When an Overbought Indicator is a Buy Signal

The stock market is overbought. That is a common theme on CNBC as analysts talk about how extended averages are. They are certainly correct that the S&P 500 and some of the other major averages are overbought. But, that is not necessarily bad news for the bulls.

Overbought is a term used by technical analysts to describe a market that seems to have moved too far to the upside. It usually results from a relatively rapid gain. After a market becomes overbought, technical analysts look for a pullback in price.

The theory of overbought, and the converse of that idea which is an oversold market, is grounded on a logical belief about how markets behave. The logic can be understood by imagining markets can act like rubber bands at times.

We all know when a rubber band is pulled too tightly, it will usually snap back to its unstretched size. In the markets, price action, at least in the short term, is expected to behave in a similar manner. When prices are stretched, technicians expect them to snap back.

Reversion to the Mean

In mathematical terms, this is known as reversion to the mean with the mean being the average. Reversion to the mean can be seen in the chart below.

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This is an intraday chart of the SPDR S&P 500 ETF (NYSE: SPY) which is shown as the solid black line. The dashed line is the 5-period moving average (MA), covering 15 minutes of price action in this chart. As the chart shows, excursions above the MA are followed by moves below the MA. Throughout the day, the MA does seem to act as a magnet for prices.

The idea of reversion to the mean is well established in the financial market. The Nobel Prize winning economist Robert Shiller uses reversion to the mean in his well know CAPE ratio. The CAPE is the cyclically adjusted price to earnings (P/E) ratio.

Shiller defines the stock market as overvalued when the CAPE is significantly above the average value of the ratio. The market is undervalued when the CAPE is well below the average ratio. This simply using an expectation that the CAPE will revert to its average after moving too far above or below the average.

Instead of using the terms overvalued or undervalued, technical analysts use the terms overbought and oversold. This is consistent with the technicians’ focus on price rather than value. The idea is the same. When a market indicator moves too far, it is expected to snap back.

Putting Mean Reversion to Work

The theory is sound and that has led to extensive research into how to identify a market that is extended and likely to reverse. Shiller’s CAPE ratio is useful but it’s for the long term. Many traders prefer to focus on the short term and there have been a number of indicators developed to do that.

The moving average, as shown above, might be one of the simplest indicators that technical analysts use. Technicians have also focused on indicators that attempt to measure momentum which would tell them the speed of the market action. Here, the simplest possible too is the rate of change (ROC).

ROC simply measures the price change in percentage terms over a certain period of time. The next chart adds the ROC measured over 15 minutes to the chart shown above. The ROC tends to oscillate above and below zero.

The ROC is just a starting point for what technical analysts have come up with. Other popular momentum indicators include the MACD, the Relative Strength Index (RSI) and stochastics. These indicators all have their advantages and disadvantages. And, most momentum indicators will provide signals at the same time.

To truly benefit from the idea of overbought and oversold indicators, it is important to look at the correct chart. The intraday charts shown above are useful for traders with a very short term outlook. For most of us, daily, weekly or even month charts will be more useful.

The next chart is a monthly look at SPY. Here, in the long term, we see that stock prices move in extended trends. In other words, prices are mean reverting in the short run but tend to move in trends over the long term.

In this chart, prices stay above or below the MA for years at a time. The horizontal line for the ROC indicator has been moved to 40%, which tends to be the level where bubbles develop and prices are set up for a downside reversal.

Putting Trends to Work

The next chart we’ll look at is a monthly chart of SPY with the stochastics indicator at the bottom. Once again, we can see that prices trend and this means we should expect momentum indicators to trend as well. As the chart shows, the stochastics indicate can remain overbought for years.

Using overbought indicators as a sell signal would mean an investor would miss out on the majority of the gains in a bull market. Momentum tends to signal the continuation of an up trend rather than the end of the trend.

Visually, the charts tell us that we should ignore the warnings that the stock market is overbought. We can also test this idea. We will use the indicator shown below in the final chart we’ll look at. This the 2-period RSI or RSI(2).

RSI can range from a low of 0 to a high value of 100. It is at 99.90 and has little room to move higher. This is the second month in a row the indicator has been above 99.9, a relatively rare occurrence.

Using monthly data for the S&P 500 index dating back to 1928, a period including 1,074 months, we find that this trade setup has occurred just 8 times. One month later, the index was slightly lower on five of those 8 occasions. The average decline was less than 5%.

Six months later, the S&P 500 was up an average of 8.4% and the win rate was 87.5%. This is a strong performance for the index. The typical six month gain is only 4.8% and the market moves higher about 80% of the time for a six month holding period.

Buy the Dip

Data tells us something different than logic about overbought markets. In the short term, prices do tend to act like a rubber band stretched too far. For short term traders, mean reversion strategies can be profitable.

As an example, an intraday trader may find it useful to buy when RSI(2) falls below 10 and to short the market when RSI(2) rises above. Both positions could be closed when RSI(2) crosses the 50 threshold. But this strategy would be less effective for a long term investor.

In the long run, we tend to see prices move in strong trends. Selling when the rubber band is stretched too far, or when the market is overbought, could result in missing large portions of the trend. This would hurt the performance of a long term investor.

Analysts noting that the market is overbought are correct. Almost all momentum indicators confirm this fact. But, analysts warning of a significant market selloff may be incorrect. Based on history, we are likely to see a short term pullback followed by a resumption of the long term up trend.

History can be wrong, but it is the only tool we have to measure the probability of a market move. History is telling us we should buy the dip if the market declines.