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Stocks Overbought? One Simple Gauge Nobody's Using

Kevin Cook

There are plenty of technical indicators that you can use to tell when stocks are overbought, such as market breadth and relative strength.

Several breadth indicators can tell you how many stocks are making new highs vs. new lows, or what percentage of stocks are above their 50 and 200-day moving averages.

But there is one very simple tool that needs to be used when stocks are flying high: the distance from the 50-day moving average.

The reason I use the 50-day is not just because it is so commonplace. It's also a good intermediate time window in between quarterly earnings, whereas the 20-day would be too brief and volatile and the 80-day just a bit too wide and tame.

What happens in strong bull run periods for the market is that the 50-day can take on the "look and feel" of ascending at a 45-degree angle or higher.

But, as we all know,overbought can stay overbought for longer than bears can keep their heads.

So how do you know when the 50-day is telling you that the market is too overbought, for too long?By where price is in relation to it.

There are certain “windows of extreme extension” in the short-run where the only remedy is some “mean” reversion to cool off for a bit before the bull can run again.

Extreme Rallies and Mean Reversions: Gifts That Keep Giving

While many investors bemoan “fake rallies” and their inevitable harsh cleansings, the smart ones are cleaning house by taking profits near peaks and getting ready to buy some reversion to the mean.

In the video that accompanies this article, I explain exactly how to see and use this simple tool on both the S&P 500 and the Nasdaq 100.

I have specific parameters I use for these two different indexes, one of which is dominated by growth and technology.

And for sectors that are even more concentrated with growth and tech, like the pure tech and pure communications ETFs, I suggest using a higher parameter for "overbought."

For instance, the QQQ has as its top 5 holdings Microsoft MSFT, Amazon AMZN, Apple AAPL, Facebook FB, and Alphabet GOOGL. These comprise over 40% of the market capitalization-weighted index.

But the S&P Technology Sector (XLK) only includes MSFT and AAPL as it recently moved FB and GOOGL to the new Communications Sector (XLC). And AMZN has always been in the Consumer Discretionary Sector (XLY) where it dominates as 24% of that ETF.

By themselves, these heavy weights can consistently run around 7% above their 50-day MA in strong bull market periods.

And don't get me started on explosive stocks in the Software industries. Many of those are running 10% above their 50-day.

But that's what individual growth rockets will do. For our purposes here, we're more concerned with the major indexes and some of their leading components to tell us when the market is most ripe for a turn lower.

In the video, I give examples like the Dow in January 2018 when Boeing and Home Depot were vaulting 10% above their 50-day and this caused the index to be +7%.

Be sure to watch and learn how I use this simple tool where I also explain how it's similar to and different than Bollinger Bands.

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