Unmasking the VooDoo: Overbought and Oversold

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Wouldn’t it be great to have indicators that tell you just when the market moved too far in one direction and was about to pull back, if not reverse? The holy grail, you say? Indeed, it would be.

We technicians love to bandy about terms like overbought and oversold, which we think mean just that. An overbought market means too many people bought too many shares/contracts so there is nobody left to buy any more. The market MUST be about to turn lower.

Ditto for oversold. The decline overdone. Too low. Must be a bottom.

That sounds about right. Too bad it is wrong.

Famed technician Alan Shaw used to say, the most bullish thing a market can do is get overbought and stay that way.

Have we all forgotten the very definition of trend? You know, the one from physics that states, somewhat, that a trend in motion tends to stay that way unless acted upon by an outside force. Just so we are clear, that outside force is increased supply or demand, depending on trend direction.

Stochastics reaching 95 is not an outside force. Rallying above the upper Bollinger Band is not an outside force. Neither are VIX spikes nor sentiment survey extremes nor Elon Musk smoking a doobie. Yes, they do tell us about the environment for the market but they are not outside forces that turn the trend.

The only thing that can kill a bull trend is a rise in the amount and aggressiveness of sellers. You know, supply beating demand. Boom! And they said we’d never use what we learned in intro college courses.

How many trends keep going up as short sellers get crushed? Not enough sellers.

How many (dollar) trends kept going up as the balance sheet of the Fed exploded? The dollar was supposed to collapse under the weight of money printing but it did not.

Bad earnings but the stock rallied anyway? Sorry, no sellers.

I think you get the point. Overbought and oversold indicators tell us how far the trend may be stretched but they are not the reasons trends snap back. As I keep preaching, two lines crossing on a chart is not the reason the market moved. The lines crossed because the market moved.

Keep that straight and you will never be ridiculed when you get interviewed or booed when you make a speech.

As with age, overbought/oversold is just a number. It all depends on what else is going on in the market’s, or your, life.