The following is an excerpt from Richard Russell's Dow Theory Letters
Guest post by Jon S. Strebler
"Well, when events change, I change my mind. What do you do?” – economist Paul Samuelson
What happens when markets get over-bought? The answer is supposed to be: They go down. Yet most of us have been around long enough to know that things don’t always work out as they’re “supposed to.” So maybe it’s not much of a surprise to learn that over-bought markets, such as the US stock market today, frequently continue to go up, rather than drop.
That’s the unexpected result of some analysis I recently completed on the Dow Industrials over the last 5 years, based on the weekly RSI, a momentum indicator often used to gauge when markets are over-bought or over-sold. The idea with this chart is that as the RSI (the top line on the chart below) approaches 70, it enters the over-bought zone and “should” therefore have trouble going any higher. So how’s that theory worked out? The short answer is: Not so hot.
To see why I say that and, more importantly, to understand the value and limitations of measuring over-bought and over-sold, check out the following table. Identified here are the ten instances where the RSI first exceeded 70 in the last 5 years or, as in the cases of 2008 and 2009, where it came close to 70 before dramatically dropping. In each case, we see the Dow’s approximate value when that occurred, and the approximate gain or loss one year later (where relevant, shorter-term results are also shown).
So – WOW! The data show that, with the exception of the Great Collapse of 2008, the U.S. market, over-bought according to RSI (or just about any other measure) was either unchanged or higher a year later. Often – a lot higher. During the summers of 2009, 2010, and 2011 -- the market’s “weak” six months of the year, historically – the Dow did take a big tumble. But even in those cases, it was higher a full 12 months after the RSI danger signal.
This tells us a couple of things. First, it confirms that, following the disastrous 2008 stock market collapse, we’ve been in a bull market. Being over-bought in a bear market tends to bring different consequences, i.e. big sell-offs, compared to the same condition in a Bull Market. Thus, the second thing it tells us is that avoiding the stock market – this stock market, today -- because it is “over-bought,” may not be a great decision.
Yes, there are problems galore: the debt, the dollar, Europe, QE∞, and so on. There always are. That’s the basis of Richard’s old saw: Bull markets climb a wall of worry. And we are both troubled by the fact that stocks are hardly fundamental values, as described in my first column here a few weeks ago.
But it is a bull market by virtually any definition, including the fact that the last Dow Theory signal was a Bullish confirmation on January 18th (see Richard’s comments on this from Letter #1520). It’s not really surprising that the Industrials have failed to match the recent all-time highs of the Transports (until today!), as both Averages have played leap-frog over the months -- one making new highs, then the other doing so a few weeks or months later. And it’s common for markets to take awhile to finally break above key resistance areas, such as the Industrials’ 14,164 all-time high. The Industrials might take several weeks or even months to reach new highs. But the odds are that it will happen.
Richard hit the nail on the head last week by writing: I'd have to say that this is a market that has had every opportunity of going down, but it's a market that has no intention of heading south….It's the oldest story on Wall Street -- when a market refuses to go down, it takes the other direction -- and it goes up(Richard’s Remarks, 2/28/2013). The trend has been up and other than “over-bought” indicators, nothing is telling us that is about to change.
Is there enough upside potential to warrant the risk of buying here? No one ever knows how far a bull market will go; markets often surprise us on both the upside and the downside. But this longer-term P&F chart, using 200 point boxes and a 4-box reversal, shows the Industrials’ explosive potential. StockCharts.com shows an upside “count” or target of 17,200, some 3000 points higher. P&F counts may not be particularly reliable, but they do give us some idea of the Dow’s potential; it is substantial in this case.
Readers shouldn’t load up on stocks here, after 4 ½ years and 7500 points of a rising market. But let’s apply Richard’s new optimism to the stock market. The proper procedure for most investors (which we’ll look at more next week) is to own at least some stocks during a bull market. That suggests that all but the most conservative readers should own some stocks here. And as long as the big trend remains bullish, plan on adding to that position on market sell-offs. Because the weight of evidence is that by doing so, you’ll be worth more a year from now than you are today.
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