February 14th, 2012

Is the Market Overvalued and Overbought?

I was struck by a post on Slope of Hope entitled “An Ongoing Balloon Ride” the major premise of which was that the the market has risen too far and diverged too far from its 400-dma such that there’s no questions “if this debt-filled balloon will disintegrate, but when“.  The writer’s premise is that the several times in the past when the Index has diverged as far as it has from its 400-dma have all been followed by a drop or correction.

I have my own database and decided to do my own research and gather my own facts to see whether I could replicate those results and come to the same conclusions.  My database goes back to 1963 and the moving average I rely on is the 300- rather than the 400-dma (but what difference does a hundred days make between friends).  The Slope writer visually picked the areas when the index diverged significantly from the moving average and eyeballed the subsequent change.  What I discovered was:

The S&P 500 Index is currently 6.38% above the 300-dma.  In the 12,089 trading days between March 12, 1963 and March 11, 2011, a spread between the index and the 300-dma of 5.00-7.99% occurred on one out of every 6 days, or 16.89% of the time.  One could almost say that this spread is “typical”, not large or overbought or stratospheric.  Actually,  it’s fairly typical.

One can look at both tails of the distribution as indications of how extreme the spread defining overbought or oversold situations, times when one needs to sell or has a true opportunity to buy.  In 2008 and 2009, at the depths of the Financial Crisis Crash, the market was over 35% below the 300-dma …. we should have all bought then but few had the nerve.  In August, 1987, the market was 24% above the 300-dma; a few months later, the market suffered it’s largest single daily decline in the October Crash …. we should have sold.

The market was more than 20% above the 300-dma also in 1983 as the market rocketed in celebration of its exit from the secular bear market of the 1970’s.  Rather than crashing, the market went into a horizontal consolidation lasting 15 months (just like the past 15 months?  I’ll leave that determination for you to make.)

So is the market now overbought?  Not if you use the 300-dma as a benchmark.  Did the Slope of Hope contributor select a seldom used 400-dma benchmark to prove his point?  It’s possible.  Where would the market have to be for it be overextended or overbought by these measures?  Somewhere around 1500-1550 …. interestingly, exactly the level of the market’s all-time high as measured by the S&P 500.

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