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Prepare for a market pullback

Remember the tech wreck a couple of months ago? 

This morning I found myself thinking back to the last time the market pulled back: In September. If that feels like ages ago, here’s a recap:

  • The market was in correction territory. They called it the September Swoon.
  • Investor sentiment dropped from a multi-year high in August to a neutral reading in September (NAAIM).
  • Then came the presidential election, with many bracing for a blue wave and how that might damage equities.

While all of those points above were valid at the time, I think the real reason for the fear was due to challenging market performance. I’ve always believed that headlines follow market prices… not the other way around.

When markets are blasting higher seemingly every day (like now), most headlines are largely positive, and the pundits are quite bullish. It makes me wonder if the media chooses their guests based on which way the air is blowing.

It’s true that markets are screaming right now. Nearly all of my personal accounts are at or near all-time highs. So, is it the time to kick back and relax?


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How overbought markets work

There’s no question the markets are elevated right now. But that doesn’t necessarily mean a pullback is imminent… 

By now, you know I follow the flow of Big Money. If money is flowing into stocks, I tend to be bullish. When money is flowing out, I’m less bullish. 

Let’s take a look at the Big Money Index (BMI). It plots the direction of Big Money buyers.

 

When the yellow line is increasing, buy signals are growing. When the yellow line jumps above the red line (80%), it indicates an overbought market. When we’re at levels near 90% (like now), that’s very overbought. It basically means there are very few sellers.

This index has been back-tested back to 1990. And believe it or not, markets tend to be in overbought territory 17% of the time. That actually shocked me when I looked over the data.

If you look at the average length of time the market stays overbought, it’s usually around four weeks. So far, we’ve been in the red zone for seven days. Needless to say, I’m expecting another few weeks of elevated markets before the BMI starts its fall.

Right now, few seem to be considering a pullback on the horizon. And you’re unlikely to get a headline warning first. But before a meaningful pullback, we’ll see the Big Money slowly start to exit stocks.

The bottom line is this: Headlines are rosy as markets are frothy. Take the time now and get yourself prepared for when the pullback comes. Based on history, it’s likely weeks away. If I had to guess, late January could line up for a much needed retracement.

Things are good, folks. The stock market headlines and pundits confirm it. But always remember that events can change on a dime. 

Don’t forget to start making a game plan… then you’ll be prepared for anything.

Luke Downey is the co-founder of Mapsignals, which focuses on finding outlier stocks by following the big money. Luke is also an options instructor with Investopedia Academy. Prior to Mapsignals, he spent many years on institutional derivatives desks at Cantor Fitzgerald & Jefferies, LLC.

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