About that overbought stock market...

Key points

• The SPY Breadth (% > 50 Day Avg) indicator recently spiked above 90%
• This triggered the usual chorus of "overbought market" warnings
• Reality paints a very different picture

The vast majority of S&P 500 stocks are in uptrend

As the name implies, the SPY Breadth (% > 50 Day Avg) indicator measures the percentage of S&P 500 stocks trading above their respective 50-day moving averages. A reading of 90% or more invariably occurs only after a powerful thrust higher in the market - such as the one we've seen in the last several months.

Low readings indicate an "oversold" market and, often notably, not always - suggest a decent buying opportunity. Therefore, when high readings occur, human nature triggers a tendency for many investors and pundits to raise fears of an "overbought" market that is likely to decline. This is precisely why we "crunch the numbers" and attempt to quantify results because reality is quite different from theory in this case.

The history of crosses above 90% sends a strong signal

The chart below highlights each date when the SPY Breadth (% > 50 Day Avg) indicator crossed above 90% (including overlaps) since 1998. The most recent signal occurred on 2023-12-19.

The table below summarizes performance results for the S&P 500 Index following previous signals.

As a frame of reference, since 1998-01-02, the median 12-month return for the S&P 500 Index is +11.1%, with a Win Rate of 77%. As you can see in the table above, the median 12-month return following the dates highlighted in the chart above was +13.13%, with an exceptionally high Win Rate of 98%.

Traders relying on gut instinct and trying to play the short side of stocks following previous supposedly "overbought" readings paid a high price. Conversely, investors who used to confirm an ongoing uptrend profited handsomely and consistently.

What the research tells us…

Does the recent cross above 90% by the SPY Breay Avg) indicator imply a 98% probability of a gain of 13% for the S&P 500 Index in the year ahead? That's not exactly how this works. The numbers highlighted above are merely history. No signal from any indicator ever guarantees anything. The information highlighted above does not constitute a standalone trading system. The recent signal on 2023-12-19 is best thought of as "weight of the evidence" for the favorable side of the ledger.

Most importantly, a trader who thinks that the recent "overbought" status of the market means they should load up on the short side ought to seriously consider market history more closely and verify that they have other reasons for being bearish. Investors who are long in the market but are feeling nervous following the recent strong rally should probably take some comfort in the results highlighted above (while still maintaining whatever risk controls they have in place).