Key Overbought Signal Hit Historic Highs - A Bullish Sign For Stocks

Summary

• The percentage of stocks trading above their respective 40-day moving averages has only been this high three other periods since 1986.
• Each period was a bullish rebound from a market sell-off, crash, and/or recession.
• The S&P 500 followed each period with more gains and ended the year in even stronger position - this time should rhyme even if not exactly repeat.

My favorite technical indicator measures the percentage of stocks trading above their respective 40-day moving averages (DMAs). I dubbed it "AT40" for short (originally called T2108 by Worden2000). I use this indicator to measure cycles of extremes in the stock market: from overbought (over 70%) to oversold (below 20%) and back again. The market crash in March plunged AT40 to low single digits and generated the second longest oversold period going back to the crash of 1987. Now, AT40 has rebounded sharply and impressively. AT40 closed today (at the time of writing) at the stratospheric level of 92.1%. Since 1986, AT40 has only closed above 90% 37 trading days….keeping such rarefied company is a bullish sign for stocks.

Typically, an overbought reading is bearish. Traders should take profits on long positions and even consider shorting over-extended stocks and indices. However, I learned quickly with AT40 that overbought readings can confirm the bullish buying power in the market. In other words, this indicator cannot achieve such heights without significantly strong bullish sentiment. A look at the 37 trading days where AT40 closed above 90% before this current cycle explains the bullish implications of reaching these heights.

February 6 to March 6, 1991: 15 total trading days

The U.S. was in a mild recession from Q3 1990 to Q2 1991. The S&P 500 (SPY) gained 5.1% from February 6 to March 6, 1991, the period that included 11 trading days with AT40 closing above 90%. On March 6th, the index was 27.3% above what proved to be the final bottom on October 11, 1990. By year-end, the S&P 500 was up another 10.9% from the March 6th close, mostly thanks to a vigorous Santa Claus (December) rally. The recession became a distant memory.

May 12, 2003 to June 17, 2003: 11 trading days

The stock market hit an extended bear market after the 2000 collapse of the tech bubble and then the tragedy of the September 11, 2001 terrorist attacks. The U.S. attacked and invaded Iraq in March, 2003. On March 12, 2003 the S&P 500 came just short of what became the ultimate stock market bottom on October 9, 2002. From May 12, 2003 to June 17, 2003 the S&P 500 gained 7.0% and was up 30.2% from the bottom. At year-end, the S&P 500 gained another 9.9% on the heels of a steady, grinding rally.

April 13, 2009 to May 11, 2009: 11 trading days

At the time, the financial crisis was the worst economic calamity in U.S. history since the Great Depression. The stock market essentially collapsed from September, 2008 to the ultimate, historic low on March 9, 2009. From April 13 to May 11, 2009, the S&P 500 gained 5.8%. On May 11, the index was up 34.4% from the bottom. At year-end, the S&P 500 gained another 22.6% on the heels of a strong rally that kicked into gear starting in July. It took years for fears of a return to a financial crisis to fade from the general economic conscious.

June 5, 2020 and counting

History does not have to repeat itself, but it can rhyme. AT40 is on its second day trading above 90%. The S&P 500 is already up 44.5% from the current bottom set on March 23, 2020. This performance far surpasses the last three extended overbought periods; each subsequent episode of above 90% trading has generated larger gains from the ultimate bottom. No doubt larger and larger interventions from the Federal Reserve are at least partially responsible.

One of many lessons from the previous three episodes is the ability of the stock market to cool off from 90%+ levels without leading to a fresh stock market calamity (in the short-term). Indeed, the current overbought period is the confirmation of a bullish change in sentiment and price mechanics…a final confirmation of the bottoming action from late March.

Bring on AT200

With AT40 so high, I am paying relatively more attention to AT200 (or T2107), the percentage of stocks trading above their respective 200DMAs. The 200DMA is a key long-term moving average. AT200 closed recently at 42.1%. Like AT40, AT200 traded in the low single digits at the nadir of the stock market's woes. The steady march higher for AT200 has been useful in trading the breakouts of individual stocks above their respective 200DMAs. As long as this indicator keeps rising, 200DMA breakouts provide low risk bullish trades no matter what AT40 is doing.

Curiously, AT200 has actually been in a long-term secular decline since the financial crisis. The last peak in AT200 was right under the downtrend line. This behavior suggests that over time fewer and fewer stocks are participating in rebounds, like a long-term narrowing of market breadth.

Source for above charts: FreeStockCharts

Will it ever be safe to get bearish again?

Of course. The stock market moves in cycles. However, the next time to get bearish could very well be at higher prices than current levels. Watching for AT200 to hit that long-term downtrend line is one method. A faster and more timely method is to assess market behavior after an overbought period ends. My studies of AT40 show that the end of overbought periods (or similarly the failure to break through the 70% level), is a bearish event. The duration of the bearish window depends on other factors. When my AT40 trading rules flipped me cautiously bearish in late January and then outright bearish in early February, I could not even come close to anticipating the calamity ahead.

Now the S&P 500 is on the edge of going parabolic. The index is moving up far and fast along its upper Bollinger Band (the Bollinger Band, or BB, is a measure of the daily expected price range). Once the index pulls that BB closer and closer to a vertical, a parabolic move is in effect. At that moment, strong buying power is subject to exhaustion, and it is time for traders and investors to get cautious. Ironically, the subsequent pullback could be shallow and provide a buying opportunity that many will miss waiting for a deeper loss. Time will tell…! (The bond market provided a particularly stark example of how badly a parabolic move can end back in March).

Source: TradingView.com

Be careful out there!

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SSO over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.