Every investor is asking the same question right now: Is the market overbought? Year-to-date, the market is up 6.10% and 11% from July 2012 . So, what should you be doing right now? Well, that depends on each investor's objective, because one size does not fit all.
It all really comes down to this: Should investors start reducing equities at these levels or use some type of hedge overlay on their portfolio? Every "expert" has an opinion, which is not very helpful to the average investor. ChartLabPro wants to look at the hard facts and empirical evidence to give us an edge in our decision.
In our last column, as the markets were trading above 1,500, we said that the markets were not overbought and only approaching overbought. Of course, certain individual equities have been over extended as we saw recently and have reverted back to their mean.
My last few columns, on Jan. 8 and Jan. 23, respectfully, said that the S&P 500 (SPY) was not extended based on our proprietary countertrend reading. My partner has been using his proprietary countertrend for over 15 years to run his fund. On a high level, we use an approaching overbought level as a money-management tool to reduce typically 50% exposure, as there is no guarantee we will get an overbought condition. To see the accuracy on a few stocks as to how the countertrend worked, you can reference my last column on Jan. 29.
Okay, now let's take a look at the empirical data points. We reviewed the most overbought markets in the last 18 years, and here is what we came up with. First, for a reference point, our countertrend, which reads a maximum -1, is currently reading a -.60 on the S&P 500. Since we have been using our countertrend we have never seen a -1.
Dec. 15, 1995, countertrend: -.90.97
Aug. 5, 1997, countertrend: -.74.19
Jan. 16, 2004, countertrend: -.72.28
Feb. 14, 2007, countertrend: -.69.03
Jan. 14, 2010, countertrend: -.74.52
Feb. 2, 2011, countertrend: -.72.52
Here is how the S&P 500 performed 30 days following these readings.
Dec. 15, 1995, -3.13%
Aug. 5, 1997, -2.20%
Jan. 16, 2004, +1.00%
Feb. 14, 2007, -3.15%
Jan. 14, 2010, -5.63%
Feb. 2, 2011, -2.69%
So what is the takeaway? Is this market melt up going to go down as one of the most overbought markets in the last 18 years? This is very possible, as you had one of the greatest S&P 500 selloffs in the last 70 years as a result of credit deleveraging. As we see in most markets, the pendulum often overswings to find the true range.
One can argue that markets have become extremely overextended as global monetary policy is driving a unprecedented amount of liquidity, ultimately pushing all asset prices to the moon and well beyond their true value. With slightly better economic and fundamental data coupled with global easing, getting a countertrend reading above -.70 is certainly foreseeable. At which point, we would be going to all cash.
For our members, we went long and fully allocated to stocks around 1,355 in the S&P 500 in the last several months. So reducing 50% to 70% right here is prudent. However, it all depends on your objective and risk tolerance. If we were to see another .10 drop on the countertrend indicator, generating a reading of -.70 that would represent a roughly 2% move in the S&P 500.
Lastly, we wanted to update readers on Google (GOOG) and the Strongest 20 S&P 500 names. Both can be viewed with the link below. In our Jan. 23 column, we told readers not to allocate capital to Apple (APPL) and instead to focus on names that are working like Google. We went to a buy rating on Nov. 30 around $698 in Google. The name is not even approaching overbought as the stock hits new all-time highs, so remain long at this juncture until either a downgrade in our rating or an approaching overbought level.
http://i.mktw.net/_newsimages/pdf/chartlab_pro_20130204.pdf
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