The market is overbought even by NDW standards, raising worries that much of the upside has been realized while the market is more vulnerable to pullbacks and declines. Should investors be worried about these concerns?

Everyone appreciates a good rally, but a natural question after such positive movement is whether those gains will continue, hold, or reverse, especially if most indices are trading in extended territory. The S&P 500 index funds group within the Asset Class Group Scores page, which NDW views as the “core” of the market, holds an average overbought/oversold (OBOS) reading of 104%. Levels above 75% are considered elevated territory, with readings above 100% being more significantly overbought, and this is denoted by the green line on the chart below. Investors tend to fear overbought markets because prices have advanced abnormally quickly, raising concerns that much of the upside has already been realized while the market is more vulnerable to pullbacks and declines. Given that the market is overbought even by NDW standards, should investors be worried about these concerns?

Is an Overbought Market Abnormal?

Before addressing the outlook of an overbought market, let’s focus on whether it’s really that rare to see one in the first place. While the S&P 500 group is undoubtedly in extended territory, the group sees OBOS readings above 100% more than one might expect. There have been 38 instances since 2004 in which the S&P 500 group had an OBOS reading above 100%, excluding clusters within ten weeks. Said differently, investors should expect two distinct overbought periods in any given year. Additionally, the market can remain overbought for significant periods of time. As a result, the group has experienced an OBOS reading above 100% roughly one eighth of the time since 2004. In fact, our current reading of 104% doesn’t even rank in the top 10% of trading days, underscoring that we shouldn’t view things as too unusual just yet. Readings above 150% are be much rarer, as they occur only 1.3% of the time, making that a more significant level to watch for.

Do Overbought Markets Perform Worse?

That said, just because something is common doesn’t mean it can’t have a big impact. Many investors assume that rapid upside leaves the market with less room to run, but does the data actually support that view? Looking at the previous 37 times the core was this overbought, the market wasn’t always due for a bad year, even if the next month wasn’t great. Historically, those overbought periods have seen negative to muted returns over the next one to two weeks, which is consistent with the near-term nature of the OBOS metric. As a result, we might want to temper our expectations for the next couple of weeks or the next month. However, overbought periods have typically seen solid returns across longer horizons, as the average one-year return was 10.8%. Additionally, those instances generated positive returns at a higher rate than usual, as more than 86% of those instances were higher over the next year.

Do Overbought Markets See Sharper Declines?

While the market technically performs better in overbought environments, some may argue those environments are due to higher levels of volatility, often seeing sharper declines before rallying. However, even those claims fail to hold up when examined more closely.

Previous instances saw limited downside over longer periods, with the worst one-year return being a decline of 6.5%, which is low in comparison to the maximum one-year return of 32.4%. Meanwhile, the average peak-to-trough decline of the S&P 500 during those examples was lower than usual. The S&P 500 averages a maximum drawdown of 14.7% at some point during the typical year since 2004. Meanwhile, overbought environments averaged a maximum drawdown of 12.7% over the next year from when they first became 100% overbought. In fact, overbought periods saw less extreme drawdowns on average than non-overbought periods across each timeframe from the next one-week to the next year. Meanwhile, there was usually an extended period without an overbought market (marked in green) before some of the sharpest declines (e.g., 2008 & 2022), as seen in the graph below. That isn't to say things couldn't decline sharply from here, but regardless of how you slice it, overbought periods were less likely to decline than standard markets over the last 20 years, which comes in stark contrast to expectations.

Recent research has shown that you shouldn’t be afraid to go all-in or buy at all-time highs, and the same appears to be true about buying in overbought conditions. If anything, an overbought market has been a positive signal for the broader health of the market, serving as a sign of confidence in its long-term relative strength, even if the next couple of weeks are slower than normal. After all, a strong market is usually required to push things into extended territory, which helps explain why performance and downside were better than normal. It might be tempting to fade an extended environment, but history has shown the market’s long-term strength tends to be unfazed by overbought conditions. Meanwhile, an overbought market can always become more overbought in the near term.