Joshs Finance

Estimate Strength of the Stock Market Recovery. | by Paul Blazejewski | Apr, 2022 – DataDrivenInvestor

How to spot whether the reversal is real or fake and how strong it may be.

In this article I want to bring your attention to interesting indicators that can help you estimate a reversal from the bottomed market — especially major indices tracking S&P500 and Nasdaq. Such bottoms happen in all market conditions, give it bull or bear and can be caused by either news, black swan events or technical market structure. Recoveries of lows can tell you a great deal of where the market is going in the next weeks/months.

Hunting for stock or market reversals is extremely hard but can be very lucrative if spotted correctly. Especially in the current market environment where there’s a lot of uncertainty, every bigger dip fuels chatter that the bear market or a crash has started. So the idea is to stay away from the noise and look into what the data says.

This chart below is the 4-day breadth of the Nasdaq 100 (Technology ETF) that measures how strong the breadth is on the nasdaq 100 over last 4 days. Market breadth indicator analyzes the number of stocks advancing relative to those that are declining in a given index. Positive market breadth occurs when more stocks are advancing than are declining. On the other hand when there’s just a handful of stocks participating in the rally, you should know that it may not be a real or lasting very long.

Coming back to this indicator, large-cap technology stocks are critical to US economy so it’s important to keep a special attention to their behaviour. You can see below that there were just a few times in the history when the blue line has been crossed around 85 and it systematically corresponds to major bottoms and major beginnings of large moves up.

Late March we had one of the strongest readings on this indicator that tells us that the rally of the bottom was very powerful. Such a reading wouldn’t be seen in the bear market rally meaning that conviction about the continuation of the movement would be limited among market participants.

The broad thesis behind this is that we’ll see major leg up, possibly to all time high before the actual bear market begins. Usually such moves can be the strongest ever seen as there’s a lot of speculative action around the euphoria when market moves against the logical direction.

Aside of the long-term market development, let’s analyze this recent market correction more closely.

Zooming in just before the recent market reversal, notice how a relationship between the price action and RSI reading has played out.

$SPY chart and RSI 14-period daily reading between September 2021 — early April 2022

I’ve mentioned this already in one of the previous articles. You can observe that during this recent sell off lasting few weeks, the price action was making lower lows but the RSI (14-day period) reading was making higher lows. Such a divergence is an extremely powerful indicator of an expected strong move to the upside.

You may ask, what could be a stopper to not jump in during a first reversal over first few days of February? Price drop from late December to early February was one of those really powerful moves down where the price broke a few key levels of resistance and moving averages. Distance from top to bottom and then range of a bounce in a given short time interval has pointed to an increased probability of a false move. The double top — also highly accurate pattern of price tops in February was a great shorting opportunity indeed. Observe similar moves across stocks and indices, it’s quite common to notice such a behaviour and differentiate it as a healthy pull back followed by a true gap fill.

It all comes down to a good old truth in the markets you should keep in mind — never trust the first move.

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