After a strong first half of October, last week’s (and Monday’s) action has brought all three major indices back to the lower bounds of a downward channel they’ve been in since July’s highs. Both the Dow and S&P 500 tagged new post-July low closes on Monday, with the Nasdaq having hit its own post-July low on Friday of last week.
The action, as shown in the chart below, has prompted market bulls to highlight contrarian indicators (such as very bearish sentiment) amidst calls that stocks are potentially oversold.
We’ll get to what it means when a stock is oversold shortly, but first, a little more context on the market.
As you can see in that image, stocks have been generally capped to the upside by that hastily drawn green line while the lower (and declining) red line approximates lower support levels.
Support and resistance levels are generally not binary but tend to be measured on a spectrum and are better thought of as zones of support and resistance with varying degrees of significance.
For the S&P, last Friday’s weekly close below its 200-day moving average, for instance, was more significant than its brief intra-day dip below 4,200. Monday’s daily close at lower lows would seem to be the most important, however, as it signals a continuation of the primary intermediate-term trend.
There’s a well-known Wall Street adage, “The trend is your friend,” which should be taken to mean that the prevailing trend is a stock’s North Star … until it isn’t.
When you’re attempting to identify a primary trend, a good rule of thumb is that more established, longer-term trends trump shorter-term trends. That’s why we will periodically point readers to long-term charts (like the 100-year stock market chart) as evidence that, over the long haul, stocks will trend higher.
Secondary to that ultra-long-term chart would be secular bull or bear markets, where stocks can be trending higher or lower for years on end. After that, you’d look to multi-week moving averages like those used in our own Cabot Trend Lines, and then you’d look for multi-day averages, multi-hour, etc.
Stocks in oversold (or overbought) territory can easily remain there if a longer-term trend is dominant. A stock can easily show overbought conditions on an intra-day chart if it’s going through a period of multi-day or multi-week accumulation.
Even overbought conditions on the same time scale can remain in place if a stock is trending higher. For example, take a look at this chart of Nvidia (NVDA), one of the best-performing stocks this year and the primary beneficiary of the new developments in artificial intelligence (AI).
As you can see on that chart, NVDA was technically overbought eight times throughout the year (as measured by an RSI reading over 70, top of the chart), but the stock simply kept trending higher.
When a stock is oversold or overbought it’s not a green light to buy or sell shares. Instead, technical traders are looking for signs of a possible reversal of the prevailing trend. We’ve written before about using divergence in indicators like On Balance Volume to bolster the case for a potential reversal (we may have some signs of that with NVDA when the RSI diverged in June/July when shares were less overbought at higher prices), but remember, the trend is your friend, don’t fight it.
If we look at the same chart, but for Tesla (TSLA), which owes much of its 2023 performance to the abysmal last months of 2022, we see both the larger impact of the June/July divergence as well as a stock with a weaker overall trend.
A stock that’s not in a strong uptrend or downtrend (higher highs, higher lows, or lower highs, lower lows) is more likely to react to overbought or oversold conditions by reversing course or correcting. TSLA was extremely oversold (reading below 30 on the RSI) to start the year, rebounded until it was overbought, corrected/consolidated until May (oversold again), hit overbought territory hard in June/July, and has come back down to oversold levels now.
So, the first thing you should think when you read that a stock is oversold or overbought is, “What’s the stock’s trend?”
More on RSI
RSI, an abbreviation for Relative Strength Index, was devised by J. Welles Wilder Jr. and introduced in his 1978 book, New Concepts in Technical Trading Systems. It compares the percentage change on up and down periods over a specified timeframe (usually 14 periods). Readings above 70 are considered overbought and readings below 30 are considered oversold, with the most extreme readings (100 or 1) only coming during the strongest of trends (a stock rising every day for 14 days would trigger a 100 reading, for instance).
The RSI is one of the most-referenced momentum indicators and is very simple to read. I’ve also included the MACD Histogram (blue bars on the bottom of the chart) which measures the difference between a 9-day signal line (red line, 9-day average difference between 26-day exponential moving average and 12-day EMA) and the MACD line (black line, the absolute difference between the current 26- and 12-day EMAs).
MACD does trigger one of my pet peeves (averaging an indicator’s averages) but can offer some buy/sell signals when the MACD line crosses above or below the signal line. The reason I’ve included it today is that the histogram itself can give you a good sense of the scale of outperformance or underperformance. In other words, it’s a quick visual representation of the rate of change of buying and selling pressure; muted histograms like NVDA showed in the first half of the year are signs of steady pressure over time, whereas June’s gap higher and commensurate spike with the histogram show rapid high-volume accumulation.
What Resolves Overbought or Oversold Conditions in Stocks?
Like with almost everything chart-related, price and time are the two factors that determine whether a stock is oversold or overbought. A quick correction in price (reverses direction) can resolve overbought and oversold conditions (as we see with TSLA above), as stocks trading in a range will bounce between the upper and lower bounds of the range. Alternatively, and which is better portrayed by NVDA, a period of consolidation can also bring overbought stocks back in line, even if they’re at higher prices.
The RSI looks at only 14 days of data, and a month of sideways up-and-down action can essentially reset the longest-dated input into the MACD (26-day exponential moving average).
So, next time you see a call for a stock or index recovery based on oversold conditions, ask yourself the following questions:
The Oversold Stock Checklist
1. Is there a technical trend in the stock on any timeframes?
2. What is the longest-term trend in the stock?
3. Is that trend at risk of being invalidated if the shorter-term trend continues?
4. As the shorter-term trend meets the longer-term trend, are there signs of momentum reversals (such as the RSI or MACD)?
5. What is my course of action if the longer-term trend overrides the short-term trend, or, conversely, if the short-term trend prevails?
Trend reversals are only confirmed after the fact, but keeping some momentum studies on your stock charts can help put stocks that may be nearing inflection points on your radar.