It's mutual for traders to assume that markets that receive got risen meaningfully inward a brusk menstruum of time, similar the electrical flow stock market, volition either conk along inward their recent direction (momentum) or contrary because they are "overbought".
As of yesterday, nosotros had over 80% of SPX stocks closed higher upward their 3, 5, together with 10-day moving averages (shoutout to Index Indicators for the data). Since 2006, nosotros receive got had 132 occasions of such strength. Two days later, the average modify inward SPX has been -.37%. That compares to an average two-day hit of +.08% over that same period. On the surface, it appears that "overbought" markets atomic number 82 to "mean reversion".
If, however, nosotros intermission downwardly those 132 occasions yesteryear median dissever based upon the equity put-call ratio, a dissimilar designing emerges: Overbought markets alongside depression put-call ratios (bullish sentiment) receive got averaged a two-day loss of -.68%. Overbought markets alongside high put-call ratios (bearish sentiment) receive got averaged a two-day loss of entirely -.06%. In other words, roughly all of the weakness seen straightaway next rigid markets has occurred when overbought has been accompanied yesteryear stretched bullish sentiment, which is what we're seeing equally of yesterday's close.
It's a squeamish instance of how context matters: The same toll movement inward dissimilar environments of marketplace position psychology tin atomic number 82 to really dissimilar forwards toll paths.
Further Reading: Finding Trades When Sentiment is Stretched
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