Rally Sign? Market Most Oversold Since Financial Crisis

Stocks are at their most oversold levels since the doom days of the financial crisis and may be due for a rally, according to one measure.

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NYSE Trader

Though the relative decline seems tame in comparison, the 7 percent drop since early April in the S&P 500 index compared to recent trends is on par with tumbles during the financial crisis, as well as low points during four previous market corrections over the past decade, according to Bespoke Investment Group.

In total, the S&P 500 is now three standard deviations from its 50-day moving average. A standard deviation is a measure of how far results vary from the expected average. A reading of three is not exactly the territory of Black Swans, which author Nassim N. Taleb explored in his book of the same name, but it still pushes the level of the expected.

Bespoke says five of the S&P 500's 10 sectors are three standard deviations from their 50-day average.

"This is as oversold as they have been at the lowest points that the market has seen going back to even the financial crisis," Bespoke's Paul Hickey said. "We simply haven't gotten more oversold than this versus the 50-day."

Indeed, Wall Street was preparing for a higher market open Friday, propelled in part by enthusiasm over the Facebook IPO, but also likely because of the extreme oversold conditions.

To be sure, though, not everyone agrees that a rally is coming.

Abigail Doolittle, the Peak Theories Research founder and frequent guest on CNBC's "Fast Money," says charts, particularly those of the U.S. dollar, indicate a "potentially devastating correction" is on the way "and probably soon" that could drive the 10-year U.S. Treasury yield below 1 percent on a flight to safety.

Doolittle says the S&P could fall 18 percent to as much as 44 percent.

But Hickey points out that a line that measures the 10-day advances and declines of stocks also is at a low point not seen since the 2008 crisis. Also, he points out that sentiment readings are around levels of the 2001, 2008, 2010 and 2011 stock market corrections, defined as losses of 10 percent or more.

The American Association of Individual Investors reported Thursday that bullish sentiment — expectations that the market will rise over the next six months — came in at 23.6 percent last week, its lowest reading since Aug. 26, 2010. Bearishness, meanwhile, surged to 46 percent, its highest show since Sept. 29, 2011.

As for investor behavior, money continues to pour out of stocks and into bonds.

For the week ended Wednesday, mutual funds that track U.S. stocks — a popular destination for retail investors looking to invest in equities — lost another $2.4 billion, according to the Investment Company Institute. Bond funds gained a whopping $7.6 billion. For the year, bond funds have taken in about $135 billion while stock funds have lost $15 billion.

Including exchange-traded funds, which have taken a bite out of the mutual fund market because they are easier to trade intraday, stock funds lost $3.1 billion in April while bonds gained nearly $27 billion, according to Lipper.

Because of the oversold readings and the dour outlook among investors, Hickey believes a rally is close at hand.

"We may see another down day or even two more down days," he said in a note, "but all of our historical research suggests that we’ll be higher a week and month from now than we are now."

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