The Great Paradox In Markets

Over the past few weeks, the stock market has moved from an oversold extreme to an overbought extreme, a function of the violent December sell-off followed by the near-vertical rally.

On December 24, the S&P 500 closed at 2,351, down 14.8% on the month and 20% from its all-time high. Notably, the NYSE McClellan Oscillator (a market breadth indicator) hit one of its lowest levels in the past 20 years: -109.61.

Note: Data on $NYMO (McClellan Oscillator) is from Stockcharts.com and goes back to June 1998.

By all accounts, the market was extremely oversold. What happens historically when the market is extremely oversold?

It tends to bounce, with above-average forward returns over the next 12 months (+20.7% vs. +7.9% for all readings) and a higher probability of a positive return (up 87% of the time over next 12 months vs. 76% for all readings).

Note: Highlighted area in the table represents the bottom 1% of all $NYMO readings, or the most short-term oversold data points going back to June 1998.

And bounce it did, with the S&P 500 rallying 10% in the next 2 weeks to close at 2.584 on January 9.

The NYSE McClellan Oscillator did a 180-degree shift, hitting its 2nd highest level in the past 20 years: +117.76.

By all accounts, the market was now extremely overbought (on a short-term basis). What happens historically when the market is extremely overbought?

It tends to continue to rally, with above-average returns over the next 12 months (+20% on average vs. +7.9% for all readings) and a higher probability of a positive return (up 98% of the time over the next 12 months vs. 76% for all readings).

Note: Highlighted area in the table represents the top 1% of all $NYMO readings, or the most short-term overbought data points going back to June 1998.

It is one of the great paradoxes in markets that both extreme oversold and extreme overbought conditions can be followed by above-average returns. How is this possible? Likely because extreme strength begets strength (momentum) while extreme weakness does the same (mean reversion). Momentum and Mean Reversion are the most powerful forces in markets, and they exist because investors overreact and underreact to new information, again and again.

1 2
View single page >> |

Disclaimer: At Pension Partners, we use Bonds as our defensive position in our absolute return strategies for all of the above reasons. Bonds have provided a more consistent defensive alternative to ...

more
How did you like this article? Let us know so we can better customize your reading experience. Users' ratings are only visible to themselves.

Comments

Leave a comment to automatically be entered into our contest to win a free Echo Show.