The S&P 500 has been on a steady uphill climb over the last week, from the near death 671 level to its close of 799 today.  In the sub 700 level, there was constant talk of the S&P being “oversold“, and since the run-up, that talk has turned to descriptions of “overbought“.  Both of those terms have nothing to do with the fundamentals of the S&P 500 components.


Considering only the fundamentals, the S&P still has plenty of room on the downside.  The latest earnings estimates for the S&P 500 for 2009 are only $35.  With the S&P at the 800 level, those $35 in earnings correspond to  a price to earnings ratio of nearly 33, a staggeringly high number considering the rampant fear and uncertainty in today’s market.  And at the low of 671, the $35 in 2009 S&P earnings estimates correspond to a p/e ratio of 19, still pretty high in this environment.

But as I said, those “oversold” and “overbought” adjectives flying around are technical analysis terms used to describe the current market SENTIMENT.  And the STOCHASTICS are the technical indicators used to measure market sentiment.  The chart below is from Yahoo Finance, and it depicts the SPY (S&P 500 ETF) year to date pricing, along with the fast stochastic and slow stochastic indicators.

spider-fast-stochastic-slow-stochastic

Similar to moving averages, stochastics can be calculated with your preferred choice of parameters – %K and %D.  It’s best explained with an example.  The slow stochastic graph above is calculated using a %K of 15.  This means that each point on the %K graph (blue line) is calculated with that day’s closing price, and the closing prices of the 14 preceding days.

%K = 100 * ((Recent Close – Lowest Low(n) / (Highest High(n) – Lowest Low(n))

The “n” in the equation above represents the last 14 trading days.

%D is calculated using a 5 day moving average of %K.

Simple enough, right?  Sure it is, but to make it even simpler, just use your favorite charting software to toggle the display of the stochastic indicators, and voila, you now have  a view of market sentiment and can determine for yourself if it is overbought or oversold.

What is overbought and oversold? – Market technicians haver differing views on this.  Some will say that any reading above 80 is overbought and below 20 is oversold, presenting good selling and buying opportunities.  Others prefer to wait for a confirmed reversal.  When the stochastic indicator crosses below 80 (after hovering above it), its time to SELL.  And when the stochastic indicator crosses above 20 (after hovering below it), its time to BUY.

But whatever decision you make, remember that it’s your money, and it’s YOUR RISK!

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