It's the Wall Street knee jerk reaction. The market gets oversold and buyers come in and the market bounces higher. It is really quite simple and quite effective until it isn't. Of course, when it fails to work, we get all sorts of angst from our stewards of the market (i.e., Federal Reserve and others). But more importantly and for our purposes let's ask the question: what happens if an oversold market doesn't bounce and the selling continues?

The answer: oversold becomes more oversold, and like the overbought market that gets stuck in "overbought", a new trend is likely to form. In this case, it would be a downtrend. And that is the juncture this market finds itself in.

By most accounts, the market is short term oversold. Figure 1 shows a daily chart of the S&P Depository Receipts (symbol:SPY) with the McClellan Oscillator in the lower panel. The McClellan Oscillator is constructed from NYSE advance decline data. The indicator, which is a measure of market breadth or health, is at an extreme low, which is suggestive of an oversold market. After 5 days of losses on above average volume, other measures of market health and price based indicators are showing a market under strain. The market is oversold. Period. Albeit it is on a short term (i.e., daily) basis. Looking at figure 1, we can see how recent instances of an oversold market, as determined by the McClellan Oscillator, have coincided with the market finding support and subsequently moving higher. See orange vertical lines on graph.

Figure 1. SPY/ McClellan Oscillator/ daily

So this is how new down trends are made. If the market fails to bounce and oversold becomes more oversold, then this is the start of a new downtrend. Yes, the market is on edge. It is on the edge of having the majority of investors recognize that we are starting a new down trend, and the positions that they bought several days ago will likely be under water.

As an aside and a plug for our market timing service called "Premium Content", we had the down trend officially pegged several weeks ago. That research went into the concepts behind the article entitled, "Gaps Below Support are Never Good". Stay ahead of the market with Premium Content. It is best $104 you will spend on market research. To read more about this service, click on the navigation tabs above.