Stock Exchange: How To Trade An Overbought Market

For the last three weeks, the term “overbought” has been frequently used to describe the overall market as well as many specific stocks. What does this really mean?

It has a dangerous sound, and that is indeed the common message. A stock, or a sector, or the overall market has rallied more than expected over an extended time.What does that mean for traders?Or for investors?

It is an excellent question for our experts.

Review

Our last Stock Exchange focused on trading sector rotations, Oscar’s regular mission. There was an excellent discussion. It provides special value when readers engage with our crew of “technical analysts.”

To encourage this discussion and diversity we will have some visiting experts for the next two weeks:

Brian Gilmartin of Trinity Asset Management, a leading expert on corporate earnings and fundamental analysis reported at his blog, Fundamentalis.

Robert Marcin of Defiance Asset Management. Bob is an oft-quoted legend, a deep value manager, and a curmudgeon par excellence.While I often do not agree with him, I always listen carefully in our discussions on Defiance Asset Management. You will enjoy the banter and can keep your own scorecard.

Today’s Theme

An extended stock move is often described as overbought or oversold. For most observers, an overbought stock or market is poised for a selloff. Some technical analysts measure this in terms of relative strength measures (RSI).

How important is this warning sign?

Pension Partners warns of an “optical illusion,” citing multiple prior examples and then considering the current Nasdaq 100. Look at the interesting evidence in the entire article leading to this conclusion:

If one is going to predict anything based on extreme overbought levels (and I would advise against doing so), it would be further gains. I realize that doesn’t conform to the prevailing narrative of “overbought is always bearish,” but the truth in markets rarely does.

Chris Ciovacco has a nice chart pack of prior overbought conditions. The mixed results are a warning to anyone thinking about trading on this approach – despite the recent somber warnings from the NYSE floor via Art Cashin.