First, definitions: I am using as an overbought/oversold measure the percentage of SPX shares trading above their five-day moving averages. (Data available from Index Indicators). For sentiment, I am looking at the put/call ratio for all equities on all exchanges that have listed options. (Data available from e-Signal). For this exercise, we'll look at the period from 2010 to the present.
If we just break the market down by a median split on the overbought/oversold measure, what we find is that the next five days in SPX average a gain of .12% when we've been overbought and .38% when we've been oversold. In general, chasing strength or weakness on the short-term has been a bad idea: if we waited for several days of "price confirmation" before entering long or short, our near-term results suffered.
Now let's break down the overbought occasions by a median split of daily sentiment readings. When we've been overbought and sentiment has been bullish, the next five days in SPX have averaged a gain of only .01%. That is a paltry return, considering the bull market. (For the sample overall, the average five-day gain was .25%.) When we've been overbought, but sentiment has been bearish, the next five days in SPX have averaged a gain of .22%--nearer the sample average. In other words, overbought readings have only led to diminished returns on average when they've been accompanied by bullish sentiment.
Next, we'll break down the oversold occasions by a median split of sentiment. When we've been oversold but sentiment has been bullish, the next five days in SPX have averaged a gain of only .09%. When we've been oversold and sentiment has been bearish, the next five days in SPX have averaged a whopping gain of .68%. In short, the best time to buy stocks is when people have been dumping them and sentiment is bearish--precisely when stocks look their ugliest. The trader who bought stocks when they were their prettiest earned almost no positive return over the past 4-1/2 years.
One takeaway: The very same ideas in the stock market yield wildly different returns depending upon how they are executed. You could have been a bull the last several years and still not made money in U.S. stocks if you needed the reassurance of price confirmation and could not take the heat of short-term price disconfirmation. Buying when the market has been pretty and selling when it's been ugly has guaranteed losing returns.
Further Reading: Volume and Volatility in the Stock Market
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