247Bull.com Editor: On Friday the S&P 500 index overcame recent congestion and broke out to its highest close since December 2007. A whole host of technical indicators show that the S&P 500 is in overbought territory, something which typically indicates that a short-term pullback or correction is due. Longer-term however, the trend is still up, and the flow of funds out of bonds and into stocks is likely to continue to propel the major market averages higher.
One of the general rules of the stock market is that things will get as good (or bad) as they can get, then prices will start moving in the other direction. This is another way of describing “regression to the mean”.
This is the reason that we technicians have our indicators — so that we can get an idea when conditions have reached extremes that could cause prices to start moving in the opposite direction. One of the indicators I like is the Percent of PMOs (Price Momentum Oscillators) Above Zero because it is smoother and has less noise than other intermediate-term indicators.
The second panel on the chart below shows the PMO for the S&P 500 Index, which is the price index just above it. The bottom panel shows the percentage of individual S&P 500 stocks that have PMOs above the zero line.
As you can see, the indicator has recently topped at a very overbought level. In similar cases noted on the chart, half were absolute top pickers, and, while the other half announced an internal peak in strength, they arrived well ahead of the price peak. But, even though they were early, the indicator peaks in early 2011 and 2012 were ultimately followed by price declines that sent prices lower than they were when the internals peaked.
While indicators may be topping in very overbought territory, a price top is not guaranteed. Nevertheless, conditions are less than ideal for making new commitments to the long side, and increased caution is warranted.