It Isn't "Overbought"!

If you watched CNBC for more than 5 minutes today, you heard it: "The market is overbought."

If you watched CNBC last week, you heard it: "The S&P 500 is overbought. The retailers are overbought right now. We're due for a correction."

If you watched CNBC in September or October, you heard the same thing. And in November you heard that the market went through a correction because it had been overbought for the previous two months. Of course, all of a sudden in December these same people were telling you the market was overbought again. (Amazing how quickly that happens, isn't it?) Had you listened to them, you missed all the profits of a terrific month.

All these warnings have three things in common: 1) They will never help you make a penny. 2) They serve to keep the average investor out of potentially profitable periods. 3) They are meaningless, because they are based on a fallacy. "Overbought" and its imaginary evil twin "oversold" have no basis in reality. And if you think they do and it impacts your investments, you will lose money because of these false beliefs. Period.

Nonetheless, many traders use indicators to measure these imaginary figments. A common strategy is to buy when a stock is leaving "oversold" levels, and sell short when a stock falls from "overbought" status. To an extent this is a profitable trade if executed with discipline, but not for the reason those who practice it suppose. Either way, it's difficult, as you have very little edge due to all the other people trying to do the same thing.

Now here's a much simpler idea that produces much better results. Buy when your favorite indicator reaches "overbought" status and sell when it loses that status. Yes, you read that right. For that matter, any time you hear someone on CNBC say that the market is "overbought," buy. Buy whatever they are telling you is most overbought, if you want to really have some fun. And then buy some more when they tell you the same thing in two months.

Here's a monthly chart of the S&P 500 from 2001 to now. Just eyeballing it, the market was slightly down in that time period. The Lost Decade. Below it we have a simple stochastic indicator, which allegedly tells you that the market is "overbought" when it reaches 80 and "oversold" when it reaches 20.

 

How about this simple strategy? Buy the S&P when it is edging towards becoming "overbought," say when the stochastic is 70, and sell when it goes below 65. Short the market when it nears "oversold" levels at 30, and cover when it gets above 35. Could investing be any easier?  

The result? 6 trades in 10 years changes a do-nothing market into approximately 150% in cumulative returns. Now that's efficient trading! And easy as pie, simply by ignoring everyone who says the market is overbought or oversold.

I've adapted this concept and added some proprietary features to improve upon it, but the same general idea works on any stock and over any time period. Take a look at any chart you like, and the majority of the gains come when the stock is considered "overbought" and the majority of the losses come when the stock is considered "oversold." 

The reason for this is simple. Markets and individual stocks are ruled by supply and demand. Overbought/oversold indicators don't measure those two meaningless terms. Ask yourself this: What the hell does "overbought" mean, anyways?

Investopedia says it means:

1. A situation in which the demand for a certain asset unjustifiably pushes the price of an underlying asset to levels that do not support the fundamentals.

2. In technical analysis, this term describes a situation in which the price of a security has risen to such a degree - usually on high volume - that an oscillator has reached its upper bound. This is generally interpreted as a sign that the price of the asset is becoming overvalued and may experience a pullback.

"Demand for a certain asset unjustifiably pushes the price... " Unjustifiably? Seriously? Says who? I may think the demand for Deckers' Ugg boots is unjustifiable, but what difference does that make? If too many people are buying those hideous boots, do the Shoe Police start barring purchases? What about the stock? If you think something is "overbought," does it do any good if people continue to buy it at higher prices? Can we lose this whole concept, already? We've already shown that #2 above is ridiculous, unless you believe it's perfectly reasonable to wait years for a pullback.

What these indicators truly measure is supply vs demand, which makes them useful if you understand that. If you must use the prefixes "over" and "under," consider them "undersupplied/oversupplied indicators." When the indicator is high, demand exceeds supply. As it goes higher, demand is exceeding supply even more. This often builds on itself, as items in demand usually attract more demand on that basis alone. The whole thing tends to last for a decent period of time, until something causes demand to slacken, supply increases to exceed demand, or price increases beyond the point of demand. 

The best thing about knowing this is that I also know that nobody wants to believe it. People love the idea of something being "overbought." Probably comes from some sort of fear of heights... who knows? But most traders, and certainly the talkers on CNBC, would much rather spend time telling me I'm wrong (or simply dismissing the idea altogether) than spending the 20 minutes it would take to do enough research to show it to be obviously correct.

Therefore, the simplistic strategy of buying stocks after they have gathered positive momentum will continue to pay handsome profits.

The market may be about to plummet to depths never before seen. Maybe tomorrow. I have no idea and I don't pretend to. I do know this... if it does happen, it won't be because of some imaginary concept like the market being overbought. It will do so because supply exceeds demand.