Are risk assets oversold?

US equities may be approaching a turning point, and Facebook will be a key test.

PORTFOLIO POINT: US equities appear oversold, but with markets vulnerable and Europe's situation uncertain, the Facebook IPO should provide a key to what’s ahead.

From January 1 to May 1, the S&P500 climbed 11%; in two weeks, it’s dropped by 7.5%. The S&P is still up for the year, but European stocks and commodities are now in the red.

The US market is currently very oversold, as are many other risk assets such as the Australian dollar, but the market refuses to rally. Apart from an oversold market, we now have a bearish sentiment reading from the American Association of Individual Investors, which in the past has identified a market bottom.

The American Association of Individual Investors asks investors the following question every week: "I feel that the direction of the stockmarket over the next six months will be'¦?”. They have a bullish poll and a bearish poll. I subtract the bearish poll from the bullish poll to come up with a bull/bear index.

Being a contrarian indicator, high readings indicate that the market is overly bullish and can indicate tops, while low readings can often indicate market bottoms. This indicator is a leading one, so some caution is warranted in terms of timing. However, you can see last night’s reading of -22.39 was equal to last September’s reading of -22.

Perhaps the market finished so badly due to Facebook raising $US16 billion (the top end of the range), which sucked the life out of the rest of the market. Facebook hits the boards tonight, going into a weekend at a time when markets look very vulnerable and with Europe teetering on the brink. This will truly be a face-off.

On March 28, Apple closed at 617 and I brought to your attention an article in the Sydney Morning Herald titled 'Apple’s devoted shareholders get rich, and hang on’.

"I know there is so much euphoria around Apple, but it's very hard to sell a stock which seemingly has its products in everyone's hands," said Matt Reiner, a 25-year-old financial adviser whose investment in 40 shares of Apple has gained about $US11,000, who knows he should get out while the going is good.”

Oh Matt, I hope you sold; Apple has broken the key 550 level and like every other asset in the world, is heading for its 200-day moving average.

The chart below of the Barclays Capital High Yield Bond ETF is something else investors are fleeing. In a risk-off scenario, investors shun high-yield, high-risk bonds. As you can see on the chart, the ETF has now made a new lower low after making a lower low and lower high. The trend is now down, although this ETF is getting oversold like the rest of the market.

The Russell 2000 Index is comprised of the smallest 2000 companies in the Russell 3000 Index and has just confirmed a very familiar head and shoulders top formation and crashed last night to its 200-day moving average. This is another bad omen for risk assets, but it too is oversold.

The world’s biggest earth mover is in free fall and sliced through its 200-day moving average like a hot knife through butter. Caterpillar is telling you that the global growth story is grinding to a halt.

If you are not scared by now, you should be. Investors should be as defensive as possible. That means cash, and if you must be in stocks make sure they are defensive with a high dividend and be prepared to weather the storm, because a storm is coming.

For traders that are short, you might consider covering down here, due to the severe oversold state of the market, and look to sell the rally. For interest sake, the percentage of stocks trading above their 10-day moving average is just 7% and above their 60-day moving average is 17%; both levels are getting extreme, but do not guarantee a rally.

Below is the chart of the S&P500 futures. From its May 1 high to last night’s low, it has fallen 112 points. The 50% to 61.8% retracement level is 1355 to 1368, which would be the ideal level to sell again. However, I would keep something on for some insurance as this situation feels bad.

Tom Lovell is an independent strategist, trader and adviser with boutique advisory firm Pulse Markets and is the author of Lovellslandscape. His note is prepared for general information only. It does not have regard to a reader’s specific investment objectives, financial situation and/or his/her particular needs regarding the appropriateness of investing in any securities or investment strategies discussed or recommended herein. Readers should understand that statements regarding future returns may not be realised. So please do not act on any recommendations in this report without seeking independent advice.

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