Overhanging Supply – Where Is It Coming From & What Happens Next?

Click Here For Wyckoff Wave Chart 10-05-12

The stock market, as measured by the Wyckoff Wave, has spent most of the last two months in two long, slow, tedious reactions.  The first came after a Sign of Strength that took the Wyckoff Wave to the top of the 2012 trading range.  The reaction was to a Last Point of Support and put the Wyckoff Wave in a position to move into new high ground (jump the Creek).

That happened and, as expected, the Wave then needed to react back to the resistance/support at the top of the 2011 trading range on reduced spread and volume.  This is also known as the backup to the Creek.  Once this was completed, the market could begin its mark up phase.

However, this process has taken much longer than expected.  The culprit seems to be a tremendous amount of overhanging supply.  Overhanging supply is basically shares purchased at a higher level by entities or people who now wish to get out even or at a small loss.

To understand this better, we need to go back as far as the 2000 highs, or the end of the “Tech Bubble”.  To better understand the concept, it is important to remember that the Wyckoff Wave displays results. The Optimism – Pessimism Index, which is a pure volume index, represents effort.

At the top of the 2000 “Tech Bubble”, the Wyckoff Wave was at 38,000.  The O – P Index was at 20,000.

Fast-forward six years to the top of the 2002 – 2007 bull market.  The Wyckoff Wave is now at 40,000, but the O- P Index has rallied all the way to 57,000.   The Wyckoff Wave had an overall gain of 5%.  The Optimism – Pessimism Index gained 285%.  That represented an unbelievable amount of effort with marginal results.

Everybody was trying to get in and that includes many large investors like mutual funds and pension plans.  However, the market was not responding with the same level of enthusiasm.  That’s why they call it a bubble.

Suddenly, the bubble burst and the market crashed.  The Wyckoff Wave reacted from 40,000 all the way down to 14,750, or 64% .  However, the O – P Index reacted to 47,000.  This was only a loss of 18%.

Wyckoff students who paid attention to the O – P Index and the tremendous amount of effort it showed with little results, were well prepared for the 2008 bear market.  It is absolutely wonderful how the Optimism – Pessimism Index and the other Wyckoff Tools bring marvelous insights to the stock market’ s future direction..

Unfortunately, many large entities were not nimble enough to sell stock and ended up in the situation of having to “ride it out”.  This left millions and millions of shares in the weak hands of institutions and organizations that were now wishing and hoping they could somehow get out even.  This is the overhanging supply.

Last July at the top of the Sign of Strength, the Wyckoff Wave reached a high of 32,383.  It was back at the old distribution areas we saw in 2000 and 2007.  These distribution areas are marked on the attached weekly chart of the Wyckoff Wave.

Finally, stock that has been bought during the “bubble” could now  be liquidated.  Since there was a tremendous amount of stock, as represented by the Optimism – Pessimism Index, it’s taking longer than expected for those quantities to be absorbed back into the market.

The good news is that as all the stock is being unloaded, it appears to be taken in by stronger hands who expect the market to move to the upside.  Evidence of this is the market’s inability to strongly react.  So far, it has followed the perfect Wyckoff concepts of backing up to a Last Point of Support.  In fact, it’s done it twice.

Where do we go from here?

On September 28th, the Wyckoff Wave had backed up to the Creek and tested the short term down trend channel at point A.  The Technometer was in an oversold condition and there were positive divergences in both the O – P and Force Indexes.  This suggested the Wyckoff Wave was prepared to rally.

This week it did just that.  However, the rally was not particularly good quality.  Usually, rallies after an important Last Point of Support do not begin this way.

While the rally could continue, we are probably looking at one of two scenarios.

The first is that pesky overhanging supply is not yet dried up and the Wyckoff Wave needs some space to react and put in a good quality Last Point of Support.

The second is there is much more overhanging supply than expected and the Wyckoff Wave will successfully tests point X and react back into the trading range.

While the second is always possible, the behavior of the Wyckoff Wave over the past several months continues to support the first scenario.

The Wyckoff Wave weakened the short term down trend channel.  It will test the support line of the channel on a reaction.  In addition we will also see support at the creek and the halfway point of the W – X rally.  Finally there is a very important intermediate-term support line drawn through points L and W.  A tremendous amount of supply will need to be dropped on the market, and not taken in, before all of the support areas collapse.