Skip to main content

One thing most technical analysts agree on is that the market is currently overbought. What they can't agree on, however, is whether this bodes ill for stocks.

The stock market has moved up sharply over the past two months, with both the



S&P 500

climbing about 9% and the


up 10% since hitting a low on Nov. 18.

"The market has reached a technical condition that has oftentimes preceded a market pullback, or at the least an extended consolidation phase," said Francois Trahan, chief investment strategist at Bear Stearns.

The indicators that Trahan monitors closely suggest that stocks are extremely overbought. In technical analysis, stocks are said to be overbought when more demand exists than is historically normal. The concept is part of the chart-based philosophy employed by these analysts to predict movements in individual issues and the broader market. (To see a free sampling of the latest technical opinion from columnists on our subscription sister site,


click here.)

Technical analysis is viewed by some as a science that can discern supply-and-demand trends in stocks, and by others as snake oil that has no probative meaning. Because it has so many adherents, however, its findings can sometimes be self-fulfilling prophecy in the short term.

Scroll to Continue

TheStreet Recommends

Trahan looks at the percentage of companies trading above their 10-week moving averages, because he believes this has been a reliable indicator in the past, heralding the consolidation in the summer of 2003. At present, almost 90% of stocks are above their 10-week moving averages, which he said is "well into overbought territory."

The VIX, or volatility index, a measure of fear in the market, is also flashing a warning signal while various sentiment surveys are pointing to a high level of complacency and bullishness among investors. The put-to-call ratio has not yet reached a critical level but is moving in that direction, Trahan said.

What's more, he noted that the typical recovery following a "bubble low" lasts about 15 months, after which a big decline usually ensues. "If the market were to continue this pattern, then we would be poised for a major correction in the months to come," he added.

Don Hays, president of Hays Advisory, agrees that the market is overbought at current levels, noting that the percentage of


stocks trading above their 200-day moving averages has moved "within a hair" of 90%. Still, he doesn't think the market is about to break down.

"Logic tells you to expect a correction but history tells you that a market able to generate this much upside fuel has staying power over the next three, six and 12 months," he said. Hays believes there is at least a 50% chance that the S&P 500 will climb 31% over the next 12 months.

Richard Dickson, a technical analyst at Lowry Research, noted that the market has been overbought for a long time but has continued to march higher. Still, he does believe a short-term pullback is imminent, because his proprietary buying power and selling pressure indices are about to cross paths.

"In the last 70 years, there have been 33 instances of crosses, and over 50% of the time the cross has been just preceded by or just followed by a short-term market correction," he said. "That's why we think there's a good possibility of a correction in the market."

Dickson said the decline will be modest, however, at about 5%, and he remains optimistic on the longer-term uptrend. "During bull markets, being bullish is the right thing to do," he said. "Being contrary only works when people are bullish and the market is showing signs of deterioration."

Woody Dorsey, president of Market Semiotics, said his proprietary sentiment indicator registered a 99% bullish reading on Tuesday, but like Dickson he dismisses the significance of this, noting that sentiment is not a determinant of the market.

"Even though the market is overbought technically and overoptimistic short term, I would not say the party is over," he said.

Dorsey, who specializes in investor behavior, expects the market to retreat for about a week before resuming its ascent. The absence of any big negative headlines, such as war with Iraq or deflation, and the "larger liquidity boom" should help carry stocks forward into May, he said, adding that volatility is also likely to increase.

"We haven't had a really good short-term correction in quite a while, and this has frustrated so many people, but volatility is going to pick up over the next few months, which means the corrections will also be bigger," he said. "The stakes are getting higher here."