Articles

By: Chris Rowe — March 6, 2019

The Market is Now Overbought - Here's How to Play It

CHRIS

Currently, we are in a short-term overbought stock market...

... in the early stages of a new bull market.

There's three pieces to that description...

  1. The market is currently overbought...
  2. In the short-term...
  3. And it's the early stages of a new bull market.

One implication of this is that it could be time to watch for the PULLBACK so you can buy some quality stocks at a discount.

But also, there are a number of other things you can do to play this (very healthy!) bull market.  I'll come to those in a second.

First let me set the stage a bit.  Let's unpack those three pieces so you can see the "true" current market more clearly.  To save time I'll handle the first two pieces at once.

Now, I know my way of phrasing that market description can sound strange --"The market is overbought in the short term".

Why not just say "The market is overbought" and leave it at that?  After all, overbought is overbought, right?

Actually, no, it isn't.  Not exactly.  In fact, if you just think "overbought" without the "short-term" part... you could get yourself in a world of trouble.

As you know if you've been reading this column regularly, the stock market is made up of many mini-stock markets -- 45 of them in fact. They're called "sectors".  Sometimes one or more sectors shows strength... and sometimes they're showing weakness, independent of what the larger market (and other sectors) are doing.

Well, you can also view the market in terms of time frames.  Seen this way, the market is made up of three distinct "markets" -- the short-term, the intermediate-term, and the long-term markets.

Sometimes risk is elevated in one time-frame... while at the same time risk is small over a longer or a shorter time frame.

The Key Difference Is In Today's Context...

An overbought market is very different from an oversold market.  Not just for the obvious reason -- one is up and one is down.  The way those two markets behave is what makes them so different.

For example, the way a market "reverses" from overbought territory can be very different from how they "reverse" from oversold territory.  If you don't understand these simple differences, then you could get hurt.

In general, when markets are overbought, people are feeling "greedy".  Or in a mature bull market they're feeling "euphoria".

What about the third piece of that description?  Right now we are in the very early stages of another bull market.  It's not "mature", and so that euphoria isn't there, not yet.

Last week, ("Why This Market Is Headed "Up Up and Away") I said, "A stock market that recently bottomed out (after going through a bear market) and then made its first jolt higher, is one where "overbought" readings can be ignored."

Today we're going to fill out that idea.  We'll focus on the short-term because that's the "market" that's overbought right now.  That's the market where risk is elevated (and opportunity is present).

Also in last week's article, I said, "Overbought readings in a bull market that's not very mature tend to suggest a shorter-term top with a coming price pullback (5%-10%) or correction (10%+)."

That's why now could be a great time to "buy on the dip" if you're a trader who favors a short-term focus.

(If you're more comfortable with a longer-term orientation, that's fine.  You can feel comfortable just riding out any coming downturn.  Remember, this is a healthy new bull market.)

Let's look at the current stock market landscape and see how it's likely to pan out over the next month or so.

We'll start with the longer-term picture, so you can feel reassured we are indeed in a healthy bull market.

Here's a Point and Figure (P&F) view of the NYSE Bullish Percent Index (NYSE BPI).  This shows you the percentage of stocks on the New York Stock Exchange currently on technical Buy signals.

(Click any image to enlarge)

NYSEBPI_Annotated

The chart is currently in a column of X's (bullish)...

... at a level below 50%.  Above 70% is considered overbought.  So with just 48% of stocks trading on Buy signals, the bull market has plenty of room to run.

Turning to the short-term, here's a chart of the NYSE 10-Wk MA.  This shows you the percentage of stocks on the New York Stock Exchange currently trading above their 10-Wk MAs.

This shorter-term indicator is also in Xs, but as you can see, it's well into overbought territory.  The risk of a short-term pullback is elevated in the short term.

NYSE 10-WK_ANnotated

Here's another (admittedly busy) view of the same data.   Notice that the last time we saw readings this elevated was back on May 24, 2016 (red arrows).

NYSE10-WK_MayLabel_Arrows

That was also right after the market had bottomed out (in January/February 2016).  In other words, we were also in the "early stages of a new bull market".

Here's what happened next...

PortraitHealtyMarket

Given this current situation (we are short-term overbought in the early stages of a new bull market)...

It might make sense for shorter-term players to consider the following:

  • Tighten up stop-loss orders...
  • Sell Covered Calls on stock positions...
  • Buy Protective Puts on stock positions...
  • Sell Naked Puts (slightly out-of-the-money or at-the-money)...
  • Pivot away from long-stock positions to the Stock Replacement Strategy, where you use deep-in-the-money Call options that expire 6-9 months out.  (You'd buy approximately 1.3 calls for every 100 shares of stock you're replacing.)

As always, I prefer selling premium.  That's because selling when you aren't using options contracts, when you restrict yourself to only stock/ETF trading, then it's black or white.  Buy or sell.  You own it or you don't.  You're either bullish (you own it), neutral (you don't have a position) or bearish (you sold it short).

With options, there are all the different shades of grey.  Not quite 50, but maybe a dozen.

You can create a position where you're "bullish to neutral", by selling covered calls or selling naked puts.  You can create a position where you're a little more directionally biased with the stock replacement strategy or by owning stock plus protective put. But in these cases, you're pretty well prepared for a jolt lower.

As for the intermediate-term and long-term players, you might want to just ride out whatever price dip we encounter next.

Sometimes trying to time the market isn't the best idea.  In the early bull market, if the timing isn't great then upside may be missed.

But selling premium can also be a good idea just to attempt to pick up a couple extra percentage points, which is powerful, considering the general stock market returns 7% - 8% a year, on average.

I'm guessing most people won't read this and hedge 100% of their portfolio with options.  But if this is a new concept for you, you may want to try it with a couple of positions and see how it pans out.

I think we're going to be having a lot of bullish conversations in the coming months!

Trade safely,

Chris

CHRIS

 

 

 

 

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