If the market is overbought, why does it continue to go higher?

If the market is overbought, why does it continue to go higher?

There are two main reasons for this. The first reason is that the stock market will occasionally continue to move higher despite being overbought. When designing a successful system that will work well in different market environments and for many years to come, you have to consider the risk-reward ratio when deciding what is overbought and oversold. Meaning, if we did not trigger the sell signal after the close on August 16th, looking back and most likely looking forward, we would miss many tops entirely. We have to make the decision as to where to trigger a buy and sell signal that will not necessarily be perfect for each top or bottom, but will produce the highest gains in the long run. So the first reason is quite simple, the stock market can become overbought and continue higher just as the stock market can become oversold and continue lower. When designing our system, we had to find the area that would limit the size of corrections while only missing a few tops and bottoms all together.

The second reason has to do with the current market environment. We have been in a difficult trendless market for almost three whole years now (the longest one in history). This market is difficult to time and as it fell so much more than anticipated in May, it is quite possible that the market is making up for the difference by becoming more overbought than normal in the previous two weeks. This would serve to confirm the recent strength. If the market fell quickly from our recent sell signal key support levels could have been broken. Especially in the Russell 2000. When the fall does come, we will not have to worry about key support levels being broken and we can be fairly certain that another strong move higher will begin after the decline.

Having said that, the current correction is rather small in all three of the indices we follow. If you look at our mid-term works page you will notice that most sell signals have a correction of at least this much before their decline. This correction has been less than average so far. So we are definitely in the area of where we would expect to be on a historical basis. As timing systems never perform as well in the future as they did in backtesting, the fact that the correction has been this small so far is definitely not a reason to be concerned.

The first chart is of QQQQ. QQQQ has broken our resistance area, but is still has resistance above. If the ETF does continue higher from here, we would expect 40 to be the stopping point. A break of today's low should suggest that the downtrend has started.

SMH has also broken above our resistance levels. A sustained break to the downside of 33.50 should suggest that the recent upleg is over.

IWM is currently at very powerful resistance. A sustained break of yesterday's low, followed by a break of the 71 area will suggest that the downtrend has started.