We all need to stop and rest. Don't tell that to Parisians though. While New York is the city that never sleeps, Paris is the city that never stops. The city has one and only one stop sign; it's in the 16th Arrondissement. Throughout the rest of the city, drivers just yield to traffic on the left and traffic lights.

But sometimes, we need a stop sign, especially for the market. For instance, it would be great to know when the market is about to overheat. Just like a car, we would be able to roll back the engine (our risk) before an overheat happens and a meltdown comes (a correction).

Luckily, the market has many stop signs – it's just a matter whether or not we see them. The consequence of choosing not to see signs in the real world can be steep. The same can be said for ignoring the market's warning signs.

One sign I rely on is the overheat-meter of big buying and selling. I look at more than 5,000 stocks daily. I then look for which ones likely have unusual buying and selling going on. Those buy and sell signals get tallied up and plotted in a ratio. You can see that below.

When the ratio goes into the green, the market is oversold. We can expect a market rally shortly thereafter. When it goes into the red, the market is overbought, and we can expect a pullback soon thereafter. You can see below that oversold conditions are very reliable. Overbought indications are a little less so but are still clearly something to pay heed to. Notice that the ratio for is in the overheated orange range:

Chart showing the performance of the Russell 2000 and the corresponding MAP-IT ratio
www.mapsignals.com

This ratio drawing close to overbought was a warning sign. It was an opportunity to take profits and reduce risk in some portfolios for aggressive traders. Notice what happened to the market and most sectors as soon as the market got overheated – we pulled back:

Chart showing the performance of major stock market indexes over the past week and since Dec. 24 lows
FactSet

Semiconductors were the lone bright spot. That can be reflected in the signals. Information technology saw some buy signals – 27 out of 180 possible stocks. Look at materials as well – the sector was one of two that were positive for the week. And notice below that the buy signals were 22 out of 79. You can also see the power of big money trading in energy, as the sector was down 2.7%, while 35% of energy stocks logged sell signals.

Chart showing unusual institutional (UI) buy and sell signals by sector
www.mapsignals.com

The signs are there for the seeing – you just need to know what to look for. Imagine driving a car in a country that has completely different traffic signs and laws. You wouldn't know what to look for. The market is similar. There are many different ways to navigate the market. Big money buying and selling is a very effective way that I discovered through years of working on institutional trading desks. 

But now that we have our signals showing us an overheated market, what do we actually do with that information? Does an overheated market mean we are headed for disaster? The answer comes in the undercurrent ... Let's look at the overall picture:

  • The market is overheated, not overbought. A retreat from being overheated back into neutral territory means markets can reset and resume an upward trend.
  • The overall trend has been one of big money buying.
  • The U.S. stock market remains the oasis in the choppy global landscape. Europe, Asia, and Latin American equities offer uncertainty at best. U.S. sales and earnings are continuing their strong march forward. As stocks rally, their dividend yields drop. But even with record-high stocks, compressed U.S. bond yields are simply no match for investing in stocks. Look at the table below, and you'll see that (for wealthy investors) just buying the S&P 500 and earning its dividend yield of 1.87% gives you 18% more money in your pocket than buying Treasuries at 2.05%:
Image showing the yield on the 10-year Treasury yield vs. the S&P 500 dividend yield
FactSet

An overheated market doesn't mean get out; it just means be vigilant. I am using this opportunity to raise cash on profitable trades I don't intend on being in for the long haul. I am not touching core holdings and long-term positions. This is because history has shown that the market will likely just resume its march higher after any reset.

To me, this means trim risk and raise some cash to have some on hand when the market offers us discounts on great stocks. So, when and if the ratio of buying to selling drops, I'd advise to have dry powder and buy-tickets ready. It means I am on the lookout for a potential buying opportunity in the coming weeks. August notoriously brings volatility. My data echoes this setup. 

Markets ebb and flow. As I try to navigate them, I look to what the big money is doing. Right now, it's telling me that buying is taking a pause. But that pause will bring opportunity. U.S. stocks are the best place to put money, but there may be bumps ahead as summer rolls on. Using the market's signage can tell us when to speed up and when to slow down. But the most important thing is that we don't stop. 

U.S. stocks are still the best long-term place to be. As a $2 billion manager told me, "Where else are you going to go? You want negative rates the rest of your life?"

Maybe Paris urban planners consulted Confucius: "It does not matter how slowly you go as long as you do not stop."

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. Overheated markets can offer sales on stocks if an investor is patient. 

Disclosure: The author holds no positions in any stocks mentioned at the time of publication.