Does 'Overbought' or 'Oversold' Matter?

02/08/2013 9:45 am EST


Lawrence McMillan

Founder & President, McMillan Analysis Corporation

Market veteran and options expert Larry McMillan discusses some of the misconceptions about overbought and oversold markets.

Is the stock market overbought? Here to answer that question is Larry McMillan. Hi, Larry, and thanks for being here with me.

Glad to be here.

We’ve had a great run in the market in the last year. I think when we were here last year it was about 12,800, and now we’re closing in on 14,000. Do you think it’s overbought, or do we still have a way to go?

It’s overbought, but that doesn’t necessarily mean sell. I usually tell people that oversold doesn’t mean buy either. The market can keep doing the same thing for a long period of time. I mean, I wouldn’t rush out to sell it right now until you actually had sell signals. Overbought indicators will eventually develop into sells signals, but we really haven’t seen any of that happen yet.

For example, one thing we track is the number of advances minus declines every day, and we keep a cumulative running total of that and some other things, too. It’s gotten very overbought...but typically when a new bullish phase gets started—and it’s hard to say that last November it started a new bullish phase, but I think it really did because people were so worried about the fiscal cliff that they were holding back and then they started putting money in real quickly at the beginning of this year—we’re in sort of a new bullish phase and it got overbought, and that’s pretty typical.

They can continue that way for quite some time. In fact, we had what we called 90% volume days, and 90% of the volume was on advancing stocks versus declining stocks. We have two of those; the last day of last year and the first day of this year. Typically when that happens, yes the market is overbought, but it goes for a while after that.

It’s not a sell indicator?

Not a sell yet, so if you’re a short-term trader—and I’m not sure how short term you would be—you would want to see at least a weekly close below the previous week’s close just as a bare minimum. We haven’t even had a day where that’s happened yet this year.

Secondly, we’d want to see it start to go from adding positives every day to start adding negative numbers, and that would be a sell signal as well.

Then there is another indication that I consider overbought as well, and that’s volatility being low—specifically stock option volatility. We track what’s called a composite implied volatility, and right now it’s in the fifth percentile—meaning that on average, take any average stock, its options 95% of the time in the last 600 trade days have been more expensive than they are right now.

So they’re cheap. IBM (IBM) options have never been this cheap before in the history of IBM options. That’s fine. The market can continue to go up while that happens, but if that rises up to the 17th percentile—and we’ve back-tested this—then you’ll have a sell signal.

That could take a while. I mean, I think at this point, if you’re looking to short this market, you definitely need to be careful. Even if you’re looking to sell to take some profits on longs, I don’t think it’s time yet. We really need to see confirm sell signals.

Not time to run for the exits yet.

Not quite.

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