The Market Snapshot bar chart provides us with some very useful information. You have often heard me state that the market is oversold or overbought. What does this really mean? Markets are like rubber bands, when stretched to extremes they have a tendency to snap back. This snap back is referred to by the pros as “reversion to the mean”. When we are at market extremes good buy and sell opportunities are revealed.
Warren Buffet said: “A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.”
Volatility & Bollinger Bands
In the Daily Market Snapshots presentation (part 1) I said that the green and red lines on the S&P 1500 Chart (duplicated below) represented volatility expansion and contraction; I will now refer to these lines as Bollinger Bands. In terms of the markets historic volatility, these Bollinger band lines are placed two standard deviations above and below the current day’s price. Statistically, the share price will only move outside of these lines just 5% of the time. Ninety five percent of the time price changes will confine themselves within these boundaries. When the share price moves beyond these boundaries it can be said that the stock or market is oversold or overbought.
John Bollinger originated the Bollinger Band concept.
Slice & Dice
Ian Woodward, a very savvy independent investment analyst, expanded on the Bollinger Band idea by adding another very useful element to this valuation method. He divided the distance between the upper and lower Bollinger Bands by ten; creating ten “%B Buckets” as he calls them. From bottom to top, he labels the buckets from .01 to 1.0 (bottom axis). Then, for good measure, he adds one additional bucket at both the extreme top and the extreme bottom. These are labeled <0 and >1. (See the Chart Below)
Next, the S&P 1500 stocks are analyzed to determine their valuation in %B Bucket terms individually. In the bar chart above we can see that about 14% of the S&P 1500 stocks reside in the .06 bucket and about 23% reside in the .08 bucket. I will interpret the %B Bucket readings for you in a moment.
The <0 through the .05 buckets are always painted red. The .06 through >1 buckets are always green. The ratio of %B >0.5 vs. %B<0.5 is illustrated in the pie chart on the right.
%B Buckets and Rubber Bands
By now bullish investors might be thinking that more green is better than more red, and rightly so. However there is an exception. At extremes the bar chart is warning us of an overbought or oversold condition; a market reversal is imminent.
Example:
The Market Snapshot clearly shows that on November 25th 2011 the market was extremely oversold, with more than 97% of S&P 1500 stocks below %B 0.5 and over 40% below %B 0. (Notice the height of the red bars on the extreme left and how short the green bars are on the right)
After reaching that extreme low on Nov 25th the market reversed course and took off to the upside.
We can now see at a glance how the market is currently valued, whether it is relatively cheap or relatively expensive. Most importantly, the Market Snapshot alerts us about overbought and oversold situations that allow us to invest like Warren Buffett with confidence.
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