A Healthy Pullback is Coming BY LUCAS DOWNEY, CONTRIBUTING EDITOR, TRADESMITH DAILY Think back to one year ago. If you can believe it, back then the S&P 500 was at 4,204. That’s more than 1,500 points below where it is today. And the mood was dour, to say the least. Few imagined a monster rally was coming. But if you recall, we were one of the lone bulls pounding the table that the bears would soon be going into hibernation. We didn’t make that bold call using our gut… Nope – we analyzed extreme oversold positioning and found an incredible risk/reward setup. Since that crowd-stunning call, the S&P 500 is up a staggering 34%. Not bad! Congratulations if you heeded that call. But where we find ourselves today is the opposite side of the spectrum. The S&P has now made its first break into overbought territory since December. After a big, fat rally like this, though, few can imagine that stocks will ever pull back again. Recency bias is a powerful drug, where humans put extra weight on recent events and less on the past. Look, I’m no bear. What I am is a disciple of data. And the same indicator that signaled the green light ahead for stocks last October has finally flipped to red. While this doesn’t mean doom and gloom is on the horizon… it does suggest that now is the time to start planning for unexpected turbulence in the weeks ahead. So, today I’d like to point you to one powerful indicator that will alert us to when a healthy pullback is afoot. If you missed the big bullish wave the past year… keep reading. Because you might get that buy-the-dip opportunity before year-end. Stocks Finally Reach Overbought Territory If you’ve been a trader for any length of time, you know that markets are constantly shifting from one extreme to the other. When investor anxiety is high and folks are fearful, prices plunge. When investors are cheerful and extremely confident, prices soar. Fortunately, we have a powerful indicator to help us understand investor positioning: the Big Money Index (BMI) from Jason Bodner’s Quantum Edge system. The BMI is a real-time tool designed to plot a reading of big institutional appetite for stocks. It performs price and volume analysis on thousands of stocks each day… searching for the extremes in price action. When we reach these extremes, we identify them as red (overbought) and green (oversold) zones. Here’s a snapshot of all 10 overbought signals since 2018. I’ve also included the seven oversold instances, too. The right side of the chart reveals that we just entered the red zone: What Happens After the Signal Flips I want to point out a few things from the chart above: - First, oversold signals often fire near market troughs… like we saw last October.
- Second, overbought signals are more frequent and tend to occur after powerful upside moves in stocks.
Specifically, looking back at times when the BMI has dipped into oversold territory since 2018, the S&P 500 has then ripped 26.1%, on average. Clearly you want to have this tool available when the going gets tough! On the flip side, when we break into the red overbought zone, rallies can eventually stall. Here’s a zoom-in on the last handful of overbought instances (since 2022). The red arrows highlight how the SPDR S&P 500 ETF (SPY) experienced a healthy pullback shortly after: If you’re inclined to run for the hills, think again. Because overbought signals on the BMI are actually a near-term momentum signal. See how, after the last overbought signal around the new year, stocks kept climbing for a good while before the pullback? That’s no fluke. Since 2014, once the BMI broke into the red zone it tended to hang there for an average of 21 trading days… call it a month. So, be prepared for the party to last a few more weeks. It’s when the Big Money Index breaks below the overbought threshold that investors should take notice. Below shows the average performance of major benchmarks from the first day the BMI fell below that 80 overbought level, 80%: - One week later, the S&P 500 fell 0.9% and the Russell 2000 sank 1.2%.
- One month later, the S&P 500 dipped 1.6% and the Russell 2000 flopped 2.3%.
- Two months later it didn’t get any better, with the S&P 500 off 2.1% and the small-cap heavy Russell 2000 cratering 3.9%.
Now, why would a falling Big Money Index forecast a struggling stock market? It comes down to supply and demand. Right now, demand is in overdrive – and that rarely lasts forever. In fact, it’s always ended at some point! A much-needed cool off period is likely in store… and that’s where the big opportunity is for you. Now’s a great time, while the yellow light is blinking, to trim some fat off your portfolio. Anything you don’t love, consider selling to raise some cash. Then, when the healthy reset comes, you’ll have capital to deploy into all-star stocks on sale. That’s a solid gameplan. Plenty of stocks are beginning a new multi-year uptrend. Utilizing state-of-the art software like Jason Bodner’s Quantum Edge will alert you to high-ranking companies on the move now. History and evidence suggest a healthy pullback is around the corner. Start getting your buy list ready now. Jason has some ideas for you – click here to watch his new free presentation now. Regards, Lucas Downey Contributing Editor, TradeSmith Daily |
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