Is the JSE overbought in the short term?

With global equity markets losing steam in the last few days, there is increasing talk about markets being overbought and overvalued in the short term. The FTSE/JSE All Share Index is no exception and the Index has pulled back by 2,1% since its high of 29 565 on 15 April 2010.

According to Dr Prieur du Plessis, Plexus Asset Management chairman and author of the Investment Postcards blog, an important measure of a market’s short-term overbought or oversold status is the trading range of an index around its 50-day moving average. “The moving average of a stock market index or share price is the arithmetic average of the prices over a certain moving time frame, for example for a 50-day period from 8 February to 21 April, from 9 February to 22 April and so on. A moving average smooths out the daily price fluctuations and helps to indicate the emerging trend,” explains Du Plessis.

Du Plessis points out that the FTSE/JSE All Share Index (ALSI) has been trading above its 50-day moving average for most of the time since mid-March 2009, i.e. just after the market made a low and began its recovery. “After crossing above the 50-day moving average in early March, it only dipped below very briefly three times during the remainder of 2009,” says Du Plessis.

“The market’s recent pull-back of 9% from mid-January to early February 2010 saw the ALSI substantially decline below its 50-day moving average. The market resumed its upward trend and the ALSI went back above its moving average towards the end of February. While the Index went below the 50-day moving average, the average barely reversed its upward slope, which shows the short-term trend in the market remained positive.”

So where are markets now? “The market’s pull-back over the past few days has resulted in the ALSI easing back into its normal trading range. It is therefore no longer in extremely overbought territory,” says Du Plessis.

According to Du Plessis, the graph below can also indicate market momentum. “If the trading bands move wider, there is momentum in a direction and when the bands contract, there is a large probability of a turnaround in the short-term trend. There has been a slight narrowing in the trading bands of the ALSI over the past few days. If this continues there could be a further downside in the short term. It should, however, be noted that this graph has a short-term nature and the position can change very quickly,” he warns.

Graph

The graph below indicates how the FTSE/JSE All Share Index (black line) has been trading above and below its 50-day moving average (grey line) over the past 15 months.

The graph also shows the ALSI’s trading ranges, with the shaded yellow area representing one standard deviation from the moving average (the market’s normal trading range) and the red and blue shaded areas representing between one and two standard deviations. When the Index moves into (or even below) the blue area it is a good indication of a short-term oversold position while a move into the red area (or above) indicates a short-term overbought position.

 (Click on image to enlarge)