As we frequently point out, diffusion indicators have a tendency to remain overbought while oversold measures tend to reverse off the bottom more quickly. One of the most common ways that diffusion indicators are constructed is to measure the percentage of stocks in a given investment universe that are trading above their 50-day moving average.
Mark Hulbert of MarketWatch, recently wrote about an indicator from Ned Davis Research that measures the percentage of common stocks trading above their 50-day moving average. Using data that goes back to 1967, Ned Davis points out that this indicator has only exceeded 90 percent 12 times, before the current measure.
Hulbert on Ned Davis’ indicator:
Prior to the recent buy signal, there had been only 12 of them since 1967.
And two of those 12 prior buy signals occurred in the last 12 months alone. In other words, between 1967 and March 2009, this indicator gave just 10 buy signals — an average of just one every 4.3 years. Since March 2009, in contrast, they have averaged once every four months or so.
That’s a very friendly trend indeed.
The indicator in question comes from Ned Davis Research, the quantitative research firm. It generates a buy signal whenever the percentage of common stocks trading above their 50-day moving averages rises above 90%. Davis refers to such events as a “breadth thrust.”
The recent buy signal, according to this indicator, occurred on April 5. The other buy signals over the last year occurred on May 4 and Sep. 16 of last year.
How has the stock market performed following past buy signals? Quite well, according to Davis’ calculations.
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There are plenty of people arguing that the market is due to correct because it is so overbought. Perhaps. However, history suggests that extremely overbought measures have portended good, not bad, returns for the stock market in the subsequent months and year.
