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Market Outlook: S&P 500 Is Finally Overbought, Should You Sell?

Michael J. Carr

After another big gain, the S&P 500 closed in overbought territory for the first time since October.

Overbought, but Not a Sell Signal

To define overbought, the 52-week rate of change (ROC) is a useful indicator. When the 52-week ROC is greater than 25%, I consider the stock market to be overbought. After gaining 2.16% last week, SPDR S&P 500 (SPY) moved into overbought territory. Previous overbought extremes in SPY are marked in blue on the chart below.

SPY Chart

SPY was overbought most of the time from 1996 to 2000, and stocks were in an extended bull market for most of that time. Since then, other overbought signals have also appeared at acceleration points. This chart makes it clear that an overbought market is not necessarily one that should be sold.

Yet overbought markets do seem to bring out bears. Some investors are contrarians. They make buy and sell decisions that are contrary to what everyone else is doing. Their philosophy is that the majority of investors will be wrong at key turning points and the best way to profit from the markets is to take positions on the opposite side of the majority opinion.

This philosophy only works well precisely at tops and bottoms. Most of the time, the majority of investors have to be right. That is why markets trend. It takes widespread buying or selling to create sustained trends. At turning points, the majority of investors will be wrong, but there is no way to know in advance whether we are seeing a trend or a reversal.

Right now, contrarians are bearish because the market has gone up so much so quickly. I think they are wrong. We know overbought markets can become more overbought so there is no reason to expect a decline based on the technicals. And on a fundamental basis, we can argue we are just beginning a new bull market.

On a long-term chart, the price-to-earnings (P/E) ratio of the S&P 500 has just broken above its two-year moving average. This is bullish because P/E ratios expand in a bull market. The breakout is similar to the one seen in the mid-1990s.

P/E Chart

Both the 52-week ROC and P/E ratio look like they did when stocks soared at the end of the 20th century. This certainly doesn't mean that stocks will not sell off. But it does indicate that the market could continue to deliver big gains. Until prices reverse, traders should remain long.

(Note: If you are worried about a market crash, you're not alone. Luckily, there is a simple way to know when the next one is coming. Check out my free report, 3 Indicators That Flash 'Sell' Before a Market Crash.)

Recommended Trade Setup:

-- Maintain long position in SPY
-- Raise stop-loss to $156, the level where prices break below the 38.2% retracement of this year's gains
-- Raise price target to $176

Gold Shows How a Bear Market Unfolds

Many years ago, military planners focused on a sneak attack with nuclear weapons. It was the worst-case scenario and was called a "bolt from the blue." The war would start with a single missile appearing without warning, almost like a bolt of lightning crossing the calm blue sky. Responses were prepared, but fortunately never used, as the results of each were catastrophic.

Investors always seem to be waiting for a bolt from the blue. They call them "black swans" or "six sigma events." No matter what term is used to describe it, the results of unexpected market crashes are always catastrophic.

These events are impossible to prevent, but they are also rare. Instead of a bolt from the blue, we usually see market crashes unfold as they have in gold.

GLD Chart

Everyone now agrees gold is officially in a bear market. The chart shows that traders should have been selling positions in gold more than a year ago. SPDR Gold Trust (GLD) broke below its 10-month moving average six months after setting an all-time high. That is a signal that the long-term trend has changed.

As we usually see before bear markets accelerate, a rally toward old highs failed. This is very similar to the pattern we saw in the stock market in 2007.

SPY Chart

Rather than preparing for crashes, traders can usually make more money focusing on the trend. In the case of gold, the trend is still down. GLD fell 6.11% last week.

PowerShares DB Gold Short ETN (DGZ), an inverse fund that goes up when gold prices fall, gained 5.89% last week. DGZ remains a hold as gold continues to fall.

Recommended Trade Setup:

-- Hold DGZ
-- Raise stop-loss to $13.15
-- Maintain price target at $14.80

This Week's News

The week starts slowly, but news in the second half of the week could drive markets. Fed meeting minutes may move markets on Wednesday when they are released. Economic reports on Thursday and Friday will be analyzed based on what those minutes reveal. Other events to watch include:

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