ChartWatch: Stocks are “Overbought”, here’s what you can do about it

If you’re a market nut like me, and you’re constantly consuming everything you can find about markets, no doubt you would have heard this term applied to US stock indices over the last couple of weeks: “Overbought”. For example, “The Dow Jones Industrial Average notched its second consecutive record high as it moved further into overbought territory”.

Overbought appears to the trend word in the financial media for the last couple of weeks

Gosh I love financial jargon! What does overbought even mean? As a technical analyst who has spent the majority of his life studying price action, I must admit I get a little frustrated when I hear the term overbought bandied around in the financial media.

Pineapples are overbought

Let me start with an analogy. Let’s say you go down to your local supermarket wanting to buy a pineapple. But when you ask a staff member where the pineapples are, they tell you they’ve run out.

You go to the next supermarket, and the next, and get the same result. It seems pineapples are overbought. There’s another possibility here. Pineapples are undersupplied. The third possibility is the combination of both. Pineapples are both overbought and undersupplied.

I love pineapples. I love piña coladas. It’s summer. It’s Friday afternoon. What I would give to have a piña colada right now! But how do I get one? What will I have to pay for a pineapple? It depends on how desperate I am for my piña colada!

Do you get where I’m coming from? Overbought is a term which simply means a market is exhibiting substantial excess demand. That is, the demand for the asset exceeds its supply. If I remember correctly, my Economics 101 professor told me that when this happens, the price of the asset rises.

Stocks are overbought

So, this brings us to the stock market. Stocks are a lot like pineapples. When their demand exceeds their supply, their price goes up. If stocks are overbought, it just means people really want to own stocks right now. That’s a good thing, right?

In my extensive experience in the markets, yes, this is a very good thing. It tells me there’s plenty of high conviction unfulfilled demand out there for stocks. It also tells me the supply side is equally committed to owning stocks – therefore they’re not selling – or more specifically, they’re not selling unless they’re compensated by higher prices.

Why are investors who own cash so desperate to buy stocks at ever increasing prices? Why are investors who own stocks so desperate to hold unless they’re compensated with more cash?

1. Either both cash owners and stock owners have lost their minds and stocks are irrationally overbought; or

2. Both cash owners and stock owners are making rational decisions and are allocating capital accordingly to minimise their opportunity cost. Stocks are rising because they’re cheap.

Stocks are overbought and cheap?

The two options above bring us to the heart of the overbought conundrum. Whatever option you naturally gravitate towards may define you as an investor. There’s no right or wrong answer, but, as a trend following technical analyst, I have programmed my brain to only ever consider Option 2.

You see, I love buying stocks when they’re overbought because it fits with my philosophy of trying to be in the market when there’s high conviction and excess demand. In my experience this is the environment which provides the highest probability of continued price increases in stocks.

It’s not easy to do though, because of Option 1. What if the market has gone crazy, stocks are too expensive, and if I buy now I do so at the top?

My simple answer is: This scenario is entirely possible, and if you do happen to buy at the top, you’ll lose money. The trend follower knows they’re going to lose money at the top of the bull market, and at the bottom of the bear market – and they’re OK with that. It’s the juicy bit in between the top and the bottom the trend follower seeks – the high probability part.

So, as a trend follower, you’re really committing to occasionally trading off profitability for probability. It’s a style issue. It’s a belief system, and it’s not for everyone.

Nobody does bull markets like the USA!

With all this in mind, let’s start with the Dow Jones Industrial Average (“DJIA”). The DJIA contains thirty of the largest stocks by market capitalisation in the USA. We’d typically refer to these as “blue chips”. 

Dow Jones Industrial Average

The DJIA is trading at record highs

Technical signals consistent with excess demand:

• Rising ST & LT trend ribbons (indicates excess demand among short term traders and long term investors)

• Higher peaks & higher troughs (indicates buy the dip activity)

• White candles and/or candles with downward pointing shadows (indicates dominance of programmed buy orders)

• Previous points of supply acting as future points of demand (indicates rising support/valuations)

The DJIA is a picture of excess demand. There’s absolutely nothing in its chart which suggests to me the prevailing short-and-long term trends are going to end anytime soon. That doesn't mean they won’t change, just I can’t see anything as of Thursday’s candle which indicates supply is creeping in to shift the balance from excess demand, to equilibrium, or to excess supply.

The signals which do indicate a shift are simply the exact opposites of the signals consistent with excess demand – so for example, lower peaks and lower troughs and black candles etc. If I see those, I’ll know to take the necessary steps to manage my risk. Until then, with the DJIA trading at record highs there’s no obvious points of potential excess supply to get in the way of the prevailing trends. So long live the trend!

Many argue the DJIA is not a very good reflection of the American stock market and its economy because it’s far too narrow. This argument holds some weight considering the DJIA only contains thirty stocks, and thirty of the biggest stocks at that. It hardly reflects what’s happening on the ground in the heart of corporate America.

For this reason, many analysts (including me), don’t even consider the DJIA in their analysis. Instead, I prefer to look at the NASDAQ Composite (“COMP”) and Russell 2000 (“RUT”) instead. These indices are far more representative of corporate America, consisting of around 5,000 and 2,000 stocks respectively. Where the COMP tends to favour technology and high growth companies, the RUT contains smaller capitalisation companies. In both cases, each group of companies tends to be far more sensitive to changes in the US economy than their bigger, blue chip counterparts.

NASDAQ Composite

The COMP not at record levels like the DJIA is, but is showing an increasingly strong set of technical

There’s plenty to like in the COMP chart also. I can see strong short-and-long term trends, healthy price action and candles, and the recent upswing has not pushed far from a zone of support I define using previous points of supply between 14,423 and 14,447. I would argue that this chart hardly looks over extended, and like the DJIA, is a picture of excess demand.

Admittedly, Thursday’s candle was not as emphatic as the one observed on the DJIA, but it’s not enough to concern me that there's a substantial threat to the prevailing short term trend. I can’t see any reason why the short-and-long term trends can’t persist, but I will be watching closely for signs of excess supply at the next historical point of supply 15,319.

Russell 2000

The RUT’s technical are strikingly different from the DJIA and the COMP

Rarely will you see such a sudden and large change of fortunes in a major stock index as what has occurred in the RUT over the last few months. As if to prove my point about trend followers being wrong at the top and bottom, there has been the most amazing reversal of performance since the RUT closed below major technical support on 27 October.

I would have thought only one thing on that day – short! But trend followers’ views, like the trends, change. The gap and run on 2 November, with its large white candle and close at session high, is a major signal excess demand has returned. Another gap and run, white candle, session high close on 14 November sealed what is one of the most emphatic major swing lows in recent memory.

There are too many massive white candles with closes at or near session highs in the current run for me to think this is a fluke. Unlike the DJIA and COMP though, the RUT has arrived at what should be a significant zone of potential excess supply. I love the current uptrend, but I can see reason to exercise a little caution on the RUT until the price action can probe and break the range between 2004 and 2030.

There are many other important stock indices in the USA which reflect different views of the underlying strength, or lack thereof of the US stock market and the US economy. We will investigate these in future ChartWatch editions, but for now, I hope this serves as a useful insight into how US markets are presently performing and how you can position yourself as a result.

Over overbought

I will leave you with this thought: Overbought is a misnomer. It’s used far too often and too flippantly in the financial media to scare you into clicking or listening. But there’s no need to trade based upon emotional responses if you understand the demand and supply dynamics which contribute to the so-called overbought state. Markets which are supposedly overbought are simply experiencing a state of excess demand – and rarely has that been bad for stocks.