The Experts Are Wrong: Overbought Means Time To Buy

Many experts rely on folklore rather than data.

Is easy to see why. Folklore is widely available. Sounds good, and besides, it takes a lot of work to find reliable data.

CNBC is a place where experts gather folklore. The business network provides a platform for many experts to share ideas. This means that many experts simply repeat what they heard someone else say in a previous interview.

Since the web does not require experts to prove their opinions are accurate, folklore becomes widely accepted.

One of the most popular views is that stocks are overbought. An analyst says the word “overbought” and smiles for the camera almost every day.

The problem is that few experts tell us what overbought means.

Actions are not rubber bands

Technically, the term overbought means that prices went up too fast. When they say overbought, analysts picture stocks as an overstretched rubber band. Overstretched is the same as overbought.

Now, release the rubber band and it will quickly return to its normal size. With stocks, the assumption is that after stretching too far, prices return to lower levels as they fall.

The rubber band sounds like a good way to think about markets. But it is not a useful way. A better way sees a rapid price increase like a rocket.

It takes tremendous power for a rocket to break the grip of gravity. The force we see in the initial stage of the rocket’s journey propels it to new highs.

We now have a testable question: Are actions like a rubber band or a rocket?

Well, the data shows that the stock market is more like a rocket than a rubber band. Overbought markets usually continue to rise.

This is bullish for the current stock market.

Recently, the Dow Jones Industrial Average was 15% above its 200-day moving average (MA). Analysts call this overbought.

In 2009, the Dow Jones was accelerating after a devastating bear market. This is the first time the Dow Jones has accelerated so fast in more than seven years.

History shows that overbought means time to buy

With more data, we learn that this is far from the second time we’ve seen it. Since 1900, the Dow has moved this far from its 200-day MA more than 150 times. This market action was common in the early part of the 20th century, but it has been rare in the last 60 years.

These signals are generally bullish. On average, the Dow offers above-average return with below-average risk in the months after the signal.

The data confirms that overbought markets are strong markets. Now is the time to wait for more profit and invest aggressively.