Stocks May Be Hitting the Wall Soon, or Maybe Not

By on October 6, 2010

Trader’s Narrative and Bespoke Investment Group in posts yesterday point out that the market is overbought. According to TN, the market is hitting levels seen last April which is cause for concern:

With today’s strong showing, the bulls pushed the breadth measure to 91%, the highest it has been since April 16th. So while the gains may seem impressive, just as they were in late March, I’m growing wary of what is coming around the corner.

B.I.G.’s take on this:

As shown, with 69.8% (349) of the stocks in the S&P 500 currently trading more than one standard deviation above their 50-day moving averages, there are more overbought stocks now than at any other time since April 23rd, which coincidentally was the closing high for the year. While this may sound ominous, we would note that the percentage of overbought stocks has gotten as high as 77.6% (4/9/10) this year. Furthermore, back on 4/23 the percentage of overbought stocks was actually on the decline, while for now at least the percentage of stocks reaching overbought levels is still rising.

TN adds a couple of caveats to the correction scenario:

As a caveat, I should mention two things. First, NDR actually considers this development to be very positive for the market. They were in fact saying this in mid-April: A Very Rare Breadth Buy Signal From NDR. I’m leery of disagreeing with any research firm of this caliber but I think I spot why we disagree.

This brings me to the second caveat and the exception I mentioned before. While this breadth measure is a reliable indicator of market tops, it does fail spectacularly at times. As all oscillators, there are instances where it gives us a reading of extreme overbought and the market continues to power higher in spite of it.

Sources: Trader’s Narrative, Bespoke Investment Group
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