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S&P 500 may be ‘overbought’, but think before you sell

More often than not, stocks climb higher

Birinyi Associates
S&P 500 showing ‘overbought’ reading.

With the recent rally in the S&P 500 index, one indicator is showing the index is “overbought,” but before you start hitting the sell button, consider that historically overbought conditions don't necessarily indicate an imminent selloff.

In a little over a month, the S&P 500 SPX, -0.11% has rallied about 12% off recent lows—levels that were in the same neighborhood as the correction lows in late August. That jump in that short a time, places the S&P 500 in an “extreme overbought” state, according to Jeffrey Rubin, an analyst with Birinyi Associates, in a recent note.

Technically speaking, the S&P 500 is considered “overbought” or conversely “oversold” when it moves two standard deviations outside of its 50-day moving average. In plain English, this means the more volatile the S&P 500 trades and deviates from its running average, the wider its average trading range and standard deviations. As a general rule, at two standard deviations, the S&P 500 should be trading within that range about 95% of the time. Currently, the index is trading outside the upper level of that already wide range.

“This would normally be thought of as a level where investors should take some profits, write some covered calls and for the most aggressive perhaps even short some stock,” Rubin noted.

But Rubin goes on to say that when the S&P 500 shows “such extreme overbought readings, this quickly more often than not the market continues higher—not necessarily immediately—but sooner rather than later.”

In the chart below, Rubin outlines (in the red dots) instances when the S&P 500 has reached this “extreme overbought level” and how the S&P 500 has performed.

Birinyi Associates

Overbought doesn’t always lead to a big selloff.

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