longer it remains overbought, the more likely we are to see a decline. After eight weeks of gains, a pullback is expected. SPY has had three other winning streaks of this length, and each one was followed by a pullback the next week.
Gold Reaches a Critical Level
SPDR Gold Shares (NYSE: GLD) gained 0.65% last week as prices found short-term support near $120.
This is an important price on the chart of GLD. A break below $120 would have a downside target of $105. This is based on the September highs near $135. The difference between that high and current support provides the target $15 below the current price level.
In order for the pattern to turn bullish, we would need to see a significant gain in the price of GLD. A break above $132, just above the most recent high in late October, could signal a bullish reversal in the short-term trend.
Risk outweighs the potential rewards for now, and new investments in gold should be avoided.
This article originally appeared on ProfitableTrading.com:
Market Outlook: Stocks Shifting From Strength to Exhaustion?