The U.S. equity market continues to look very bullish right now, but it’s also starting to enter into a territory a technical analyst would call “extended” and “overbought”. So I did some work today to determine how extended and how overbought the equity market might be. But before I do, let me quickly explain the difference between trending and trading markets. This will help define how important such an “overbought” and “extended” call may or may not be.
Stages Analysis
First of all, markets move in four stages:
- Basing Stage
- Advancing Stage
- Distribution Stage
- Declining Stage
We can even break those stages down into two: trading and trending. When a security or market is topping or basing, it’s typically trading within a narrow range as supply and demand begin to equal each other out. When a security or market begins to trend, that means that either demand or supply has full control over the primary direction. We use basic trend analysis to determine whether a security or market is in these two stages. Once we determine the stage, certain technical, breadth, and sentiment indicators can help us trade these stages.
Time Cycles
Beyond these stages, there are also time cycles.
- short term
- intermediate term
- and long-term
How you define each is subjective. One trader’s long-term may be 24 hours while an Investor may look at long-term as 90 days or a year. It’s important when discussing overbought or oversold conditions or buy and sell signals that we discuss these conditions in reference to a time horizon. Calling a 5-10% correction over a two-month time span is an incredibly different market call than a bear market bottom or a bull market top. Over the past three years, such 5-10% corrections were the basis for many bear market calls, even by some of the best traders I know.
Overbought/Oversold
When a security or market is “overbought”, I’m using trading oscillators like the Relative Strength Index (RSI) indicator and breadth indicators like the percentage of stocks above a moving average to make such judgment calls. What’s important is that these are not sell signals or, in the case of being oversold, buy signals. Instead, this is merely an exercise in discussing when we might begin to see supply pressure. Topping stages and bottoming stages are processes that take time to develop. Each stage may take place over an extended period in an overbought or oversold condition, or a very short amount of time.
*This is all to say that overbought and oversold calls are not an exact science, but in all things technical, an art.*
An Overbought S&P 500
When looking at the S&P 500, I believe we have entered into an overbought condition. As I mentioned before, I must be specific and base this on a time horizon. I’m viewing this call using two approaches, as mentioned before, based on a high RSI reading on the daily chart and on my breadth indicators – the percentage of stocks above a short, intermediate, and long-term moving average.
RSI
Stockcharts.com defines the RSI indicator as follows from their website:
“Developed J. Welles Wilder, the Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements. RSI oscillates between zero and 100. Traditionally, and according to Wilder, RSI is considered overbought when above 70 and oversold when below 30. Signals can also be generated by looking for divergences, failure swings and centerline crossovers. RSI can also be used to identify the general trend.” If you’d like to learn more, you can click on this link.
At 71.83, the RSI indicator has entered the overbought zone. This also is a sign of strength, as it means that there is significant bullish momentum to enter into such a condition. A security or market can last a good amount of time (say a month or two) in such a zone or for a short while (a couple of days or less). The last time the S&P 500 was overbought, was in September when the S&P 500 traded near 1475 for a short while and then corrected. How long we stay overbought before a correction is not known, but it increases the probability that short to intermediate term traders will begin to cash in their chips and supply the market with shares.
In addition to the overbought RSI indicator, the current trend resistance from the April 2012 peak to the September peak is here at 1500. Overbought conditions coupled with a resistance level are two things that should give any buyer pause. Finally, we have the 2007 top near 1550. That’s only 3.7% higher than where the S&P 500 closed today. In technical analysis, you always want to gauge your upside against your downside and trade where you have the best win ratio. If my upside is 3.7% and my downside support is the 50-day moving average near 1429 at the moment, or 4.3%, that’s not a great ratio. Trade when the ratio is in your favor, typically 2:1 or more!
Breadth
The other indicator I follow is a breadth indicator. The percentage of stocks above a moving average. Stockcharts.com defines this indicator as follows from their website:
“The percentage of stocks trading above a specific moving average is a breadth indicator that measures internal strength or weakness in the underlying index. The 50-day moving average is used for the short-medium term timeframe, while the 150-day and 200-day moving averages are used for the medium-long term timeframe. Signals can be derived from overbought/oversold levels, crosses above/below 50% and bullish/bearish divergences. The indicator is available for the Dow, Nasdaq, Nasdaq 100, NYSE, S&P 100, S&P 500 and S&P/TSX Composite. Stockcharts users can plot the percentage of stocks above their 50-day moving average, 150-day moving average or 200-day moving average. A full symbol list is provided at the end of this article.” To find out more click this link.
I like to use a 10-day, 50-day, and a 200-day moving average to discover overbought and oversold conditions in the market. All three are in overbought territory, which is anything above 70% of stocks. The percentage of stocks above the 10-day moving average shows approximately 83%. Notice the drop in the indicator relative to the beginning of the month? That means there are few stocks above the short-term 10-day moving average at 1494 than there were at 1466 on January 4th. That’s what we call bearish divergence and a warning sign of a short-term top.
Looking at the other two longer-term moving averages, they too are in overbought territory above 70%. When I look at the percentage of stocks above the 50-day moving average, 90% of the S&P 500 are above their respective 50-DMA.
As you can see, we can use other technical analysis tools like trend lines and chart patterns to assist in analyzing these indicators. As I mentioned earlier, and as you can see from the chart above, we can stay in overbought and oversold conditions for a short or long period of time. My intermediate-term indicator is still healthy, above 70%, but it’s at the highest reading in a year. The last time it was this high was October 2011 before a 10% correction during the Europe crisis. For statistics sake, I reviewed the last few times the S&P 500 had 70% or more stocks above the 50-DMA and for how long those periods lasted.
Overbought Breadth:
1/2/13 – present ... 16 days
8/3/12 – 9/26/12 ... 37 days
1/9/12 – 4/4/12 ... 60 days
10/12/11 – 11/17/11 ... 27 days
12/2/10 – 2/23/11 ... 57 days
So as you can see from the statistics above, the S&P 500 has been overbought before, and for longer than 16 days before a serious 5-10% correction took place. Usually, before we see a technical sell signal on the S&P 500, we’ll begin to see this indicator fall as fewer stocks participate in the index’s price movement to higher highs. Typically, a higher high in the S&P 500 but a lower high in the breadth indicator will form, citing a divergence in momentum and a warning sign that the market is beginning to weaken. At 91% of stocks above the 50-day moving average within the S&P 500 index, we could be looking at a momentum high and the beginning of a more selective market as extended stocks begin to undergo some distribution, as we see in some financials, while laggards continue to be bid up, like in energy. Sector rotation theory seems to support this somewhat as we see late-stage sectors performing like industrials, materials, and energy.
Sentiment
Finally, the other indicator that divulges whether the market is near an important top or bottom is how bullish people are. I usually look at these numbers once a week because they’re not as timely as some of the other indicators I’ve already discussed. The last time I checked the Investors Intelligence Overbought/Oversold Oscillator was very overbought at a reading of 85.4%. The CBOE Volatility index (VIX) which tells us whether investors and fund managers are starting to buy put protection has dropped to 12.69, which is the lowest figure in 6 years! Another sentiment indicator is the call to put ratio. The one I use moved up last week to 1.36, which was the highest since December 24th.
Conclusion
To wrap this up short and sweet, while my article last week highlighted the all-time highs in the transports, the S&P 400 mid-cap index, and the Russell 2000 small-cap index, there should be some pause for long-term purchases here as we enter into an overbought market condition. We still need to see the Dow Jones Industrial Average confirm the new highs of the Transports. We need to see the same confirmation in the large-cap S&P 500 index as we’ve seen in the S&P mid and Russell small-cap indices. I try to temper my bullishness after a nice uptrend because way too many times investors and traders are bullish at tops and bearish at bottoms. The overbought condition and overly bullish sentiment in the equity market is a warning for the short-term while we need more time to for an intermediate top to form.
Markets can remain in overbought and oversold territory while they’re trending, and so far this trend hasn’t shown any signs of long-term weakness. That is the most important theme despite some of these short-term warnings, investors should always look at the big picture which continues to look good with higher highs and higher lows. There is plenty of cash still sitting on the sidelines as investors continue to doubt this bull market. So while the market is overbought and overly bullish based on my indicators, these alone aren’t sell signals, merely warnings and it should give investors pause. Consider trimming extended positions or companies near 1-2-year resistance zone and saving cash to buy new advancing stocks like in energy, select financials, and transports. The word of caution is that overbought markets become more selective. The easy money has been made on this leg since the November bottom. It’s time to be more selective.
