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Optical Illusions

In August 1987, the Nasdaq 100 was extremely overbought.

In July 1998, the Nasdaq 100 was extremely overbought.

In January 2000, the Nasdaq 100 was extremely overbought.

In October 2007, the Nasdaq 100 was extremely overbought.

The Nasdaq 100 is extremely overbought today.

Sell everything?

If only it were that simple. When looking at the chart below, our eyes tend to gravitate to overbought levels (using 14-period RSI) that were followed by sharp declines (most notably, early 2000). But our minds are playing tricks on us; it is an optical illusion. For we are ignoring the many other times in which overbought levels were followed by advances.

Going back to 1985, the evidence suggests that overbought is actually bullish, on average. Come again? In the year following an extreme overbought reading, the Nasdaq 100 Index has been higher 85.5% of the time with an average return of 14.8%.

*Note: The above table is price only. The returns would be higher if dividends were included.

Does that mean we can rule out another 1987/1998/2000/2007 top? No, just that one cannot predict another bear market based on extreme overbought levels alone. Bear markets can happen at any time, and “overbought” is neither a predictor nor a precondition. If one is going to predict anything based on extreme overbought levels (and I would advise against doing so), it would be further gains. I realize that doesn’t conform to the prevailing narrative of “overbought is always bearish,” but the truth in markets rarely does.

Related Posts:

Overbought, Oversold and the Great Paradox in Markets

Dead Cat Bounces and Armchair Contrarians

Interesting vs. Actionable

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This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Charlie-Bilello

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

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