Why stock-market bulls say ’embrace weakness’ after biggest stumble in 3 months

The Dow Jones Industrial Average
DJIA
dropped 475.92 points, or 1.3%, on Wednesday for its biggest one-day percentage drop since Oct. 3, ending a streak of five straight record finishes. The S&P 500
SPX
which had rallied to less than 1% away from its Jan. 3, 2022, record close, dropped back 1.5% to close just below 4,700 for its biggest percentage decline since Sept. 26; the Nasdaq Composite’s
COMP
1.5% drop was the largest since Oct. 26.

Both the Dow and Nasdaq had rallied for nine straight days before Wednesday’s setback. The rally, which had accelerated a move off the October lows, had left major indexes significantly overbought based on technical indicators, analysts said.

All three major indexes were solidly higher early Thursday.

“Most pundits concluded that the market was overbought and due for a correction. We agree, which is why we haven’t raised our longstanding year-end target of 4,600,” said market economist Ed Yardeni of Yardeni Research, in a note.

As noted in MarketWatch’s Need to Know column, Yardeni remains quite bullish over the long term, looking for the S&P 500 to hit 6,000 in two years.

Need to Know: It’s time to take profits, says strategist with top S&P 500 target for next year

Bullish sentiment had also moved to extreme levels, as measured by investor surveys.

Technicians note, however, that heavy bullish sentiment is a less reliable signal of market tops than heavy bearish sentiment is a signal of bottoms.

In a Thursday morning note entitled, “Embrace Weakness,” technical analyst Jeff de Graaf, chairman of Renaissance Macro Research, said a setback “in an uptrend with momentum is buyable.”

In the chart below, plotting future returns for S&P 500 futures
ES00,
+0.97%
versus the Consensus Inc. measure of sentiment, de Graaf notes the bar “is higher to be bearish” based on sentiment measures.

“We’re in the camp that any weakness, unlikely to be more than 3-5% is buyable for those with a [six-month] horizon,” he wrote.

Bears expect to see further weakness. Michael Kramer, founder of Mott Capital, argued in note after Wednesday’s close that the “entire rally has been built with a pile of very loose sand,” with the potential for the S&P 500 to fall back to 4,100 over the next several weeks.

The expiration of options contracts on the Cboe Volatility Index
VIX
on Wednesday likely contributed to the selloff, he said. Options activity had served to suppress the VIX, often referred to as Wall Street’s fear gauge. Elliott Wave analysis, a form of technical analysis that counts market waves, also points to a peak, he said.

Kramer cautioned that he didn’t want to get “too far out in front” with a downside call, noting that the rally has seen large, downside intraday reversals that failed to mark the top.

“At least this time, things seem to be in better alignment, given there is a count that works; the VIX is moving higher, and the S&P 500 can’t get more overbought than it has been the last couple of days,” Kramer wrote. “So again, if this is some top, it would make sense.”