Monday, April 20, 2009

The Most Overbought Market At Least 23 Years?

I’ve seen it pointed out a few places that the number of stocks above intermediate-term moving averages (40 or 50-day) is now at an extreme level. I’ve done some testing in the past and found such indicators to be of limited value. Worden Bros. has several indicators that show the % of stocks trading relative to the 40-day moving average. In addition to the simple % above/below, they also show how many are at least 1 and 2 standard deviations above and below the 40ma. I believe these indicators are more telling. I’ve found this information to be especially useful in looking at extreme selloffs and have compared the % 1-standard deviation below the 40-ma indicator (T2114) to my Capitulative Breadth Indicator (CBI). (Click here for that post.)

Part of what gives the CBI and T2114 their effectiveness is the propensity for sharp and powerful short-covering rallies to emerge from such extreme conditions. In developing the Catapult method and CBI indicator I was unable to find an overbought equivalent. Of course the market is dealing with different emotions near tops than it is near bottoms. Fear, which is prevalent near bottoms, is much more powerful than greed, which is prevalent near tops.

So the question then becomes, since there is no CBI reading for extremely overbought, what might the Worden 1-standard deviation measure suggest when it gets extremely high? As of Friday it was certainly extremely high. Over 80% of stocks closed at least 1 standard deviation above their 40-day moving average. Worden Bros. maintains data back to 1986 and this is the 1st time the indicator has cracked the 80% level. I looked at other overbought levels to study the 1-month returns following some less-extreme readings.


As you can see above, returns have generally been positive following other times the indicator has reached extreme levels. On the low end the results are about the same as the long-term market drift. While not shown, periods leading up to 20-days are also all generally positive. As the indicator moves higher the results look even more bullish. But instances are incredibly low, so not much can be extrapolated. I see two points to take away from this exercise: 1) When the market gets extremely overbought that is not necessarily a bad thing, and on its’ own is certainly not a signal to sell short. 2) By this measure the market is now more overbought than it has been in at least 23 years.

The most overbought ever would seem to suggest the market is unlikely to continue to rise at anywhere near its recent pace. On the other hand, those expecting a sharp, sustained selloff from here had better be basing their expectation on evidence other than just overbought breadth.

6 comments:

Panama said...

This seems inconsistent with the idea that bear corrections from overbought conditions are often sharp and short relative to bull corrections from oversold conditions 'The bull climbs up the staircase with the bear jumps out the window'. It may be due to the different nature of top's and bottoms and the overbought/oversold signals used.

I see Fear and Greed as about the same thing - Greed being simply a derivative of Fear - the fear of missing out (opportunity cost versus out of pocket cost) so perhaps it's unrealistic to use precisely the same metric to describe/compare and determine tactics for overbought and oversold markets.

I look forward to your thoughts
Cheers

TraderPsyches said...

"I see Fear and Greed as about the same thing - Greed being simply a derivative of Fear - the fear of missing out (opportunity cost versus out of pocket cost)" - in coaching many traders of all stripes we have found this to be true.

Also from a neuroecon angle, the brain tends to default to expecting same result tomorrow as got yesterday, this drives overbought and OS IMO.

Guru said...

Interestingly, the immediately previous extreme reading of T2110, &1 Chan Above 40 Avg, was June 5, 2003 when the S&P 500, at 990, had just bottomed from the Tech Bubble Crash with a 23% run.

The Index leveled off for 2 months, correcting about 6-7%. But when the correction ended in August, the Index added another 20% to Feb, 2004.

Hopefully, this correction will be the same as 2003.

Rob Hanna said...

I believe fear and greed are vastly different and not near mirror images of each other.

The example with the strongly overbought / strongly oversold breadth indicators in this post provides some proof of this.

If greed were a mirror image then the statistics would be strongly negative based on the overbought readings just as they are strongly positive when the market becomes severely oversold.

I will be happy to discuss this more and provide further proof in some posts in the near future.

Rob

Daniel said...

I disagree with Q. and agree with Panama’s exact assessment--Greed is a “derivative of Fear”. It is NOT the opposite of Fear, it is a metabolite, a similar, derived chemical compound.

I agree with Rob that if greed were a mirror image then the statistics would be etc. etc., as he indicates. But overbought and oversold phenomena differ more because of variance in relative-simultaneity of decision process. Sell decisions are more monadic-- ie, Get Me Out. Buy decisions on the other hand involve a concept of WHICH... which choice shall I buy. Hence topping will always be non-parallel to bottoming.

The opposite of Fear is not Greed, but Love.

Daniel

Celal Birader said...

"...those expecting a sharp, sustained selloff from here had better be basing their expectation on evidence other than just overbought breadth."========================
just a couple of points to put into the mix :

1) volume during this rally has been light

2) heavy insider selling recentlycould be proved wrong. time will tell.