After Extraordinarily Overbought Breadth Readings (Full Article)

By Lawrence G. McMillan

This article was originally featured in the 3/27/16 edition of The Option Strategist Newsletter.

A couple of weeks ago, we mentioned that the highest “stocks only” breadth oscillator reading in history had taken place.  In fact, the top three readings of all time occurred on March 3rd, 4th, and 7th of this month (March, 2016).  In addition, the 15th and 17th most extreme readings of all time occurred on March 2nd and March 11th, respectively.  We wanted to study the other extreme readings to see what happened after those.  Is this a significant longer-term indicator, or is it just indicative of the fact that short-term momentum is strong?  The complete "Top 20" is shown in Table 1. 

Table 1: Most Extreme “stocks only” breadth oscillator readings

Outside of March 2016, the most extreme readings occurred as follows:

Even these can be somewhat grouped together, because several readings over a period of a few days really constitutes just one “event” for the question that we want to study.  And that question is, “What did the market do after these extremely high “stocks only” breadth oscillator readings?

Table 2: Percent Moves by $SPX After Extreme Oscillator Readings

So there were nine different times when an extraordinary reading – or set of readings – occurred.  In general, they didn’t have much effect in the short term.  The average gain or loss in $SPX was 1.5% or less over the next three months.  Only six or 12 months later did $SPX move somewhat higher.

In fact, over the first week and the first month, there was a loss on average, indicating that the market needed a rest from those overbought conditions.  Those average results over all nine cases were highly influenced by the negative July, 2011 occurrence – as that was just before the market had a very nasty patch from August through November of 2011.

As we pointed out a couple of months ago, when we did the study on a series of 1% gains, three or more days in a row by $SPX, the longer-term advances are not really significant.  I’m pretty sure that if we took any series of days in history and calculated how $SPX did six and twelve months later, the gains would average something fairly decent – only because the market goes up most of the time. 

In summary, this study produces about the same result as that previous one: there isn’t a lot of predictability from the fact that the “stocks only” oscillators registers extraordinarily high readings.  While at the time, it is an indication that there is strong market momentum, once it wanes, the gains are not worthwhile. 

This article was originally featured in the 3/27/16 edition of The Option Strategist Newsletter. Receive the feature articles immidiately each week by subscribing now.