Research & Advice

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Overextended, Overbought, Overdue, but not Over

June 10, 2013

  • The recent stock market correction has been over five percent and has triggered some concerns.
  • The stock market has been overdue a 5-10% percent correction for some months; while uncomfortable to experience, these types of stock market movements are ordinary and regular and to be expected.
  • With an absence of signs of a major top, investors should continue to focus on the long term and regard a pullback as normal and ordinary and not the start of a prolonged decline in prices.

The recent drop in the S&P 500 stock market index, from peak-to-trough, has been about 5.3%.   That compares to three previous year-to-date of corrections of 2.9% in February, 2.8% and 3.6% in April.  So this has been the largest correction of the year and has thus prompted client phone calls asking if the bull market run is over.

This correction has, indeed, triggered some concerns.  For example, Berkshire Money Management tends to consider the law of supply and demand when it comes to stock prices.  Selling pressure increases supply, thus reduces prices. Buying pressure increases demand, thus increases prices.  Quite frankly, it is that simple – for now, forget the reasons why investors might sell or buy and let’s focus on what investors are doing.

The stock market decline from the May 22nd market high has resulted in a narrowing spread between buying pressure and selling pressure to the point where, in any further weakness, sell pressure could actually become dominant over buying power.   By itself that is obviously not good for stock prices.  However, past experience has shown it is important to not view this selling indicator in isolation, but rather to consider market conditions both before and at the time the signal is registered.

The most important sell signals of this kind have often been preceded by indications of weakening demand and rising supply long before the market’s final top, as investors become more aggressive in taking profits. At the same time, buying enthusiasm begins to wane, with fewer stocks at valuations that justify new buying. Historically, these signs of more aggressive selling and fading buying occur over many months, well in advance of the final market top.

However, prior to the recent narrowing spread between buying power and selling pressure, none of these signs of weakness were apparent. Rather than exhibiting a sustained uptrend, selling pressure was at a new 17-month low as of May 20th, while buying power was at a new 6-month rally high. Thus, rather than exhibiting the months of increased selling and selective buying that historically have preceded major market tops, the recent rise in selling pressure and decline in buying power appears to be simply a reaction to the market’s two-week decline – symptomatic of a short term correction, not a bull market top.

In addition to looking for weakening trends in buying power, Advance-Decline Lines usually offer additional evidence of the increasingly selective buying that typically occurs prior to a major market top. But once again, though, there has been little evidence of this selective buying. To the contrary, both the NYSE Composite Advance-Decline Line and Operating Companies Only (OCO) Adv-Dec Line matched the new bull market high in the S&P 500 on May 21st. Similarly, the Adv-Dec Lines for the S&P 500, S&P Mid Cap and S&P Small Cap indexes all confirmed the May 21st highs in their respective price indexes. New highs of individual stock prices tell a similar story. Typically, the number of 52-week new highs begins to deteriorate as long as a year prior to a major market top. Yet, both the NYSE all-issues and OCO new highs recorded a rally peak on May 15th, showing none of the deterioration that occurs prior to a major market top.

Bottom Line: Granted, given signs of an overextended and overbought rally as well as indications of investor complacency (too much investor optimism can be a bad thing), a more extensive correction than a mere five percent appears overdue. But with an absence of signs of a major top, investors should continue to focus on the long term and regard a pullback as normal and ordinary (on average there are 3.5 five-percent corrections per calendar year, and one ten-percent pullback every fourteen months).

Signs suggest that the market’s pullback is an ordinary correction and not the start of a prolonged decline in prices.