Stock market is overbought

Jan 27 22:00 2004 Al Amzin Print This Article

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There’s no need to explain what a stock market collapse means. Possibility of a collapse is a source of tensity for a trader. Traders are afraid of it and hope this will never happen again. But it always does. Stock market crises are taking place quite often. The problem is how to estimate when this crisis will happen again. How to forecast when a stock market bubble is ready to blow up? It’s very important to estimate the moment of a collapse.

We will try to do it by using instruments based on regression model,Guest Posting such as CAPM. CAPM is a well-known regression model that is able to estimate asset risk in comparison with stock market index. CAPM model is an equilibrium model. It estimates stock market movement after market loses its balance. CAPM determines the balance conditions.

To test this system it is essential to select a country with long financial history. The history should comprise stock market bubbles and collapses. In this example we choose USA. And we select the main well-known indices, such as blue chips Dow Jones, technology-laced Nasdaq Composite and broader Standard and Poor’s 500 Index.

The Dow Jones Industrial Average is the main American index. It’s the oldest and single most watched index in the world. DJIA is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq. Charles Dow invented the DJIA back in 1896. The DJIA includes blue chips companies like General Electric, Disney, Exxon, Microsoft and others.

The Nasdaq Composite index is market value weighted index of all common stocks listed on Nasdaq. The Nasdaq Composite dates back to 1971, when the Nasdaq exchange was first formalized. The Nasdaq Composite Index measures all listed Nasdaq domestic and international based common type stocks. Today the Nasdaq Composite includes over 4,000 companies, making it one of the most widely followed and quoted major market indices. Unlike the DJIA, the Nasdaq is market value-weighted, so it takes into account the total market capitalization of the companies it tracks and not just their share prices.

The Standard and Poor’s 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market value weighted index, with each stock's weight in the index proportionate to its market value. S&P 500 consists of 400 industrial companies, 20 transportation, and 40 financial and 40 utilities companies. The S&P 500 is one of the most commonly used benchmarks of the overall stock market.

We have to compare stock market indices with Gross Domestic Product, to estimate if market oversold or overbought. We choose as a dependent variable stock market index, and as an independent variable GDP. These two variables can be presented in percent as a difference between first date and the settlement date divide by its first year value. Such variable allow us to compare different indices in single country and indices of different countries.

We’ll explain why we choose GDP as a dependent variable. Our choice based on the main stock market risk concerned with marginability. Stock market doesn’t produce new money, its just redistribute the existing money. As a result of this stock market yield should be limited by economy efficiency. When marginability is violated, when stock market rate of growth exceed economy rate of growth and stock market become very risky.

As mentioned above, CAPM estimates the point when stock market becomes unstable.

It becomes obvious if you take a look on the rate of change. When rates of change are more then 1, stock market is considered risky. The more the rates of change the more it’s risky. When slope is less then 1, we can say that stock market is underestimated and during the some period it will aspire to 1.

Variables that we place on different axes can be negative. For instance, to calculate rate of growth for GDP 1980 we have to deduct GDP 1995 from GDP 1980 and this negative deduction compare with the 1995 date.

Let’s compare 3 main American indices to find common features. The first one Dow Jones Industrial Average represents blue chip companies, second Nasdaq Composite Index - technology companies, and the third one S&P 500, consists of both blue chips and technology companies.


It’s obvious, that these three main indices have common behavior in these three patterns. Stock market growth rate outstrips economy growth. Stock market is overestimated. This situation is lasting for a long time, and now it’s getting even worse.

It’s clear that stock market indices have dependence. As a result of it let’s review the dynamic of main American index Dow Jones.

Linear part locates between 1980 and 1990. It can be revealed by line with an angle 1.14. In this period stock market rate of growth a little bit bigger then economy rate of growth. Beginning with the 1994 Dow Jones Industrial Average grows very fast comparing to real economy growth. You can see it on the graph. The angle has increased more then 3 times. This means that stock market growth exceeds real economy growth more then 3 times. Such rise lasted till the 2000. In 2000 raise changed into fall (angle equals 5.96). During the fall stock market rate of growth didn’t reach economy rate of growth. This means that stock market is still overbought. Situation is getting even worse every day. DJIA is growing and getting overheated even more. This situation may cause a stock market collapse. It doesn’t mean that stock market falls today or tomorrow. But it will happen in any case in a future.

If the S&P 500 Index looks like DJIA, the situation with the Nasdaq composite seems even worse. Since 1994 the Nasdaq Composite rate of growth grows up more then 12 times. Starting from 2000 the Nasdaq fall was much horrible then Dow. Technology index didn’t reach its fair price the same as Dow Jones. Beta coefficient equals 5.19 right now. According to these calculations we can say that the Nasdaq composite is overestimated at present. It can cause even greater collapse.

So, if the index value didn’t reach the balanced price, stock market fall possibility will always exist. We’ve got such situation right now. Stock market is overheated already and getting even more overheated. It’s time for traders to think if this a good time for investing or not and what kind of trading strategy to follow.

We are not advising you not to invest in stock market, we just warning you that it’s very risky right now. Stock market collapse is not far off. Traders, be careful!

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