The Most Overbought Market At Least 23 Years?

I’ve seen it pointed out a few places that the number of stocks above intermediate-term moving averages (40 or 50-day) is now at an extreme level. I’ve done some testing in the past and found such indicators to be of limited value. Worden Bros. has several indicators that show the % of stocks trading relative to the 40-day moving average. In addition to the simple % above/below, they also show how many are at least 1 and 2 standard deviations above and below the 40ma. I believe these indicators are more telling. I’ve found this information to be especially useful in looking at extreme selloffs and have compared the % 1-standard deviation below the 40-ma indicator (T2114) to my Capitulative Breadth Indicator (CBI). (Click here for that post.)

Part of what gives the CBI and T2114 their effectiveness is the propensity for sharp and powerful short-covering rallies to emerge from such extreme conditions. In developing the Catapult method and CBI indicator I was unable to find an overbought equivalent. Of course the market is dealing with different emotions near tops than it is near bottoms. Fear, which is prevalent near bottoms, is much more powerful than greed, which is prevalent near tops.

So the question then becomes, since there is no CBI reading for extremely overbought, what might the Worden 1-standard deviation measure suggest when it gets extremely high? As of Friday it was certainly extremely high. Over 80% of stocks closed at least 1 standard deviation above their 40-day moving average. Worden Bros. maintains data back to 1986 and this is the 1st time the indicator has cracked the 80% level. I looked at other overbought levels to study the 1-month returns following some less-extreme readings.

As you can see above, returns have generally been positive following other times the indicator has reached extreme levels. On the low end the results are about the same as the long-term market drift. While not shown, periods leading up to 20-days are also all generally positive. As the indicator moves higher the results look even more bullish. But instances are incredibly low, so not much can be extrapolated. I see two points to take away from this exercise: 1) When the market gets extremely overbought that is not necessarily a bad thing, and on its’ own is certainly not a signal to sell short. 2) By this measure the market is now more overbought than it has been in at least 23 years.

The most overbought ever would seem to suggest the market is unlikely to continue to rise at anywhere near its recent pace. On the other hand, those expecting a sharp, sustained selloff from here had better be basing their expectation on evidence other than just overbought breadth.