Measuring unusual institutional activity has historically yielded prescient markers pinpointing short-term market local peaks. These triggers also provide opportunistic entry points for those on the sidelines who have been waiting for a pullback to participate in this multi-year bull market. This overbought signal is quite rare, and the last time it fired off was Jan. 24, 2018, and nearly two weeks later (Feb. 8, 2018) the Russell 2000 ETF (IWM) fell 8.51%. I covered that overbought signal at the time in this article.
At Mapsignals, we measure potential unusual institutional activity on a daily basis and use these unusual buying/selling data points to plot a ratio. Over the years, we have found that there are peaks in this data set that coincide with local market peaks when the ratio skews heavily in favor of unusual trading activity ... likely buying. These periods tend to show extreme exuberance and often alert us to points where the market's velocity is unsustainable and due for a short-term pullback.
These pullbacks are healthy and can provide a great entry point for those patiently waiting to get long equities. The latest overbought signal triggered the morning of Feb. 7, 2019, and based on history, we believe that the market could be near its local peak and that a pullback could be ahead, or the velocity of the recent rally could slow. We are long-term bullish on the market and believe that any meaningful pullbacks should be used as a buying opportunity.
In the chart below, we define the ratio as a 25-day moving average of our buying/selling signals, overlaid with the Russell 2000. The ratio ranges between 0% and 100%. A reading approaching 25% (green) suggests an oversold market (in green), with selling signals heavily outweighing buying signals, and readings above 80% suggest an overbought market (in red), with buying signals heavily outweighing selling signals.
Below is a look through recent history at prior times when we reached overbought (red). It does show that the average forward returns tend to be negative. But again, we are long-term bulls and use this ratio as an opportunity to pick up great stocks on a pullback.
So, what does all of this mean? It basically just means that the level of buying relative to selling is extreme and there is a good chance that selling will pick up. As you can see in the chart above, the ratio tends not to stay in the red area for long.
The Bottom Line
It's rare for unusual buying to reach current levels. Based on history, selling levels will begin to increase once our ratio falls out of the red area. This overbought signal has triggered, and we believe that the market's trajectory is due for a short-term pullback. Thus, we see a potential opportunity for patient investors to pick up shares at a lower level should the market pullback occur.
Disclosure: The author holds no position in IWM at the time of publication.