Markets Historically Overbought: Dangerous to Enter New Longs Right Now

Only in a short term trader’s world can one be feeling like the markets are readying to move higher on one day and the very next be cashing out of his positions for fear that the market is ready to sell off. At the close last Wednesday I commented that I got a buy signal on the Dow thinking we could go up from there. I just didn’t expect to get all of the move in one day causing me to cash out of my stocks, take my gains, and go into the weekend without worrying about what the professionals will do when they come back from holidays next week.

I certainly didn’t expect a near 300 point rally on what was really below average volume, but I wasn’t going to miss the opportunity to take my profits. A small pullback would have been more constructive setting up a potential rally this week, but the market doesn’t always do what makes sense. It used to take the markets a week or more to move 300 points, so it’s important not to become immune to these big swings and let profits slip through our fingers.

To recap, I took my gains in gold and silver which I’ve been bullish on for weeks now as I feel metals could pullback and consolidate. I also sold my long equities in the Dow and Nasdaq as I think the chances favor a small pullback given how high we’ve come on lighter volume. The following charts will make my case as to why I think we’re slightly overbought here.

After Friday's rally I can’t ignore the facts. We are historically overbought here and entering new longs at these levels can be very dangerous. If this market has taught us anything it’s that markets go up and they go down, so there will be plenty of chances to get long in the coming weeks should this rally have legs.

There’s a few things going on in this chart I want to bring to your attention.

• RSI is closing in on the upper boundary of a symmetrical triangle.
• Stochastic nearing very overbought levels.
• Price action is approaching its upper boundary trendline indicated by the white arrow.
• The red boxes show 2 separate time-frames when this indicator rallied a significant amount. The first back in 06 was nearly 1651 points which is a large amount for this indicator in one big move. Right now this current move totals 1408 points from the bottom to Friday’s close and it did it in a much shorter time frame. Such powerful rallies are difficult to sustain and are prone to give back some of those gains. We may have one more burst left, possibly a gap up on Monday, but I suspect many sellers will be lurking if that occurs. I wanted to be in cash so I wasn’t distracted with positions and therefore trade from a more carefree state.

Comments

[Paul Price:]

One of these rallies [and it might be this one] could be the last chance to get in 'before the train leaves the station'.

Short term trading such as exiting on last Friday's big rally simply ensures that when the real move happens you won't be long stocks.

Jan 04 09:03 AM

[gybognarjr:]

Your comment: "If this market has taught us anything it’s that markets go up and they go down.." is the only thing one can say about the stock market without being wrong. Most of the investors already learned this many years ago. All the rest is pure speculation.

Jan 04 09:34 AM

[Eze.:]

It is a well known fact that when markets are overbought, it dangerous to enter. This is because, the market has a way of correcting itself of this anomaly. When there is an overbought, the danger is that the novice investor might enter at the wrong price, and get their fingers burnt when the market correction begins.

Jan 04 11:00 AM

[gordon:]

You're on the money, Jeff! Just look at the Russell ($RUT or IWM)! when it goes parabolic it always collapses, watch the signal on RSI/STO. IMO, Paulson made sure the TARP monies went to the primary dealers TRADING DESKS, these funds are being used (especially year end) to trade. Nobody has asked if regulators restricted this bailout cash from trading desks.
There may be retail investors jumping on the train (always late) Monday, but I scalped profits also on Friday. ISM# ignored, that's "old news"?

Jan 04 11:14 AM

[adan:]

one of the more balanced useful articles i've read re friday's runaway train run

thank you much

Jan 04 11:23 AM

[notsosmart:]

thats the problem.this is no longer investing.its just another form of gambling for those that dont do an honest days work.graphs,charts or count cards.whats the difference?the average dumb-dumb should stay away from this whole scene.

Jan 04 11:25 AM

[epeon:]

Consider this: hedge fund selling is over, tax selling is over, the US has pumped a lot of money into the system directly, interest rates are low, and energy prices are very cheap (helping earnings). All of these are very positive things. sooner or latter these are going to push the market up. How do we know that sooner or latter isn't now?

Jan 04 11:41 AM

[Ethel-To-Tilly:]

I saw a Dow Theory Buy Signal on Wednesday - anybody else catch that?

Jan 04 12:51 PM

[markcpa:]

These indicators are only accurate about 50% of the time. There have been many instances when the market has been overbought and gone much higher.

Even though technical indicators on the market are nearing overbought levels, many stocks are just coming out of bases pointing to higher prices in the coming weeks.

Jan 04 01:19 PM

[vpratt:]

notsosmart, you really ain'tsodumb! My sentiment exactly. Thanks.


On Jan 04 11:25 AM notsosmart wrote:

> thats the problem.this is no longer investing.its just another form
> of gambling for those that dont do an honest days work.graphs,charts
> or count cards.whats the difference?the average dumb-dumb should
> stay away from this whole scene.

Jan 04 02:10 PM

[punk_ash:]

yeah right, fools like you mentioned that the market was oversold when Dow was sitting at 12500 from 14000.

Jan 04 03:01 PM

[jrhc:]

Following indicators is one way to go, why not? In doing this you make the market also fluid. If you cash out higher you don't lose money. Something like this is what we're doing everyday anyways.

Jan 04 04:36 PM

[hrant:]

after decades investing, I learned one thing : a stock that does not pay a dividend is not a good long term stock. i want to be paid or I don't even bother to look . and if you cut a div . i am done and i sell.

Jan 04 05:03 PM

[ArtfulDodger:]

Paul and epeon, you both have spoken well and apothegmatically.

Nothing else needs be said from my view point.

Both young and new investors better listen to them! These folks write with the wisdom of experience and reason.

Thank you both. Happy New Year!

Artful

Jan 04 11:24 PM

[Fred Voetsch:]

A good article, overall.

Paul Price Wrote:

"One of these rallies [and it might be this one] could be the last chance to get in 'before the train leaves the station'.

Short term trading such as exiting on last Friday's big rally simply ensures that when the real move happens you won't be long stocks."

Paul, you really need to take look outside of your life experience and understand that this market is not going to leave anyone behind as it blasts off to historic new highs.

We have entered a secular bear market and a long period of economic contraction that will balance out the excess of the past decades and last for years and probably a decade or two. Look at the data don't listen to the market shills. Look at history and see how every twenty (40, 60, 80) years or so we enter a new era to correct for the previous era(s).

Consider that alll of the people who had learned from the Great Depression are now gone and that we just made all the same mistakes (and worse) they had made and now we will learn all the same lessons.

You are not a genius because you made money off the market for years; you are a genius if you made money in the last year. Get out now before you lose everything.

--Fred Voetsch

Jan 05 12:25 AM

[Fred Voetsch:]

"Consider this: hedge fund selling is over, tax selling is over, the US has pumped a lot of money into the system directly, interest rates are low, and energy prices are very cheap (helping earnings). All of these are very positive things. sooner or latter these are going to push the market up. How do we know that sooner or latter isn't now?"

...and the housing market is still in an accellerated decline (remember that everyone said that it would have to end befor ethe is any hope of the economy getting better; strange how those same people now ignore this fact) and the givernment is still bailing people out and the credit excess is still not out of the system and the consumer is seriously in debt, lossing their jobs and having their credit lines cut. They are in fear and it's getting worse.

But, please, go ahead and buy, buy, BUY, after all, I need someone to make money off of. :-)

--Fred Voetsch

Jan 05 12:30 AM

[ArtfulDodger:]

Mr. Fred Voetsch:

With all respect, you seem to be making the same mistake many others are making by comparing the Great Depression years to today, when there is little to compare.

You—like so many others—have taken a cursory a view of the Depression years and come to a dire conclusion for today, when the two have little to do with each other.

Different situations and different times require unique analyses. And surely the Depression years are wholly different in myriad ways from today.

E.g., America was a manufacturing nation then; it is not today in comparison. The Fed slammed on the brakes before the `29 Crash and held its foot there for years; that’s not happening today.

The Hoover Administration pushed through a huge tax increase (over the Depression years federal income taxes went from a top rate of 25% in the 1920s to over 90%; that’s not happening today (at least yet).
Aside from the cotton mills, the South was an agrarian society, and so was the Mid-West. Neither is today.

Our problems today are vastly different from then. The manufacturing society of the Depression years depended on reasonably high commodity prices to keep their margins up; the opposite is true today in many cases.

Who was concerned about oil and energy then? Who was concerned about the value of the dollar and gold then? Who was concerned about foreign competition? The dollar was still backed by gold; our coins were still real silver. The national debt was tiny relative to GNP.

High wages were not even on the list of problems in those days, as they are today.

Both the government and the Fed were sucking money out of the economy then; today they’re doing exactly the opposite.

The differences go on and on.

Thus, you may be right about stock investors “losing everything,” but you can’t justify that position simply by calling up that oldest of all canards: the Great Depression.

If you had been around in the 1970s, like I was, you would have heard the Great Depression called up a thousand times. Look at the markets today and then!

That’s why Paul is right: if you want to make money in the stock market, you have to buy in when everyone hates stocks and fears the worst. If you don’t, as he says, you stand to miss out on the greatest gains.

Respectfully, Artful

Jan 05 05:24 AM

[.*.:]

If I don't buy, and the market goes up a lot, I will be remorseful to the extent of a 9 on a scale of 1-10. If I buy, and the market goes down a lot, I will be remorseful at level of 5. I will also buy some more, then wait. Even Jeremy Grantham (!) says the market is fairly priced (that is, not overpriced) for the first time in 2 decades. I'm buying. Good Luck, longs and shorts.

Jan 06 06:02 PM