Our Sentiment Table and the Oversold Condition

March 30, 2015, 13:45 pm ET, BY Thomas H. Kee Jr- Editor, Stock Traders Daily| Editor: Thomas H. Kee Jr. (Follow on LinkedIn)

Sometimes identifying and taking advantage of reversals in the market before they happen seems like a pipedream, but there are ways to do this, and the process can be very efficient when we use ETFs like ProShares Ultra Dow30 (ETF) (NYSEARCA:DDM) and ProShares UltraShort Dow30 (ETF) (NYSEARCA:DXD) to facilitate the activity.

How you ever wondered how some people pinpoint market reversals before they happen? 

If you are asking yourself why this is important, the best way to answer that is to say it is much better to get in the market right before it goes up than right before it goes down. 

First, it is important for us to identify the types of conditions that typically exist before a sharp reversal happens.  Those conditions are typically overbought or oversold conditions, and when those conditions exist probabilities suggest that sharp reversals in the market could follow shortly after.  An overbought condition would typically be met with a sharp decline, while oversold conditions are often followed with sharp increases.

There are a number of ways to identify overbought and oversold conditions, some people use options, volume, and statistical measures to gauge them, but I find that less accurate and often much more cumbersome than a very straight forward approach that I have used for years.

I have organized this approach into a Sentiment Table that is very easy to read, and I have provided an example of what Our Sentiment Table said on Friday below, interpreted it, and then explained how to do it yourself so that you can 'Keep it Simple' and identify these conditions with relative accuracy.

Before I continue it is also important to point out that any indicator that hopes o define overbought and oversold conditions can be wrong, so it is good to use an approach that has been right far more than it has been wrong.  They are not guarantees, nothing is, but it's good to have probability on your side.

Here is what The Sentiment Table looked like on Friday:

Sentiment Table

When I use the Sentiment Table to identify overbought and oversold conditions I use the Near Term Row exclusively.  Notice that the sum of all three columns in all three rows totals 140, and that is because I have 140 stocks in my focus list (I'll talk more about this later), and my experience has told me that when most of the stocks are strong on a near term basis the market is overbought and subject to decline, but when most stocks are weak on a near term basis the market could be poised for a sharp increase.  In such a case it may be a good idea to get in, as they say.

On Friday we had such a condition, and 113 of the 140 stocks were near term weak, signaling oversold.  Thus far the bounce back has been solid, exactly as the tool would have us suggest.

Reading the Table is as easy as that, but here is how to produce it yourself.

1. Develop a list of 140 or so stock that you have identified as being highly correlated to the market over time.  DO NOT pick stocks that have little or no correlation to the market.  Remember, the objective here it to produce a tool to help you identify market moves, so correlation is good.
2. Create 3 columns that define near term, midterm, and long term strength in each stock.  For near term I use 5 days, midterm is 20 days, and long term is 6 months.  Track the strength regularly and update the columns to be weak, neutral, or strong accordingly.
3. When you find that over 100 of your 140 stocks are near term weak or near term strong you know that an oversold or overbought condition may be presenting itself imminently and it can serve you as a leading indicator of a market reversal accordingly.

I have been using this tool for years and I have found it to be very accurate.  It does not provide signals every day, it is limited to relative market extremes of course, that comes with the identification of overbought and oversold intuitively, but when it does provide a signal it certain has a high probability of being right.  This process will hopefully give everyone an opportunity to skew the probability of in deifying a market reversal in their favor as well.

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