Overbought Oversold Overused Understood – Technical Analysis in Action

Fundamental investment analysis is the cornerstone of the work we do but technical analysis sits amongst the many layers of due diligence undertaken to initiate investment decisions. Referred to as charting to many, voodoo to some, technical analysis is not simply looking at graphs to determine the fortunes of the market but a study of the behavior of market participants. Stock prices alone tell us a huge amount of information about investors appetite not only for each specific asset but also more broadly at Mr. Market’s state of mind.

Technical Analysis has many branches and its very own language among practitioners, but some terms appear more often than others and they are thrown out for the public consumption. Favorites are studies of volume, moving averages, momentum and the ever-common reference to markets as overbought or oversold. Often discussed during periods of short-term turbulence these inelegant descriptions are floated to indicate that enough-is-enough and either the immediate short-term exuberance or panic has exceeded a sustainable course and a return to calm is overdue.

2020 has for better or worse shown all investors the two emotional extremes of being an investor. The acute market volatility of March…let’s just call it what it was: a crash, superseded by an astonishing rally that has likely never been matched in the modern history of U.S. stock markets. At their extremes (March lows) (recent highs) overbought and oversold flashing lights will have worn themselves out more than at any other time, and we have had some major times in recent history. What are analysts referring to when describing overbought and oversold conditions and how can we use those indicators to help steer our assessment of investments?

The trend is your friend but sometimes when there is no trend the only friend you may have is an oscillator. When prices move sideways for extended periods oscillators help traders identify short/intermediate opportunities to profit. The Oscillators in their simplest form measure current daily price action versus recent history. You can decide on any period, but common denominators are 7, 14, 21 days etc…

Apple Inc. (AAPL-USA) 2019/12/04 - 2020/12/04
Source: FactSet

In the chart above you can see two different types of oscillator (MACD, Stochastic: the details are not important right now) revealing short-term trading momentum.

As investors, not traders, we are less interested in short-term positioning, instead we are focused on identifying trends; emerging, structural (long-term), cyclical (economically sensitive). That is where the big money is made. However, during enfolding market trends, oscillators help us gauge the temperature of the market and inform our pragmatism when establishing a new position or reducing an existing holding. We can determine whether to assert our investment ideas or apply patience when we plan a change to portfolios.

In a broadly rising market, we need to be cautious about calling red flags with short-term oscillators indicating overbought positions. Within the bigger trend, oscillators will tend to be biased in that direction. We are careful to distinguish between exuberance and optimism during an upward market sweep that may persist in good health for months even years. The same is conversely true during bear markets, short-term panics within an unfolding cyclical trough. Employed as a part of the informed trading decision and call to action, analyzing short-term overbought and oversold signals can add morsels of value that build over time and contribute to investment success.

In recent months, the U.S. market has generally trended higher, interspersed with short-term (a few days to a few weeks) of volatility. During this time there have been instances/areas of exuberance in prices that has encouraged patience. Overall, the general trend has been favorable with marquee months of strong performance. The trend is somewhat bifurcated with areas of the economy clearly struggling more than others but generally from a technical standpoint heading into 2021 the outlook is constructive optimism with fleeting signals of exuberance that should check investors’ enthusiasm when they occur. Volatility in the future is a certainty and there are often signs that help inform our expectations, but genuine trend changes indicate when to slam not tap the brakes and for that oscillators are less valid. Technical analysts offer investors help through study of longer-term trends and importantly reversal signals, a whole new area of the subject that we shall save for next time.

David Gallacher, CFA is a Partner and Portfolio Manager at C.J. Lawrence. Contact him at dgallacher@cjlawrence.com or by telephone at 212-888-3841.

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