An Overbought Market or Deeper Trouble Ahead? Here’s What to Know and the Key Indicators to Watch

By TradeSmith Research Team

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The market is at a key crossroads right now with stock valuations getting squeezed from a combination of declining profit growth and higher interest rates.

All the while, stocks are facing newfound competition for investors’ dollars… from cold hard cash.

The chart above tracks the yield — or interest rate paid — on the 1-Year U.S. Treasury Bill. As you can see, it just recently broke above 5%, which is the highest rate in several years. (It is around 4.3% as of this writing, but still, this is higher than people have become accustomed to.) Suddenly, investors can earn attractive returns on their idle cash again, thanks to the Federal Reserve’s aggressive interest rate hikes. And that provides stiff competition for the stock market.

Stocks are still suffering a hangover from their poor performance in 2022, and with things whipsawing the past few weeks, it’s easy to see why higher yields on a one-year T-Bill would appear to be an attractive place to put your money.

Cash is undoubtedly moving out of stocks and ETFs and into T-bills and other short-term investments. In fact, according to Bank of America Global Research, the U.S. stock market had outflows of $9 billion over the last three weeks alone.

But is this flight from stocks a trend you should be worried about for the foreseeable future, or is this just a pullback that’s resetting a potentially overbought market?

That question is what we’ll focus on today.

Spotting an Overbought Market

The chart below is one I watch closely to determine whether stocks are overbought.


It shows you a key measure of internal stock market breadth, displaying the percentage of stocks in the S&P 500 Index trading above their 50-day moving averages.

Generally, the higher the percentage, the better: It indicates a broad-based rally for the market, with plenty of stocks participating on the upside.

But when the indicator gets too high, it can also signal that the market is overbought and needs a reset. Notice how the indicator hit a high late last year above 90%; that’s overbought.

It reached a similar extreme high back in August. And sure enough, the S&P 500 dropped more than 16% over the next two months.

But notice also how this indicator is approaching a support level around the 40% to 45% range.

At the December low, this is the level where buyers stepped in and caused the market to rise 10% in just over a month.

So right now, there’s a battleground here between the declining red resistance line and the green support line. A break of that support line, with fewer stocks holding above their 50-day moving averages, likely means more downside — perhaps a retest of the December lows, or a drop even lower. Meanwhile, an upside break of the red line, with more stocks rallying above their 50-day moving averages, means the overbought pullback is likely over and stocks should resume their uptrend.

Bottom Line: I ultimately expect stocks to resume their upside momentum this year, but they may experience a deeper pullback first.

Our proprietary TradeSmith market indicators support this view, telling me that the health of the stock market is improving. For instance, the percentage of S&P 500 stocks in our Health Indicator Green Zone has been on the rise, but they are still outweighed by the percentage of stocks in the Red Zone.

Plus, our system flashed a new Bullseye Signal for the S&P 500 in January and for the Nasdaq 100 Index last week. This tells me the recent rally is most likely more than just a bear market bounce.

But keep a watchful eye on the market breadth indicator for the S&P 500 shown above. It’ll give you valuable clues about which way the market is headed next.