By Nick Rokke, analyst, The Palm Beach Daily

  • “Record-Breaking Momentum Ignites Warning”

  • “Key Metric Shows the Stock Market Is at ‘Extreme’ Levels”

Over the past two weeks, headlines like the two above have been plastered across the financial websites I frequent.

(The first headline is from a January 18 post on the financial website Seeking Alpha and the second is from the January 12 edition of Business Insider.)

They’re worried that the market is “overbought.” That’s when prices have been bid up too far, too fast.

Overbought markets are vulnerable to sell-offs. That’s why financial pundits fear we’re now due for a correction.

So, it’s no surprise we’re seeing headlines like those above.

Make no mistake… The media write these headlines to scare you. But acting on them would be irrational. And that could cost you a lot of money in missed gains over the long haul.

Here’s why…

Overbought Markets Can Still Go Higher

Analysts use different metrics to determine whether a market is in overbought range. These metrics measure how quickly prices move.

One of the most common is the Relative Strength Index (RSI). The index measures the size of gains compared to the size of losses over a certain time frame.

Over the past 14 months, the average gains in up periods were substantially higher than the average losses during down periods.

In other words, the market is “melting up.”

Analysts consider an RSI over 70 to be in overbought range. Today, the index is over 85. It’s only breached that extreme level twice since 1930—in 1955 and in 1996.

Here’s what’s interesting… The other two times the market was above 85, the upward momentum continued.

The table below shows you the average market return based on RSI.

As you can see, RSI has been in extremely “overbought” territory only 1% of the time. And it’s been in extremely “oversold” territory about 5% of the time.

S&P 500 Average Returns Since 1930

S&P 500 14-Month RSI

6 months

12 months

24 months

36 months

Frequency

Above 85

7.6%

17.5%

37.7%

55.2%

1%

Between 35-85 (Normal)

3.5%

7.2%

15.3%

24.5%

94%

Less than 35

5.7%

13.8%

25.1%

30.3%

5%

This is one case in which you don’t want to be a contrarian… Buying the market when it’s “overbought” outperforms buying it when it’s “oversold.”

Markets in Motion Tend to Stay in Motion

Newton’s First Law of Motion states that an object in motion will continue to move at a constant velocity unless acted upon by a force.

You could say the same about financial markets.

You see, when the market starts moving in one direction, it keeps moving in that direction until an opposing force acts upon it.

Right now, we don’t see any opposing forces. The economy is getting stronger… unemployment is near record lows… and people are feeling as confident as ever.

Now, we’re not saying the market is going to go straight up forever. In fact, we’ll probably see a short-term pullback soon. And we’ll see plenty of them going forward.

But if history is any indication, these pullbacks will be just that—short-term—at least for the next couple of years.

Don’t let scaremongering headlines shake you out of the market. Stay rational… make an investment plan now… and stick to it.

Regards,

Nick Rokke, CFA
Analyst, The Palm Beach Daily

P.S. If you’ve been sitting out this rally, now’s the time to buy. I think we’re going to see some big gains over the next two to three years. And you’ll miss out if you nervously sit on the sidelines.

MAILBAG

On Tuesday, we asked readers how they handle volatility in the crypto market (“What’s Behind Bitcoin’s January Sell-Off”). They stuffed the Mailbag with replies…

From Jerry W.: I do nothing… Except watch people panic for no reason and move on. If they can’t handle the heat, get out of the cryptocurrency kitchen.

From Elspeth T.: Here’s my answer: I’ve coped this time around by looking at the facts regarding the futures market. Bitcoin topped the very same day that the futures contracts began. It crashed a month later… when the futures contract matured.

This market has changed for good and I’m amazed that you haven’t mentioned this. I’m coping by reconsidering my positions now that there are very big players in this market who can—and will—manipulate it for their own gain. I may get out for good. I may not.

From Mary L.: Nick, you and others are not addressing the fact that bitcoin has dropped precipitously since it began trading on the Chicago Mercantile Exchange (CME) and Chicago Board Options Exchange (CBOE) last month. Please address this.

Nick’s Reply: We still don’t know what impact bitcoin futures are having on bitcoin prices. During the first three weeks that futures contracts traded on bitcoin, bitcoin’s price went up. Over the past four weeks of futures trading, the price has gone down. We can’t draw any conclusions from price data yet.

Plus, as of Tuesday, there were only 4,800 bitcoin futures contracts outstanding. That’s less than 0.035% of the total bitcoin market. Not enough to make any difference in the overall price.

It’s still too early to tell whether futures are affecting bitcoin’s price.

From Stephen D.: I was very disappointed in Nick’s article on Tuesday. I would have thought you guys would be smart enough to figure out that January begins the “World’s Largest Human Migration.” That’s when people in China prepare for the Lunar New Year. Yes, it’s profit-taking… but for a specific reason—to pay for travel plans for the Lunar New Year.

Nick’s Reply: Bitcoin’s recent volatility is baffling to many people, including us at the Daily. There could be multiple reasons. So, your guess is as good as ours.

But we think the Lunar New Year thesis is a bit of a stretch. More than half of bitcoin trading volume is in Japanese yen and U.S. dollars. And both countries celebrate their new year on different calendars than China. So, unless every Chinese bitcoin holder dumped their coins to pay for Lunar New Year celebrations, it wouldn’t have affected price much. We reserve the right to be wrong, though.

From Michael B.: I put $7,500 into alt coins last August after joining Palm Beach Confidential. Spread the money basically evenly over about a dozen recommendations in the portfolio. WAITED! In December, when I was up almost 7x my money, I got a bit nervous… and wanted to take profits. But I was unsure about the right strategy.  

Then, Teeka told us to take profits on some of our coins (“scoop some cream off the top”). I jumped at the advice and basically took half my remaining money off the table. The money that’s remaining is all “house money.” And I can rest easy as bitcoin corrects. Beautiful advice and timely!

(Personally, l was waiting for January to sell so that I could delay the tax bite for another year. Just seemed like the smart thing to do. Thanks again for the great advice, Nick.)

From Mark M.: I couldn’t help but smile at Tuesday’s Daily. I didn’t get light-headed or fearful when the crypto market dropped. I followed Big T’s advice and position-sized properly… and diversified. I’m hoping the market drops another 10–15% so I can take positions that are currently above the buy price.

Nick’s Reply: Thanks for following our advice to the letter, Mark. This shows everyone that you can weather the volatility in the crypto market if you position-size properly and have a sound investing plan… And then you can use those drops to your advantage and buy more bitcoin with your dollars.

We still want to hear from you. Tell us your crypto volatility survival plan right here…

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