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Stocks come into the new week oversold on a short-term basis and nearing potential support levels. Widespread selling last week led to greater than 2.5% declines on the Russell 2000 and S&P 500 and has left the Dow Industrials down slightly on what is indeed turning out to be a year of transition.

This, combined with some evidence that investor sentiment is shifting toward pessimism (see the chart below) may be sufficient to prompt a new round of buying in stocks. However, with the damage that has been done to the trend, lingering uncertainties about whether the economy can get and stay in a higher gear, and seasonal patterns that could become self-fulfilling, there is increased risk that the buy-the-dip mentality that has supported stocks over the past year-and-half could be vulnerable.

Breadth weakness is increasingly becoming a headwind for the popular averages. This week’s update shows the percent of industry groups in up-trends plummeting to the lowest level of the year, and the number of stocks making new 52-week lows continues to climb steadily higher. With breadth deteriorating even prior to last week’s selling, the quality of the rallies that emerge is critical.  

How far they are able to go, and what kind of participation they attract matter much more than the relative ugliness seen on down days. If the up-trend has expired, it is too early to look for evidence of capitulation. If it has not, the current oversold conditions could spark a robust rally that carries above resistance near 1970 on the S&P 500. A failure to break through that level, or to hold support in the 1920-1900 range, would add to the evidence that a cyclical peak is in place.

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Article provided by Robert W. Baird & Co. with the authorization of its author for Evan Guido, Vice President, Financial Advisor at the Sarasota office of Robert W. Baird & Co., member SIPC. The opinions expressed are subject to change, are not a complete analysis of every material fact and the information is not guaranteed to be accurate. 

Evan R. Guido

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