Is overbought really a downtrend? | chart of art

The S&P 500 SPDR (SPY) has surged more than 10% since the end of October, surpassing the upper Bollinger Band (125.1). This means that the price is more than 1 standard deviation above the 125-day SMA. Clearly, this means SPY is overbought. But is this actually bearish? Historical evidence suggests this is more bullish than bearish.

The chart below shows the Bollinger Bands (125,1). The middle line is the 125-day SMA and the outer lines are 1 standard deviation above and below this line. Since 125 days represents approximately 6 months, we consider this a trend indicator. A move above the upper band reflects a large rally that could signal the start of an extended uptrend. Here we are only interested in bullish signals.

Like all trend-following indicators, these signals have their fair share of whipsaws, but they also capture some pretty good trends. The chart below shows the last six signals, including four signals leading to profits (green arrow lines) and two signals leading to losses (red arrow lines). Both losses were relatively small (-.40% and -3.80%). Two of the four gains were also small (~2%). The bull market through 2017 generated a 19% return, while the bull market through 2021 generated a 33% return. In his book Bollinger on Bollinger Bands, John Bollinger discusses how price can follow bands during a strong trend. Notice how SPY has stepped into the upper band during the strong uptrends of 2017 and 2021. These two big trends have more than paid for the whipsaw.

Since 8 years isn’t a very long time, we went back to 1994 and tested this signal over the last 30 years. The table below shows the buy and hold results for SPY. Bollinger Band signals produced lower compound annual returns (6.7% vs. 7.9%) but had much lower average drawdowns (17.13% vs. 37%). It is important to avoid large losses. We also see a win rate of 66%, with the average gain (14.3%) being more than three times the average loss (-3.80%).

Bollinger Bands (125,1) are a solid trend-following indicator. This works well for uptrends, but not so good for downtrends because the stock market has a long-term upward bias. Although the indicator is not perfect, the recent movement above the upper band is more bullish than bearish. A close below the lower band will invalidate this signal.

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Bollinger Bands (125,1) are part of a trend synthesis that aggregates trend signals across five trend-following indicators. This indicator is one of 11 indicators in TIP Indicator Edge for StockCharts ACP. Click here to take your analysis process one step further.

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