The chart below shows several methods I look at to try and determine if buyers are potentially reaching a point of “exhaustion” which might lead to a price reversal in the short-term. The top of the chart looks at the historic deviation between the price of the market as compared to the 200-dma. The bottom 4-indicators are measures of price movement and participation (The bottom two panels are the number of stocks above the 50 and 200-dma.)
Don’t get too hung-up on trying to understand all the nuances of the chart. The important point, from a money management standpoint, is the determination of the potential risk/reward opportunity for allocating capital to the markets at any given time.
As a portfolio manager, clients tend “not to like” having their capital invested in the markets only to almost immediately suffer a principal loss. By using some measures to determine the current risk/reward outcome, the deployment of capital can be more effectively timed.
While the chart is suggesting the market has reached levels where buyers have typically been turned into sellers, it is important to understand that just because the indicator has reached an extreme level – the market will not necessarily fall apart immediately. It is a warning sign that suggests further upside in the market is relatively limited compared to the downside risk that currently exists.
The average correction that resolved the overbought condition, since the end of the last financial crisis, has been as little as -3% but as much as -19%. It is for this reason that I continue to suggest NOT chasing the markets at the current time. There will be a correction of some magnitude in the near future that will allow for a safer entry of new capital into the markets. Patience, however, will likely be tested before that opportunity presents itself.
How Can A Market Get Over Extended?
Now that we have defined what overbought means – I can explain what I mean by overextended. As I discussed in “Visualizing Bob Farrell’s 10 Investing Rules”:
“Like a rubber band that has been stretched too far – it must be relaxed in order to be stretched again. This is exactly the same for stock prices that are anchored to their moving averages. Trends that get overextended in one direction, or another, always return to their long-term average. Even during a strong uptrend or strong downtrend, prices often move back (revert) to a long-term moving average.
The chart below shows the S&P 500 with a 52-week simple moving average. The bottom chart shows the percentage deviation of the current price of the market from the 52-week moving average. During bullish trending markets, there are regular reversions to the mean that create buying opportunities. However, what is often not stated is that in order to take advantage of such buying opportunities profits should have been taken out of portfolios as deviations from the mean reached historical extremes. Conversely, in bearish trending markets, such reversions from extreme deviations should be used to sell stocks, raise cash and reduce portfolio risk rather than ‘panic sell’ at market bottoms.”
The dashed blue lines denoted when the markets changed trends from positive to negative. This is the very essence of portfolio “risk” management.
The idea of “stretching the rubber band” can be measured in several ways, but I will limit our discussion this week to two: Standard Deviation and Distance.
As I noted in this past weekend’s newsletter, “Standard Deviation” is defined as: