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Op-Ed: All Signs Point to Bulls?


Extreme overbought readings can be seen, paradoxically, as extremely bullish.

Editor's Note: As an emerging-markets banking analyst, James Kostohryz has firsthand experience of banking collapses and their subsequent resolutions in Mexico, Argentina and Southeast Asia. Since leaving his position as Head of International Investments at Brazil's Banco Pactual in 2000, James has worked as an independent trader and investor.

When the market was near its 667 low, many said the market would not bottom until the VIX and the put/call ratios had spiked. I disagreed with that assessment, and -- though these indicators did not spike -- the market did indeed bottom, and has since risen about 20%.

Today, I'd like to offer another counter-consensus call regarding some widely followed technical indicators that indicate that the market is "overbought" or "oversold."

There's a great deal of chatter about various oscillators showing extreme overbought readings, and there's something of a consensus that this is a good reason to take profits, or to at least be cautious about buying until the market works off its overbought readings.

I'm not aware of any empirical support for the effectiveness of trading strategies based on oscillators in generating excess returns. However, assuming there were such evidence, it's evident to me that -- based on the way such oscillators are constructed mathematically -- any excess returns generated by such models would have to be based on very elementary principles of mean reversion.

In other words, to the extent that oscillators are effective at all, it's because they identify certain patterns that tend to repeat themselves through time, on average. That is to say, that under normal or average conditions there is a fairly high probability of the identified pattern recurring.

The problem with using oscillators in today's environment is that there's absolutely nothing "normal" or "average" about what is going on in financial market these days. People who have been buying stocks since October 2008 because oscillators were showing extreme oversold readings have been losing fortunes.

What's the situation today?

1. A barrage of increasingly coherent policy measures by global governments and central banks to deal with the economic and financial crisis.

2. A string of data strongly suggesting that the second derivative in terms of economic activity is turning.

3. Individual and institutional investors are underinvested and are therefore being caught wrong footed by both number 1 and number 2.
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No positions in stocks mentioned.

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