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Tomi Kilgore
Dec. 23, 2010, 12:01 a.m. EST
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By Tomi Kilgore
NEW YORK (MarketWatch) "” Overbought conditions can warn of a pullback in the short term, but they shouldn't be viewed as a sign that the longer-term uptrend is over. In fact, they can actually reinforce it.
The S&P 500 Index /quotes/comstock/21z!i1:in\x (SPX 1,255, -3.44, -0.27%) closed up 8 points at 1,255 Tuesday, the highest level seen in more than two years. Meanwhile, the index's Relative Strength Index, an underlying technical indicator comparing the strength of up days to weakness on down days, rose nearly 3 points to 71.26.
The RSI oscillates between zero and 100, with moves above 70 believed to indicate an overbought condition, and declines below 30 suggesting prices are oversold. But meaningful market tops and bottoms don't occur simply because technical indicators reached overbought or oversold extremes. The ability to reach those extremes helps support the longer-term trend.
Heathrow's Chief Executive Colin Matthews has decided to forgo his annual bonus because of the snow delays at the airport. Video courtesy of Sky News.
For example, after rising above 70 briefly in May 2007, the RSI could only get back to a high of 68 in October 2007, when the S&P 500 hit its all-time high of 1,576. There were a few double-digit percentage rallies during the 2008 bear market, but the RSI didn't get back to overbought territory until July 2009, when the S&P 500's breakout to a nine-month high confirmed the start of the next bull market.
Subsequent RSI moves above 70 led to some minor pullbacks, as well as the double-digit percentage correction that began in late-April 2010. But when the index was falling to a 10-month low in early-July, amid concerns over European sovereign debt and slowing economic growth in the U.S. and China, the RSI bottomed out at 30.11.
So while stocks may seem overdue for some short-term weakness, there is a longer-term silver lining. Like MKM Partners chief market technician Katie Stockton wrote in a recent research note, while the S&P 500, and most of its components are technically overbought, the index's ability to continue to forge higher is a "phenomenon that is characteristic of strong and sustainable uptrends."
The index's close above 1,250 on Tuesday clears the way for further gains to the 1,300 to 1,310 level, where there were several intraday highs from early-August to early-September 2008. Above that, there might be some resistance at 1,365, but the next key level is the May 2008 high of 1,440.
If there is a pullback, there should be buying interest around the early-November highs around 1,225 to 1,230. But the major support area is 1,200 to 1,205, which includes several intraday highs in late-November and the 50-day simple moving average.
A growing number of chart watchers are saying that an anticipated pullback should be viewed as a buying opportunity. Based on the Wall Street axiom that if too many people expect something it probably won't happen, the S&P 500 could either fall a lot more than expected or perhaps not pullback at all.
The index's breakout gain on Tuesday in the face of the RSI's move into overbought territory suggests the latter may now be more likely.
Tomi Kilgore writes Taking Stock, a column featuring insightful analysis of equity-related topics around the world. This column originally appeared on Dow Jones Newswires.
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