Someone (thanks RSC) recently reached out with a great question. He said, "The melting up markets are an enigma to me. You know they are overbought, yet they continue to go higher. Just curious how the Big Money Index signals a hold or a sell?"

Ordinarily, I don't answer questions in an open format. But this question was perfect, and the enigma is that I don't get it more often. Everyone wants to know when markets turn, and better yet … before they turn.

For a refresher, I believe that big money dictates markets. I want to buy the best quality stocks when big institutions are buying them. I monitor what big money does by looking at unusual trading. That activity generates buy signals and sell signals.

These are added up and smoothed over a 25-day moving average: the Mapsignals Big Money Index (BMI). When it's below 25%, like in mid-March, the market is oversold. We expect a rise. When it's over 80%, it's overbought, and we eventually expect a fall.

The BMI just launched to 87.6%! People, we are very overbought in a very short amount of time.

Chart showing Mapsignals Big Money Index

It stands to reason that big money investors pull the tides along like the moon's gravity. Everything else just follows along. Riffing on that analogy, think of this: the moon has much weaker gravity than earth. Many know that you weigh one-sixth of your earth weight on the moon. Even with that, the moon's gravity tugs on entire ocean and even steals some of earth's rotational energy. The moon's gravity causes our planet to slow down by about 1.5 milliseconds every century.

As for the great question, I answered it like this (of course another analogy): Like most things in life, it's all about riding the wave. A surfer can't turn his or her board just by counting seconds of riding a wave in his or her head head – he or she must react to how it unfolds. They may be alike, but no two waves are the same.

The market is a wave. The BMI went overheated (above 75%) and then overbought (80%) quickly. The BMI is trending higher. We aren't going to fight that trend. 

The key, historically, is to ride the wave until it crests. Once the data shifts (BMI begins to level off and fall), we should think about either protecting or reducing long exposure. I often find (and write about) a key divergence: It's when the BMI starts falling but the market goes up! That is a great indicator that things are changing under the surface.

As the data confirms and reinforces that thesis, with protected or reduced long exposure, we wait until the data shifts back again to bullish … giving us an all-clear to buy.

It may sound overly simple, but who said that market investing has to be overly sophisticated? Either way, the beauty is that it's all data driven – no guesswork. Data has enabled this method of analysis to be spot on. That can help drive superior navigation through the markets.

With that said – can we get any idea of when this overbought market will roll over? We are very overbought, but we can stay very overbought for weeks. The key is to watch for when the data changes – not when it just sits in overbought territory. It may like it there and not want to leave! When the data changes, the wave crests, and then it's time to hop off and prepare for stocks to pull back – not before.

To get an idea of what to expect, I looked back at the past few times this happened. But here's the deal: staying overbought for a prolonged period tends to happen when markets flip from oversold to overbought in just a matter of weeks ... like now.

The past two times that are similar to now are February 2019 and March 2016. Both periods had a lengthy overbought period of seven and eight weeks, respectively. So just because we hit overbought doesn't mean it's time to sell yet. It's like getting off the wave before it crests because a surfer is worried about a wipeout. That is all fine and good, but the end of the ride might be the best part. We never know.

As for what is driving this rally, it continues to be technology and health care. I've been highlighting that move ever since we came out of the chasm in late March. April saw capital fly into these sectors. It's still happening. In fact, last week, we actually saw big health care buying for the first time since February. The sector flashed yellow, meaning that more than 25% of the stocks in health care that I monitor were bought in a big way:

Table showing unusual institutional (UI) buy and sell signals by sector

Staples stocks are unsurprisingly not far behind. Perhaps the most notable thing of all is the near absence of selling. That's what we want to watch for. When the big money starts selling, it's usually before the indexes drop. They tend to know before – so I want to watch there for clues. For now: nothing.

I've used Laird Hamilton's great surf quote before: "Surfing's one of the few sports that you look ahead to see what's behind." This week, it seems appropriate to add a quote from Bethany Hamilton (no relation to Laird). She is a pro surfer who survived a 2003 shark attack, losing her arm. She returned to surfing, and when asked about how she could, she simply said: "My passion for surfing was more than my fear of sharks."

The Bottom Line

We (Mapsignals) are bullish on high-quality U.S. equities in the long term, and we see moments like these as areas to pick up great companies. 

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

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