I bet you didn't know that some shrimps can boil water. In a flip-flop from boiling shrimp, the mantis shrimp can swing its claw so fast that it boils water around it and even creates a flash of light! That's pretty cool. When enough inertia is applied, things get hot.
In the market, things get hot when they are stretched to extremes. I've been warning that the market will soon get overbought for weeks now. The big money buying has been off the charts. To simplify big money buying, that’s when stocks break out of their ranges on big volume. It's as if a few weeks ago a huge memo went around to professional money managers saying "don't miss out! Everybody in the boat!"
That level of recent buying had virtually no selling to offset it. That sent the Big Money Index (BMI) racing higher. That's just a moving average of buying over selling. A reading over 50% indicates more buying than selling, while under is vice versa. When things get heavily oversold (think Q4 2018: a reading below 25% means that only 25% of all signals over the past 25 days were buying), the market usually snaps back with a vengeance, often within days. That's the time to add risk: when we're oversold. Conviction is high.
On the flipside, when buys account for 80% or more of all signals over 25 days, the market becomes overbought. Intuitively, one would expect the market to sag shortly thereafter. That would be right, but as John Keynes famously said: the market can stay irrational longer than you can stay solvent. That means, we can stay overbought for prolonged periods of time.
The reason I bring this up is, even with a slow Christmas week, the market went overbought. Last week, I saw 155 big buys against only 14 sells. For the four-day week, 90% of all signals were buys. That was enough to nudge the 25-day moving average over 80%. That's the BMI, and it now says we are officially overbought according to Mapsignals data.
What does that mean going forward? What can we expect? In short, you can expect a moderate pullback in the market in the coming weeks. I still suspect that, after the January effect of managers putting money to work, it will push us further into overbought territory, and starting in the third week of 2020, I expect the market to have a reversion.
I came to this conclusion looking at BMI readings for the past 30 years. To make it easier to see, I wanted to plot them visually in terms of intensity. So, when you see a red bar, that means a stretch where the market was overbought. A green bar means we were oversold. Yellow is cruise control, a market where buying and selling is not extreme in either direction. It may, however, be moving toward it. I represented this later.
Let's walk through a few charts together … This is 30 years of buying and selling data:
Notice that there are way fewer oversold (green) instances than overbought (red). But also notice how those greens line up with troughs. When it's green, it's time to grab with both hands. That may be a little hard to see over three decades, so let's look at the next chart:
This is half the time (15 years), which also includes the nastiest bear market in recent memory – 2008 to 2009. We start to see more clearly that green oversold lines up with local troughs in the market. Red overbought usually precedes a "cool-off" period at minimum.
The next chart just zooms us in. The collection of this data started in 2012. So, this chart begins from there:
Again, those green bars line up with troughs. What we can see with overbought periods is that they usually precede cool-downs. These are periods where the market is flat or down slightly. Occasionally, reds line up with local peaks too, like in 2012, 2016, 2018, and notably earlier this year.
The final chart just slices up the buying and selling activity into five categories. It allows us to see when buying is slowing in a neutral zone and approaching oversold or speeding up to overbought. It gives us a better idea of where we are in a neutral market.
For example, a yellow period is where buying and selling are fairly balanced: 40% to 60% buy signals. If we drop below 40% on the way to 25%, we turn light green. That is, "Hey! We're getting close to oversold!" When it turns bright green, "Hey! we're oversold!" The same goes for orange and red for overbought, which is what you can see right now. Naturally we measured this data for what to expect. It looks like this since 2012:
The bottom line is this: when the market becomes overbought, the average returns three to seven weeks later are negative. The market rebounds about two months later and chugs along its bull cycle.
What this all tells you is not to get caught up in the recent bull fever. Chill out because now is not the time to buy. It's the time to trim, hedge, and prep your buying lists for when a pullback inevitably comes. My data says it's around the corner. So be prepared. And that's not a bad thing. Denzel Washington said, "I say that luck is when an opportunity comes along and you're prepared for it."
The Bottom Line
We (Mapsignals) continue to be bullish on U.S. equities in the long term, and we see any pullback as a buying opportunity. Weak markets can offer sales on stocks if an investor is patient.
Charts and tables sourced from www.mapsignals.com.
Disclosure: The author holds no positions in any stocks mentioned at the time of publication.