Market technicians with a monthly horizon are likely to cite that oldest of adages – the trend is your friend

MARKETS IN the US are up by more than 50 per cent since March and by more than 15 per cent since early July, when stocks raced higher with barely a pause for breath.

That’s excited much debate among fundamentally minded investors, but technically minded traders have also been busy debating the significance of recent moves.

Just how technically overbought are stocks, and what does it suggest for future returns?

Market technicians tend to be uninterested in earnings and economic data, preferring to focus on what the market is doing rather than what analysts and economists believe it should be doing. Like many fundamentalists, however, technicians are stunned by the strength of recent advances.

Rob Hanna, a full-time trader and blogger – quantifiableedges.blogspot.com – uses quantitative analysis to look for short-term market edges. Hanna views the current market action as historically abnormal, noting that the percentage of stocks trading well above their 40-day moving average, (“at least two standard deviations”, to use the official jargon) is at its highest level since records began in 1986.

“Spikes anywhere near what we are seeing now have been unsustainable in the past,” he says.

However, he admits other recent studies have also indicated that a pullback was due, only “the market has ignored most all of them”.

Like Hanna, trader and blogger Bill Luby – vixandmore.blogspot.com – is widely read in the technical community. He also views the market as “vulnerable to a reversal” now that the SP 500 is trading 15 per cent above its 200-day moving average – the first such occurrence since the heady days of 1999.

A double-digit correction is not the only way the index can work off its overbought status, however.

The 200-day average is rising, meaning that “sideways action or even small gains will help to work off some of the excess in this ratio and bring it back toward a more typical range”.

The market’s overbought status is also occupying Bespoke Investment Group, who note that eight out of 10 market sectors are technically overbought and most are residing at their most extreme levels of the last year.

The financial sector, which has “definitely caught a second wind” over the past few weeks, is the most overbought sector.

The market’s rising tide has clearly lifted almost all boats. About 90 per cent of stocks are now trading above their 200-day moving average – an incredible turnaround from March when just 1 per cent of stocks were above their long-term average.

The fact that markets were then at extreme oversold levels that traditionally marked market bottoms was one of many clues that a rally was due. So too was the fact that sentiment surveys revealed that retail investors – the so-called “dumb money” – were then more bearish than at any time in history.

Those same investors remained sceptical of the recent rally, with a large majority of respondents to the weekly American Association of Individual Investors poll continuing to categorise themselves as bearish in the following months.

The recent upsurge has changed that, however, and AAII polls now show a large majority of bulls.

“Excessive optimism in sentiment” was one reason cited by hedge fund manager Doug Kass, who correctly called the March bottom, for his recent decision to underweight equities.

However, while the technicals may suggest near-term caution, history suggests that any weakness will be short-lived. Markets have rallied from at least 10 per cent below their 200-day moving average to more than 10 per cent above the same level on 21 occasions since 1921, Bloomberg data shows.

On 18 of those occasions, the Dow Jones has been higher 12 month later. The average advance has been 18 per cent.

Over a six-month period, the Dow has been higher on 17 occasions, with an average gain of 8.2 per cent. Over three months an advance was recorded on 18 occasions, with an average gain of 5.7 per cent.

The fact that the 200-day moving average is rising once again is also encouraging for bulls.

Bespoke Investment Group notes that this average had been declining since January 2008, or 571 days – the third-longest such streak on record.

Looking at the previous five longest losing streaks in the 200-day average, Bespoke found that, one year after an upturn was finally recorded, the SP 500 was higher on every occasion, registering an average gain of over 20 per cent.

Despite the grave economic backdrop and seemingly elevated valuations, history suggests this rally has legs rather than being just another bear market bounce.

Short-term, the quants may be looking for a pullback but technicians with a monthly rather than a daily horizon are likely to cite that oldest of adages – the trend is your friend.

Lucy Kellaway is away