Tuesday, August 19, 2014

When Do Overbought Markets Reverse?

Recent posts have focused on the role of sentiment in short-term market returns.  Let's take a look at strong markets and what we can learn from stretched sentiment.

It's common for traders to assume that markets that have risen meaningfully in a short period of time, like the current stock market, will either continue in their recent direction (momentum) or reverse because they are "overbought".

As of yesterday, we had over 80% of SPX stocks close above their 3, 5, and 10-day moving averages (shoutout to Index Indicators for the data).  Since 2006, we have had 132 occasions of such strength.  Two days later, the average change in SPX has been -.37%.  That compares to an average two-day gain of +.08% over that same period.  On the surface, it appears that "overbought" markets lead to "mean reversion".

If, however, we break down those 132 occasions by median split based upon the equity put-call ratio, a different pattern emerges:  Overbought markets with low put-call ratios (bullish sentiment) have averaged a two-day loss of -.68%.  Overbought markets with high put-call ratios (bearish sentiment) have averaged a two-day loss of only -.06%.  In other words, almost all of the weakness seen immediately following strong markets has occurred when overbought has been accompanied by stretched bullish sentiment, which is what we're seeing as of yesterday's close.

It's a nice illustration of how context matters:  The same price movement in different environments of market psychology can lead to very different forward price paths.

Further Reading:  Finding Trades When Sentiment is Stretched