So are we overbought or not?
The right question is, where are we in our market cycles?
I believe the market has 3 cycles: price, trend, and volatility.
When a market is stretched in a mean-reverting market, fading the move is often a profitable trade.
But if you try to fade a trending market, you can get run over.
I have a very simple method of determining what kind of "trend" we are in.
It's the relationship of Price and Bollinger Bands.
To view this study, you will need 2 things:
- 20 day, 1 standard deviation BB
- 20 day, 2 standard deviation BB
When price trends, it has a tendency to stay between the upper bands of these two technical indicators.
Here's what our current market looks like:
See how majority of the price is staying between the blue and green line? This tells us that it is a trending market.
The chart below is the QE-2 driven cyclical bull market of late 2010 in the $SPY.
Notice how in a trending market, traditional "overbought" signals often signal that trend continuation is the game. The market can "ride" the Bollinger Band higher.
So right now, the markets are overbought, but they can persist that way because we are in a trending cycle. Play the trend until there is evidence of distribution and a price topping pattern