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When an Overbought Market Is a Good Thing


Exceptionally bullish in intermediate term.

Yesterday, the 10-day average of net breadth on the NYSE reached an extremely overbought level, the kind of reading that typically precedes some short-term chop in the broader market.

While previous comparable extremes led to inconsistent short-term performance in the broader market, historically this kind of overbought reading has been exceptionally bullish in the intermediate term.

There have been 13 times when the 10-day average of the ratio reached the current level of extreme (on both a 1-day and 10-day basis), and a month later the S&P 500 was positive all 13 times, averaging +4.8%.

Three months later, it was still 13-for-13, but the average return climbed to +8.6%. Here's what's most extraordinary, though...during those three-month trades, the average maximum loss at any point was a miniscule -1.2%. That compares to an average maximum gain of +11.7%.

Only 2 of them showed a maximum loss greater than -2%, but all 13 showed a max gain greater than +2%. That's one of the most skewed risk/reward ratios I've seen in any study. Granted, volatility now is much higher so we'd have to expect greater downside - but probably greater upside, too.

Another anomaly occurred yesterday, with a slightly different breadth measurement. This time we're looking at the up-volume ratio (or UVR). The ratio computes the amount of volume flowing into stocks up on the day, expressed as a percentage of total volume. So a UVR of 60% would mean that 60% of that day's volume was concentrated in stocks that closed higher than the previous day.

Over the past 2 weeks, we have seen consistently heavy buying pressure. To such a degree, in fact, that it has pushed the 10-day average of the UVR to just under 70%, the first time in more than 20 years we've seen such an extreme.

Even more notable, however, is that over the past 65 years, the UVR has shown a negative secular trend. Over time, less and less total volume has been allocated to "up" stocks, which seems odd considering that the market has risen several-fold over the decades. In the 1940s and 1950s, it was common to see an up-issues ratio greater than 60%. Since the early 1990s, it has become much rarer.

The reason I bring this up is that it highlights just how unusual the current reading is. So instead of looking at an absolute level and trying to compare it to historical readings, we should use some kind of relative measurement that looks at today's reading in comparison to more recent averages.

A good way to do that is to use Bollinger Bands. The chart below shows the 2-week UVR in terms of how many standard deviations it is from its 1-year average. As we can see from the chart, what we're seeing now is 3 standard deviations away from "normal."

It's safe to say that's a pretty extreme event, and it's even more so when we consider that what we're looking at is not a one-day reading, but an average over the past 10 trading days. So we have to be seeing a sustained level of huge buying pressure in order to get the 10-day average to such an elevated level.

Since 1940, there were only 4 other occurrences that matched this kind of extreme (August 1942, November 1962, August 1982 and January 1987). The average 6-month return following the other instances were all positive, and all greater than +13% (averaging nearly +20%). It's tough to rely heavily on only 4 precedents, but they were all fairly consistent, which helps.

As an aside, that 1-year average of the UVR is currently residing at 46%. It's been at this level or lower only 3 other times since 1940: The spring of 1970, December 1973 and the fall of 1974.

This is news to nobody, but it helps to underscore the fact that we're seeing the current level of shorter term extreme buying interest in the context of a tape that's immensely oversold on a longer term time frame.

History has consistently shown that when we get a burst of exceptional buying interest coming out of extremely oversold conditions, it leads to further upside in the coming month(s) the vast majority of the time. This kind of overbought reading has been exceptionally bullish in the intermediate-term.

I got fooled by a somewhat similar setup in October, with the decline in early November stopping me out of some modest intermediate-term long positions. I'm looking to re-establish those in the coming days, based in part on this breadth thrust.
No positions in stocks mentioned.

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