Optical Illusions

In August 1987, the Nasdaq 100 was extremely overbought.

In July 1998, the Nasdaq 100 was extremely overbought.

In January 2000, the Nasdaq 100 was extremely overbought.

In October 2007, the Nasdaq 100 was extremely overbought.

The Nasdaq 100 is extremely overbought today.

Sell everything?

If only it were that simple. When looking at the chart below, our eyes tend to gravitate to overbought levels (using 14-period RSI) that were followed by sharp declines (most notably, early 2000). But our minds are playing tricks on us; it is an optical illusion. For we are ignoring the many other times in which overbought levels were followed by advances.

 

Going back to 1985, the evidence suggests that overbought is actually bullish, on average. Come again? In the year following an extreme overbought reading, the Nasdaq 100 Index has been higher 85.5% of the time with an average return of 14.8%.

*Note: The above table is price only. The returns would be higher if dividends were included.

Does that mean we can rule out another 1987/1998/2000/2007 top? No, just that one cannot predict another bear market based on extreme overbought levels alone. Bear markets can happen at any time, and “overbought” is neither a predictor nor a precondition. If one is going to predict anything based on extreme overbought levels (and I would advise against doing so), it would be further gains. I realize that doesn’t conform to the prevailing narrative of “overbought is always bearish,” but the truth in markets rarely does.