Friday, January 12, 2018

SPX and COMPQ: Why There's No Such Thing as an "Overextended" Market

Before we get to the charts, let's talk about the concept of "overextended" as it relates to moves within a market, because this is a term we've been hearing from the talking heads with increasing frequency (as in: "This rally is getting really overextended.").

"Overextended" is one of those terms that sounds meaningful, but which is actually somewhat arbitrary in the grand scheme of things. Terms like this can be misleading to traders, because they really can only be used subjectively, but they are often portrayed as being objective measures.  More on this in a moment.

First, let's define the term:  Typically when someone says a move is “overextended,” they mean it has run beyond what an “average” move would, and they may or may not factor in standard deviations in those calculations.  Thus what is NOT said is that: “the move is overextended in their opinion, according to the rather arbitrary metric of mean or ‘average’ movements and/or standard deviations.”

While “average” movement seems wholly reasonable on a superficial level, one glance at a long-term chart will show you that stocks rarely move in an “average” manner. Instead, they tend to move in somewhat violent fits and starts.

A $10 stock, for example, might rally to $14 in a month, then trade sideways for 3 months. You would be completely correct to look at that sample and say that the “average” gain of that stock over the past 4 months has been $1 per month.  That's true -- but it's irrelevant.  And misleading.  Because in actuality, virtually no stock moves in a steady upwards or downwards manner for long -- so it’s a mistake to look at an average and then judge that anything that falls outside of that average is "unusual" (i.e. — “overextended”).

One only needs to look backwards to understand why: Using our hypothetical stock, our trader has correctly determined that the “average” move of this stock is $1 per month. Let’s rewind him, though, and put him in the real-world past, attempting to actually use his correct average while trading:

We're four months in the past, and the stock is still $10.  Our trader goes long, and the $10 stock starts rallying. It hits $11 in a week. Our trader says, “Well, that’s the ‘average’ move for this whole month already, so I’m getting out of my longs!” He exits.

The stock continues to rally to $12 the next week. Now our trader says, “Whoa, this move is overextended! The average move is only $1/month, and it’s moved twice that much in only two weeks! I’m going short!”  He goes short.

The stock rallies to $13 the next week.  Now our trader says, "Holy cow, this stock has moved TRIPLE its average month already!  This move is now REALLY overextended."  He adds to his underwater shorts.  But now he's rather nervous, so he sets a tight stop (which he probably should have done earlier).

The stock rallies to $14 the next week and our trader is stopped out for a decent loss.  At that point, the stock finally starts correcting.  After a month, it's back to $12.50.  Our trader now realizes that the recent "average" gain of this issue (recency bias) is $1/month, so he "buys the first dip," expecting to see $13.50 next month.  Instead, the correction continues and he is stopped out of those longs for another loss.

So, what happened?  Well, our trader was 100% correct about the $1/month average, yet he still closed his longs far too early, entered short way too soon, went long again at the wrong time, and ultimately exited the total trade for a significant loss.  Why?

Because, as I said at the start:  Stocks don't move in "average" ways; they move in fits and starts.  Indictors often also use standard deviations, but using standard deviations on a mean doesn't eliminate the problems inherent in the base thinking that causes one to arrive at a conclusion of "overextended" in the first place. Standard deviations are still based around a mean.  If means and averages don't work for timing the market (which they don't), then standard deviations above or below these means will likewise not work. 

Indicators such as RSI can move deep into overbought territory and stay pegged there for weeks or months.  If the calculations that underpin these indicators actually worked to tell you when a market was truly "overextended," then that type of thing would never happen.  This is why indicators such as RSI are often more useful during oscillating moves than they are during trending moves.

In truth, moves that fall outside the average are the norm, not the exception.  And that means there really is no such thing as a move that is "overextended."  Except in our minds. 

We can bring in the concept of revisions to the mean over time, but that doesn't help you trade tomorrow.  It may hurt you, in fact, because it can lead to looking down when you should be looking up, and vice-versa.  I myself am even guilty of occasionally using variations of the "overextended" term, but I do understand their relevant priority when I use them -- which is why I have never written anything such as, "This move is due to correct because it's overextended."  I may note it for other reasons (typically I note it in terms of relative strength of a move, and that strong moves tend to beget more strong moves), but I've never once attempt to predict a reversal based on this metric. 

This is why I say that "overextended" is more of a subjective term than an objective one.  Because, really, the measure is rather worthless objectively, at least in terms of how it's so often used, which is to say the move is "due" to reverseThus what's truly being said when someone says, "This rally can't run much farther because it's overextended," is instead more akin to: "I feel this move has run long enough, therefore I will label it 'overextended.'"

As I've said before: "Overbought can always become 'more overbought.'"

I've made the next statement previously many times over the years, but perhaps the explanation above finally sheds light on why I've often said:  There is no such thing as "oversold" in a bear market, and there is no such thing as "overbought" in a bull market.  In other words:  There really is no such thing as objectively "overextended" -- so the sooner you stop prioritizing that concept, the better you'll be equipped to ride a trend for the appropriate amount of time (which is: until the market says you shouldn't).

Anyway, I felt that might be a helpful discussion to have, in light of how often we're hearing the term recently, and how the very concept can be a thorn in people's sides, as opposed to being helpful.

Moving on:  Last update discussed the speculative potential of a correction, but emphasized that unless and until we saw an impulsive decline, we had no reason to actually turn bearish yet.  As it turned out, the decline developed into a clean ABC down, indicating that the rally would continue.

I would like to reiterate that this does not mean we won't, at some point this year, see a larger double-retrace correction as shown in that update, but we simply have to await an impulsive decline before we try to game such a correction.  I tend to think we will see such a correction at some point in 2018 -- but I am aware that such a move could begin from higher prices, potentially from much higher prices.  The reason I'm alert to such a move is because it's in the nature of extended fifths to produce such moves -- but one has to await confirmation, because it's also in the nature of extended fifths to tack on extensions upon extensions beforehand.

As I've tried to assure bears previously, the upshot of this is that there should be a clean retest of the high prior to the BIG leg of any such correction.  So there's really no reason at all to front-run a move like that, because almost nothing good can come of it.  We will likely know it when it's actually here, and I will not be calling it "speculative" after a clean impulse down, I will be calling it "probable."

There's not much to add, chart-wise, as I'm simply taking this as it comes at this point, which I think is the only rational approach.  So far, we've yet to see anything that points the market in the downwards direction for more than a near-term correction -- which is why I've remained "bullish until the market says we shouldn't be" for a long time now.

We'll take a look at COMPQ, because this is the only chart that's worth looking at right now.  COMPQ is continuing to close in on its next upside target.  Even if/when we reach this target, we're going to have to await an impulsive decline before getting too bearish, though -- because that's what this environment dictates.

In conclusion, bears never received confirmation of a pending correction, so it's back to "watch and wait" mode for them.  There is presently potential for another extension (if the market wants one) to reach as high as SPX 2870-90, so we will continue awaiting an impulsive decline before shifting footing.  Trade safe.

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