I keep a daily candlestick chart amongst my mix to keep an eye on individual candlestick formations. Candlesticks can be a valuable tool to incorporate in addition to your initial trend and formation analysis. Right now the S&P500 is approaching its old highs, and is showing signs of an overbought market. Momentum studies are almost back to their overbought levels, and we are approaching the “Sell in May” time.
In addition to these factors, I note that the S&P gapped up 4 days ago. I’d encourage you to click on this link to read my primer on gaps from March.
In a nutshell, my work shows that gaps are often, but not always, filled. This is because a gap-up represents a moment over-optimism. Gap- downs are signs of momentary irrational pessimism. They too can often (but not always) be filled.
I note on the chart below – click for a larger image- that we got a bearish daily candle signal yesterday. An inverted hammer formation occurs when the market rises during the day, but settles to a low by the end of the day to create an open and close near the bottom of the trading range. Inverted hammers signal that the market is starting to change its mind about the recent rally. Inverted hammers are the opposite of bullish hammers – where the market moves lower through the day but ultimately starts and finishes near the top of the range. This can suggest that market players are changing their mind to a more bullish bet after a market washout.
Given the bearish hammer (lower close after some upside action) of yesterday, and taking into account that the market might have over-reacted to the positive 4 days ago – which formed a gap up – I’m wondering if the market may indeed be setting up for some type of selloff. Whether that reversal – should it happen- merely fills the recent gap and the S&P moves sideways or up from there – or if the market sells off further than that – is a question that nobody can answer. It does seem to me that no matter how it plays out, the risk for a pullback has increased.