Is the Equity Market Overbought?

Want to read more by Nasdaq Dorsey Wright? Visit their Featured Firm page here

The stock market has been on an absolute tear since the end of March, evidenced by the S&P 500 Index (SPX) rallying almost 43% through Friday’s close (3/23 – 6/5). While the rebound has been a relief for many, conversations concerning the overbought status of the equity market are beginning to circulate, and perhaps justifiably so. Looking at the Weekly Overbought/Oversold (OBOS) display for SPX on the Nasdaq Dorsey Wright Research Platform, we note a calculation of 87% (as of 6/5), the highest reading since January 17th of this year. To reach this value we take ten weeks of price data and put that information, along with a volatility calculation, into a statistical bell curve formula to give us a short-term trading band. When a security approaches the top of that ten-week trading band or near the 100% level, it tells us that we may expect a pullback or mean reversion to more normalized levels (and vice versa). While certainly not a guarantee, a reading of 87% suggests that the Index is further away from its rolling near-term average than usual.

Remembering that SPX is cap-weighted, the largest names in the Index have the potential to skew the OBOS reading. To accommodate for this, we can look to the Dorsey Wright Weekly Distribution for the S&P 500 indicator (WDSPX). As opposed to constructing a trading band for the S&P 500 Index itself, we take the OBOS reading for each underlying member and conduct an arithmetic (equally-weighted) average, eventually plotting the reading on a Point and Figure chart. As of Friday (6/5), this indicator resides at the 50% level, meaning that the average stock in the S&P 500 has a weekly OBOS distribution around 50%.

Although a much lower reading than 87% for the Index itself, a reading of 50% for WDSPX is elevated and rare. In fact, this is only the 10th move for the indicator past the 50-yard line since 2000. The table below depicts S&P 500 price returns following WDSPX moves above the 40-yard line, a popular demarcation level, with bolded figures emphasizing times when WDSPX moved beyond the 50-yard line. In the near-term, elevated WDSPX readings can produce underwhelming short-term returns. As shown below, forward-looking 1-month and 3-month returns have historically shown modest underperformance. However, elevated WDSPX levels do not always suggest unfavorable returns in the long run. In fact, historical precedent suggests quite the opposite.

Nasdaq Dorsey Wright offers investors a free trial of the NDW Research Platform, which provides turnkey research and analysis for securities selection, portfolio management and asset allocation. Click here for more information. For questions about the NDW strategies, contact us here.

Dorsey, Wright & Associates, LLC, a Nasdaq Company, is a registered investment advisory firm. Registration does not imply any level of skill or training.

Unless otherwise stated, the performance information included in this article does not include all potential transaction costs. Investors cannot invest directly in an index. Indexes have no fees. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss.

Nothing contained within the article should be construed as an offer to sell or the solicitation of an offer to buy any security. This article does not attempt to examine all the facts and circumstances which may be relevant to any company, industry or security mentioned herein. We are not soliciting any action based on this article. It is for the general information of and does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. Before acting on any analysis, advice or recommendation (express or implied), investors should consider whether the security or strategy in question is suitable for their particular circumstances and, if necessary, seek professional advice.

Dorsey Wright’s relative strength strategy is not a guarantee. There may be times when all assets are unfavorable and depreciate in value. Relative Strength is a measure of price momentum based on historical price activity. Relative Strength is not predictive and there is no assurance that forecasts based on relative strength can be relied upon to be successful or outperform any index, asset, or strategy.

© Nasdaq Dorsey Wright

© Nasdaq Dorsey Wright

Read more commentaries by Nasdaq Dorsey Wright