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Measuring unusual institutional activity has historically yielded prescient markers pin-pointing 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 February 21, 2017 and a month later the Russell 2000 fell 5.42%.
We measure potential unusual institutional activity on a daily basis and use these accumulation/distribution data points to plot a ratio. What we found over the years is that there are peaks in this data set that coincide with local market peaks when the ratio skews heavily in favor of accumulation…or 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 on January 24, 2018 and based on history, we believe the market could be near its local peak and a pullback is ahead, or the velocity of the recent rally could slow. We are long-term bullish on the market and feel any meaningful pullbacks should be used as a buying opportunity. (See also Top Strategies for Mastering Pullback Trading)
In the below chart, we define the ratio as a 25-day moving average of our accumulation/distribution signals, overlaid with the Russell 2000. The ratio ranges between 0% - 100%. A reading approaching 25% suggests an oversold market (in green), with distribution signals heavily outweighing accumulation signals, and readings above 80% suggest an overbought market (in red), with accumulation signals heavily outweighing distribution signals.
It’s rare for an overbought signal to trigger and thus we feel 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.
Lucas Downey is Co-Founder of Macro Analytics for Professionals. Learn more about MAP’s institutional signals here.
Disclosure: The author holds no position in IWM at the time of publication.