Is The Stock Market Extremely Overbought?

As money managers, we often get forwarded what we term anecdotal evidence “proving” the market is about to peak. We term it “anecdotal” because it often references one or two points in history, instead of looking at ten to thirty years of history. One of the most common concerns sighted is “the current market is overbought and ripe for a correction.” The term “overbought” is the laziest term in technical analysis.

Overbought Stock Market: 2003 Small Cap Stocks Overbought

The more important thing to watch is divergences that take place after markets leave an “overbought” state and go on to make a new high while an indicator fails to make a new high (known as a bearish divergence or negative divergence). Some divergences exist today on the chart of the S&P 500 that are of some concern (more on that later). Below, we show the Russell 2000’s performance after the weekly RSI hit 70 in May of 2003.

Overbought Stock Market: 36% gain over overbought

Another important thing to consider in today’s climate is an overbought market may in fact lead to some type of pullback, but it does not necessarily lead to the end of the opportunity to make money.

Overbought Stock Market

We have provided anecdotal examples of an overbought market that continued to rise using one indicator, the relative strength index or RSI. The CCM Bull Market Sustainability Index (BMSI) is based on thirty years of market data. It utilizes numerous technical indicators and tools and compares sixty-two sets of present day data with historical data. By comparison, most of the anecdotal emails we get reference one piece of data (vs. 62) over a six or twelve-month period (vs. 360 months with the BMSI). To gain an understanding of the broad scope of the BMSI, a logic flow table is available on the BMSI page.

Just how overbought is the current market relative to the BMSI and historical BMSI values? The table below shows the S&P 500’s performance (1980-2010) after periods when the BMSI fell into one of the ranges below. To create the BMSI, we studied both positive and negative outcomes, their relative frequency, and magnitude. When the risk-reward ratio drops below 1.0, it tells us historically the odds shifted against investors. Using risk-reward ratios takes into account there are no certainties with any market model or forecast, but rather probable outcomes which include potential gains as well as potential losses. The BMSI closed on February 2, 2011 at 3,745. Notice the risk-reward profile for stocks historically was favorable when the BMSI fell between 3,675 and 3,875 (see CURRENT below).

Overbought Stock Market?  CCM BMSI

As mentioned above, we are not big fans of the term overbought, but as measured by the BMSI, which is based on 62 technical parameters over a thirty-year period, the S&P 500 becomes overbought from a risk-reward perspective when the BMSI falls between 4,071 and 4,245. The next logical question is what would need to happen in the 2011 markets to possibly move the BMSI into the 4,071 to 4,245 range? Numerically, the BMSI would need to add 326 to 500 points. In the remainder of this article, we highlight logical areas, including NYSE New Highs - New Lows, where the BMSI could pick up those points to push it into an unfavorable risk-reward zone. Below, we provide some recent anecdotal evidence related to the stock market’s behavior and this breadth indicator.

Overbought Stock Market: New Highs - New Lows

The BMSI includes NYSE New Highs - New Lows in six separate market tests that can add a maximum of 600 points to the index. The present day market could pick up an additional 400 points if the NYSE New Highs - New Lows continues to rise.

Overbought Stock Market

One area of the 2011 market that is not currently overextended relative to history is the NYSE New Highs – New Lows.

Overbought Stock Market

The Summation Index is a market breadth indicator derived from the number of advancing and declining stocks in a given market. The concept of breadth is easy to understand; healthy markets have broad participation during rallies. Healthy markets have a rising Summation Index.

The Summation Index can add up to 600 points to the CCM BMSI. Currently, it has picked up 400 of those points, leaving an additional 200 as a possibility should market breadth continue to march higher. Adding 200 points to the February 2, 2011 BMSI value of 3,745 would take us very close to 4,071, the low-end of the unfavorable risk-reward range for projected future stock market performance. Below, we provide some recent anecdotal evidence related to the stock market’s behavior and this breadth indicator.

Overbought Stock Market

Keeping in mind the Summation Index hit levels of 1,100 and 1,300 prior to the January 2010 and April 2010 stock market peaks, the current level is not yet into ‘red flag’ territory.

Overbought Stock Market

If you are looking for a concerning chart to forward via email, here is one we are concerned about regardless of what the BMSI says (S&P 500 as of 2/2/11 close below):

Overbought Stock Market

At this point, it would probably be easier for most market participants if stocks pulled back a little from present levels and moved toward oversold conditions. Unfortunately, the markets rarely make anything easy for any of us. While the current day market is showing some cracks, history tells us additional gains prior to a correction cannot be ruled out. Some key levels where a possible reversal in stocks could take hold are outlined in this post.