How to Spot Overbought Stocks

October 27, 2023No Comments

Hello and welcome once again to the Smart Money Dumb Money Show and I am your host, as usual, Keith Richards. I’m president and chief portfolio manager of Value Trend Wealth Management. Today, we are going to talk about overbought stocks and we’re going to focus on one stock in particular, Nvidia.

They’ve been in the news a little bit lately. Biden’s ‘for-Bodden”, their chips to be sent. They are high-end chips to be going into the Chinese market. So that’s kind of a big piece of news for them and probably quite bearish insofar as their markets go. But I want to talk about some signs that I’ve been looking at on the stock and just a little bit of history on other stocks that get very overbought, and markets become very enthusiastic about them, which usually leads into at best a period of soft returns if not outright downside.

 

This is as much about this individual stock, Nvidia, as it is about learning how to spot overbought stocks

How to spot overbought stocks. Tesla graph example

From the beginning, this is another overbought stocks story. There’s been plenty of them. If we look at Tesla, the stock ended up being a relatively sideways stock after that monster move between 2020 and 2022. I mean the stock literally went from around 10 bucks a share or equivalent to something like $300 a share. You might’ve heard me talk about this in past videos and on blogs, their PE ratio was through the sky and really the stock in this case had to pause for, well now three years, just to allow the price part to get in line with the earnings part of that ratio.

This is what happens when you get overbought markets. Everybody’s excited and the stock can go sideways, but sometimes it doesn’t go sideways. Bitcoin. This was all the rage again right after 2020 with all the fears surrounding what happened during the Covid crisis. Bitcoin went up like crazy. Now this is the New York Stock Exchange Bitcoin index. It covers all of the products, but they are all kind of moving the same. And you can see that Bitcoin basically rose from a gain of around $5,000 in dollar terms to something like $60,000. So that was a pretty big move, a pretty big move down too. From that level. We see it eventually came back down to 15 and then it settled recently in and around 30, but that’s still quite a bit behind that 60-plus thousand dollars peak that it hit. So again, we’re going to be looking at signs to see when that’s happening.

How to spot overbought stocks: Bitcoin example

One of these signs, which you can see right here just by your good old eyeballs, is that some of these stocks often go quite parabolic before they crash and burn. Keep that in mind when considering how to spot overbought stocks.

 

How to spot overbought stocks: Canopy example

Canopy Growth

Let’s take a look at another poster boy. Now you guys remember after my best friend and bosom buddy Justin Trudeau got elected, one of his promises was to legalize marijuana and F was the biggest producer of the product in Canada. And of course, they had a lot to gain from that decision. And you can see that the market kind of went crazy. Everybody thought, well, these guys are going to be making lots of money because everybody’s going to buy the product. And well, not everybody does. But truthfully, there have been a lot of, as you probably have seen, Canopy-type stores on every corner of every city and town you go.

In fact, there’s more. I see more Canopy outlets than there are beer stores and LCBOs. Very interesting. It’s been such a plethora of these things opening, well, that should mean that they’re making tons of money, right? Well, no, because it all comes down to a gain just because people are buying a product, the company’s got to be profitable selling it. So the excitement leading into, and then after that announcement of the legalization in Canada, you saw literally the stock go in the pennies from less than a dollar to again 50, 60 bucks a share. And here we are, right back to the pennies again. So this is the problem with overbought stocks and you can see again some parabolic moves here. Look at that move right around the time the announcement was made and then a second move as it began taking off and the stores were opening. But now the market has come to the realization that, well, there are many regulations. It’s not actually that profitable because of the costs and the investments in producing this stuff. And lo and behold we’re just, there’s very few blow-ups that I’ve seen like this, but it’s also in its own way classic of what happens. Here’s another one.

How to spot overbought stocks: Gamestop example

Spot overbought stocks like Gamestop

Do you remember the meme stocks? And there was a whole bunch of them, but the GameStop was one of the poster boys. And you can see what the signs of an overbought market are. Parabolic moves? Well, if that’s not a parabolic move, I don’t know what is. This was just a game coming after the 2020 thing. This is when everybody started acting crazy, you might remember, and people were buying toys and overbidding housing prices and beginners were trading the stock market. We saw a lot of people that really didn’t know what they were doing and they were following Reddit and doing these meme stocks and for a while they made a lot of money until they didn’t. You can see GameStop the poster boy, it went from a dollar a share to a gain around a hundred bucks a share. And here we are today at 13, so that’s quite a ride from a hundred down to 13.

 

So just bear in mind that these are the kind of pictures before we look at any indicators, I want you to keep these images in your mind because this is what can happen.

 

How to spot overbought stocks: Nvidia example

How to spot overbought stocks like Nvidia

I want to talk a little bit about Nvidia, and this is a quote from Larry McDonald. Larry is the proprietor of Beartraps. As many of you might know, I have used their research for a number of years. I use a number of different companies independent research. One of the things you’ll notice that I’ve talked about in the past is don’t listen to sell side research. That’s the brokerage firm research because they always have something because to sell, they have to be bullish. I only use independent research and, of course, I do my own technical stuff. I don’t subscribe to technical research firms. I do it myself, but also I do have programs to look for stocks in my own.

So Larry though has a unique way of doing things because he’s really kind of a capitulation artist. He knows how to spot overbought stocks and oversold stock situations. And this is something that I have a great interest in as a technical analyst who has an interest in sentiment trading. So he’s talking here about Nvidia, and this is what inspired me to write this blog. So I’ve got a few notes here and then we’re going to look at some price charts and some other stuff, but let’s just get it started by talking about the streets price target, which is now average 6 55. So when we say the street, it’s all the sell side analysts. And what are they saying on average? Their consensus view is for $655 in the next 12 months, it’s about 420 something. Right now I’m recording this video on the 18th. I had to look at my watch there to see what day it is of October.

You might be seeing this in 10 days or so, but it won’t be 600 bucks I don’t think by a week from now when you actually see this video. So it’s in the four hundreds right now they’re targeting 655 and the sell side analysts have been falling all over themselves trying to outbid each other for their outlook. They’re very much reminding me of the way Tesla was in the early days when it went parabolic before it went nowhere fast. In contrast to the way analysts are speaking right now is the low points on the stock. December of 22, the stock was trading at 160 bucks. Now think of that. That’s like a year ago from less than a year ago from when I’m recording this video, it was 160 bucks and it’s now in the four hundreds and the sell ratings peaked in December 22.

Rhetorical questions

Now the rhetorical question is, which was a better time to buy now in the four hundreds or then at one 60? So I’m always telling you don’t listen to sell side analysts. I also tell you don’t listen to the media because they quote sell side analysts and they also quote the government, which tells you what they want you to think. So just be wary of consensus and the media and sell sell-side analysts because they’re usually wrong at the wrong times. So sell’s ratings, I should say peaked in December 22, the average 12 month target was 10 bucks higher or they were pretty wrong. NVIDIA’s management were not buying the stock. So the insiders didn’t like the company, but now they found religion. Lord, we praise Nvidia is going to the moon. They are saying, and they have been buying, the company itself is doing a huge buyback.

They announced that second quarter 2023 and they are buying 25 billion of their own stock. The company’s buying 25 billion of its own stock and that’s usually a sign of confidence. But I wonder if it’s also a question of where were they December of 22 when the stock was much less than half of what it is 10 months later. So that’s the points I want to make about the analysts and what they’re saying right now. And you can already read where I stand on that and we’re going to get into the charts in a minute, but I also want to just rehash what I mentioned at the beginning of the video, which is Biden is clamping down on export of their key products. Let’s take a look at this street target price, which is this white line versus the actual stock price, which is the yellow line.

 

Target Prices

And you can see that the target prices fell quite a bit. This was target what they were looking out 12 months from then. So you can see that they bottomed both the price and the targets last December. There’s December of 22 and where are they now? We’ll look at the gap between where the price is and we’ll look at the price chart in a minute, but it’s been kind of consolidating, going sideways. So here’s where they think it’s going to go. We just looked at this mid six-hundreds and here’s where it is. The gap between the sell side analyst targets has never been wider on this stock and it rarely gets wider on stocks of any type. So, this is incredible.  They are tripping over each other trying to outbid each other on who’s got the highest target. It’s ridiculous. So, I want to look at the valuations here just quickly.

 

Price to Sell Ratio

We always talk about the price-to-earnings ratio, but let’s look at the price-to-sales ratio. I’ve printed a chart like this before. This is the updated version. It hit 45 times the price-to-sales. Now it’s trading around 33 just for comparables because yes, it’s a tech and yes, they’re growth companies and yes, they deserve a higher multiple than say a utility company for example. But look at the other high-tech leaders out there and you’ll see that they’re nowhere near as expensive as Nvidia. This is just off the charts in so many ways. So I’m going to now look at the technicals. So I’ve given you kind of what the street consensus is saying and how much I trust those guys. I’m showing you a little bit of the fundamentals.

 

It’s not a short-term Indicator of how to spot overbought stocks

Now I’m going to get into the technicals and I’m going to look at some big-picture indicators and take note, these are some indicators that you can add to your own collection for big long-term views that will also help you spot overbought stocks. This doesn’t show you what a stock is going to do next week, so don’t think this is a short-term way of looking at things, but this is telling us that things are getting overbought. So I’m going to talk about a few things in a minute. I just want you to understand what each one of these indicators is. If you want and you have a subscription to stock charts.com, you can actually go to their chart school and you can look up what these things are or just Google them. I’m going to simplify them, but let’s talk about the Force index. It was created by a fellow that I used to read his work when I first got into the industry. I don’t think he’s in the business anymore, I’m gapping on his name right now. A Russian fellow brilliant technical analyst. And he created an indicator called the Force index. And what he did was he took the direction. So, whether a market moves on a given day was up or down and then the percentage moves and times it by volume and he came out with an index showing the force of the move.

 

Spot overbought stocks using longer term indicators

So it’s a very good indicator when you look at it on a longer-term basis to see what the force of the market is because for example, if you’ve got a pretty good direction and extent of volume when the market’s going up and then it has a down day, but it doesn’t really have a lot of volume and it really doesn’t fall that much, that’s a low force move. So, you’ll see that net-net. You want to see force moving in a particular direction. So the other thing that I like to use, and this is sort of my proprietary, it’s not proprietary, I tell everybody about it, but I’ve been talking about this for years and I believe I was the one that kind of discovered this, if you want to say is that the percentage of the 200-day moving average versus the stock price.

So, if you see the stock price too much above or too much below the 200-day moving average or 40-week moving average, it can be an indicator of overbought stocks or oversold stocks. And I talk about this in my technical analysis course and I’m sure a lot of you have taken that course. We’re also going to look at accumulation distribution. So a lot of you guys know what that is, but it’s basically just the relationship of the close to the high and low range and then times volume. So it really just sort of tells us money flow going into the market. And then finally, the money flow index, which is basically just taking accumulation distribution and doing an RSI on it. RSI is a momentum indicator. Okay, so how much momentum are we seeing in this money flow? Money flow may be happening, you might be moving into the stock or moving out of the stock, but how much momentum is behind that?

 

Indicators at Work

Okay, probably won’t remember all those things, but you’re just going to look at the squiggly lines in the next chart and you’re going to see these indicators at work. To start with my own favorite, which is of course the one I’ve been credited with, I guess in using is the percentage over the 200-day. And you can see back when the, remember we talked about price to sales when it was in the forties. Well, also the price was over the 200-day moving average by about 47%, 46.9%. I called it 46 here. So that’s a pretty big move over the 200-day moving average. Just to give you a comparison, typically when I see an individual stock much over 15%, and when I see the market much over 10% on a broad index, I start to get concerned and the higher, the more concerned I get. You can see here in Nvidia when it was, I don’t know the percentage there, but I’m going to guess it was probably something like 25%. The stock fell okay, it did hit this level and then instead of falling, it fell briefly. But it’s been moving in a consolidation pattern and right now it’s about 25, 20 6% above its 200 days slash 40-week moving average. So again, it’s still pretty overbought. It’s not cheap by any means.

 

Money Flow

Now let’s take a look at the money flow. Money flow. Despite the fact the chart is going sideways, you can see the money flow is moving down. Also, I might point out that this stock is below its 50-day moving average and the 50-day had been supporting it before. So that might be a sign of, again, weakening continuing for a while as it stays below the 50. So anyway, money flow has been declining, and the stock itself has been flat. That’s a bad sign. You want the money flow to be flat when the stock’s going flat. Also, here’s a negative divergence in the money flow index. Remember we talked about that? It’s basically the accumulation distribution line. This thing times RSI or RSI applied to it, I should say.

And look what’s been happening. It went into an overbought status and it’s been diverging down against a flat market, another negative sign. So final thing I want to look at is the Force index. Remember, the force index measures the direction, the volume, and the extent. So if we look at that Force index, how much muscle is behind the movement? Well, what we’re seeing is, is the muscle behind the previous uptrend, it began again to diverge negatively quite some time ago, like this indicator started moving down, meaning that the market’s a little bit less enthusiastic about it, and I’m sure Biden’s announcement doesn’t help.

 

How to Spot Overbought Stocks – a Quick Summary

I just want to bring all that to a head by telling you that when you see a parabolic-looking chart, an easy way of identifying that is my little rule of what percentage over the 200-day moving average are you seeing?

If you’re eyeballing a parabolic move, you can check your eyes by measuring that move against the 200-day moving average. It’s simple. You can do it easily enough, hand calculator or use the stock charts tool like I did. It doesn’t matter. The point is you don’t want much more than 15% on a regular basis. It can move up and down. If it’s an aggressive stock like Nvidia, you might forgive 20%, but you’re not going to forgive 45%. It hit recently; 46% I think it was. So we’ve seen all these indicators work. We’ve seen how money flow was declining even when the stock’s been going sideways.

 

No One is your Guru.

No one can tell you exactly how to spot overbought stocks

There are a lot of negative signs. It’s overvalued from a fundamental point of view. And the street’s just gotten goofy. And remember, don’t trust the street, don’t trust the media. They’ve been loving the stock. So you have to trust yourself. You have to trust your analytics. And don’t even trust me. I mean, I do believe that I’m less biased because I am very pragmatic because I’m a portfolio manager and I live and die by this sort. But even saying that I can be wrong. So you have to do your own work. Please do so because no one is your guru. There’s nobody out there that can do the work for you. Nobody can ride the bike for you. I have a little sign in my office somewhere that says, “Nobody can ride the bike for you.”

So just keep that in mind and I hope this gives you a quick lesson how to spot overbought stocks; not so much on why you should not buy Nvidia, but more on what to look for. If a stock’s been moving fast, just because cautious, and we have some quantitative tools now to determine if a stock is getting overbought.

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