The stock market internals have been in overbought territory for a while now. Just more over bought now than before. This creates a problem for those who use indicators like this to decide when to enter or exit markets instead of actual price action, as there is a difference between being on high alert and launching the missles, or placing your finger on the mouse and actually clicking for that trade execution.
For now, the market isn’t being bothered by too much. This is all ok and good, yet it also creates a near term risk for the stock market. When bullish sentiment is high and everyone seems to be leaning in the same direction, the market has a deviant way about it of making the masses look like the greater fool. As has been said, the markets do whatever confounds the most people.
The Put/Call Ratio is at 65 for the bulls where under 70 is a recognized overbought level, and is at 44 for the bears where 50 is a rcognized overbought level. Often one or the other can be extended, but both the bulls and bears have been in this area for a while. The AAII sentiment survey is a longer term indicator and the bulls are at high levels and as well the bears are at low levels; which mirrors the Put/Call Ratio. Interestingly enough shorter term indicators like the McClellon Oscillator are closer to the midpoint, but are bouncing around with daily trade and may from a technical standpoint make some rooom for more bullish action.
Each of these indicators has been the subject of an article and can be searched. A key in using with these indicators is not to get too ‘predictive’. It is best to stay in the moment and trade on what the market is doing not on what you think it will do.
Just on the basis of the S&P 500 being up 6.5% last month and 20% since the end of August, it is fair to say it is overbought on a short-term basis. In such situations, it generally doesn’t take much to rattle the nerves of participants who bought high and late to spur more concerted selling interest if a pullback starts.
Such a reversal might not occur today or tomorrow, but it is a near-term risk to be mindful of as the new year gets started on a bullish wave in front of some key economic data that includes the December employment report at the end of the week. So conditions are growing for a break in current bullish momentum. That is not to say a full-on correction is lurking around the corner, but rather that a consolidation period in price or time seems very likely in the not-too-distant future.
The depth of any pullback should be dictated by price exhaustion, the pullback is apt to be limited in scope since underlying fundamentals will likely compel traders to buy on pullbacks. However keep in mind if a pullback is created by a big fundamental force, like an earnings warning from a major company or a sharp spike in interest rates, then a pullback could run deeper and more pronounced. Either way, the sense of complacency in the market is a bothersome point.
If we take a moment to look in the rear view mirror, last year you can see that the S&P 500 surged 2.7% in the first week of 2010, registering a gain in all five trading sessions. By the end of January, the S&P 500 was down 3.7% after getting hit with a wave of uncertainty tied to concerns about China’s growth, EU debt problems, bank regulations, Ben Bernanke’s confirmation, and the stock market not behaving like it should in the face of solid earnings results. Hmm, sound familiar? With exception the Bernanke’s appointment none of these issues have left the stage.
But we also know that 2010 ended much better than the month of January did. The risk of complacency today needs to be respected because the market won’t continue up in a straight line indefinitely.
To comment more on the overvaluation/undervaluation concept it is worth noting that in order for mean reversion trading strategies to work, it is not required that the mean be realized for any definate period of time, or for that matter any overvaluation; but it requires that markets continue to behave as they always have. That is acting like a swinging pendulum between the depths of despair and irrational exuberance; or as it has been described lately as: risk-on and risk-off. As long as markets display such bipolar disorders and switch from periods of mania to periods of depression, then tradable opportunitties will abound.
If we look for the ebbs and flows in the markets and keep our balance we will see opportunity. As qouted before, there is no sure thing, only opportunity. As Ben Graham wrote, “Let me conclude with one of my favourite clichés – the French saying: ‘The more it changes the more it’s the same thing.’ This motto probably applies to the stock market better than anything else.
The stock market will continue to be essentially what it has always been – a place where an advance is inevitably followed by a pullback, a place where a rally is inevitably followed by a correction, and a place where a bull market is inevitably followed by a bear market.
Trade with a plan.