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Memo To Bears: It's A "Good" Overbought Condition

Daily State of the Markets
Friday, January 11, 2013

Good morning. As we talked about yesterday, the market has encountered bouts of intraday selling on a consistent basis so far in 2013. One of the explanations I've heard as to why traders are selling strength currently is because the market became extremely overbought after the impressive sigh of relief rally that followed the resolution of the fiscal cliff situation.

Traders understand that when a market becomes overbought (meaning things have moved too far, too fast) it has a tendency to pull back in the short-term until the overbought condition is "worked off." So, with the market having popped up more than 4% in just a couple of days recently, the "fast money" types appear to have been selling into any intraday strength in the hope that stocks will pull back a bit.

The thinking appears to be that with the macroeconomic environment far from clear and the idea that the earnings parade could contain some disappointments; stocks might be vulnerable at this stage. As such, a bet on the short side would seem to make sense given the overbought condition in the market.

However, what the fast money types may be missing is the fact there such a thing as a "good overbought" signal that not only doesn't lead to downside pressure, but rather to further gains in the stock market. Yes fans, believe it or not, there is indeed such a thing as a "good overbought" buy signal - and the most recent signal occurred on January 4th.

This buy signal occurs when stocks "blast off" to the upside and the rally is so strong that the move pushes 90% or more of stocks above their 50-day moving averages (for the record, (1) we're using an institutional multi-cap universe of stock here and (2) the signal occurs only after the percentage of stocks above their 50-day ma's had previously been below 75%). Looking at history, such a "blast" has meant that the market has reached a "good overbought" condition - one that has considerable bullish tendencies.

According to the computers at Ned Davis Research, these "good overbought" signals have led to stocks outperforming the average gains for all periods over the next two weeks, the next one, two, three and six months, as well as the ensuing year. And not by small margins.

For example, since 1967, the S&P 500 has advanced by +3.1% over the next month after the "good overbought" signal was triggered, which is more than five times the average gain of +0.6% seen over all 21 day periods. What's more, the S&P 500 has been higher 82% of the time one month after the signal.

Over the next three months after a signal, the S&P has been up an average of +6.1%, which is more than three times the average gain of +1.8% seen for all three month periods. And again, the signal has led to up markets 82% of the time.

Looking longer term, this signal is certainly worth paying attention to as the S&P has dramatically outperformed over the next six and twelve months, with the market sporting gains nearly 94% of the time six months after the signal was given.

So, while there are a great many hot-shot traders that believe stocks simply must go down each and every time a market enjoys a "blast" higher, history suggests that such events have favored those who got on board the bull train.

However, one of the keys to this game is to understand that the character of the market can change over time. Thus, we would be remiss if we failed to mention that the frequency of such "good overbought" signals has increased in recent years. For example, since 1967 there have been 17 such signals (including the most recent one on 1/4). From 1967 through 2003, there were a total of 9 signals. This means that a "good overbought" blast signal occurred only once every 3 years or so. But since 2009, there have been 7 new signals in just a little over 4 years - or almost two per year.

The likely explanations for the increased number of signals include the fact that markets are now dominated by HFT and algo-driven trading as well as the proliferation of ETFs. But while the signal may not be as "strong" as it was before computers started controlling the markets, we believe it is still something worthy of attention.

Turning to this morning... Stock futures are trading just below fair value this morning. In the overnight markets, Chinese stocks experienced their biggest pullback in nearly four months on higher-than expect inflation data. Stock markets are mixed across the pond. And traders are waiting on some earnings and economic data here in the U.S.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:
- Shanghai: -1.78%
- Hong Kong: -0.39%
- Japan: +1.40%
- France: -0.17%
- Germany: +0.16%
- Italy: -0.26%
- Spain: +0.15%
- London: +0.20%

Crude Oil Futures: -$0.67 to $93.15

Gold: -$10.80 to $1667.10

Dollar: lower against the yen, higher vs. euro and pound

10-Year Bond Yield: Currently trading at 1.886%

Stock Futures Ahead of Open in U.S. (relative to fair value):
- S&P 500: -0.27
- Dow Jones Industrial Average: -13
- NASDAQ Composite: -1.78

Thought For The Day...

Happiness is in the heart, not in the circumstances. - Author Unknown

Positions in stocks mentioned: none

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