The Myth of Oversold Markets

You hear the word “oversold” from stock traders and market watchers a lot lately, especially from those trying to figure out if the market has hit a near-term bottom or whether it still has a way to fall. Strictly speaking, “oversold” is a word that should be used only by technical analysts (those who believe that an individual stock’s or a market’s future movements can be predicted on the basis of their past movements), and since technical analysts are the market equivalent of astrologers, “oversold” is about as meaningful as “her moon is now in the house of Mars” (or whatever it is astrologers say). But when the market is as volatile as it has been over the past month, people start searching for answers everywhere, so the idea of a possibly oversold market now crops up with startling regularity.

What’s startling is not that investors remain anxious to find potentially hopeful signs in a market that has finally caught on to the reality of a dramatic slowdown in corporate earnings growth. Instead, what’s startling is just how meaningless the very idea of an oversold (or overbought) market is.

An oversold market is presumably one in which too much stock has been sold too quickly, and in which sellers have been too willing to dump shares without much concern for price. That means, we’re meant to believe, that a rally is inevitable as the market returns to some form of equilibrium, and buyers in a sense catch up to sellers.

The problem is that this only makes sense if the return to equilibrium is the natural default position. In other words, a market can only be oversold if there has not been a meaningful change in investor sentiment about the market as a whole. If investors who were once willing to pay 30 times earnings for a growth stock are now only willing to pay 20 times earnings for a growth stock, then sellers should overwhelm buyers, because the market needs to make its way down to that new “equilibrium” (though that’s the wrong word).

In other words, as with all technical analysis, the concept of an oversold market is useless because it excludes all the important information that actually moves markets, and because it doesn’t accept the possibility that things might really be different this time. That’s why it can keep predicting bounce-back rallies until the day when it can’t. As the stock market kept falling all through 1930, I’m sure there were many days when technical analysts assured themselves that the market was oversold. And yet it just kept falling.

This is not, of course, 1930. Not at all. But the ascent of this market has been so steep and so rapid (while also being so prolonged), that there is very little room for bad news, even now. More to the point, many companies have seen their stock prices rise so sharply in the past three years that even when they fall a long way, there’s a lot farther for them to fall than many investors believe.

To make this concrete, look at semiconductor equipment maker Applied Materials, which yesterday announced major job cuts and capacity reduction in response to a continued slump in demand due almost entirely to the Asian crisis. Applied Materials’ stock price is half its 52-week high, and it’s tumbled mildly over the past month. But the stock is still three times as expensive relative to the company’s underlying assets as it was two years ago, which is the last time the semiconductor industry went through a sharp downturn. Which is to say that to say the stock is now fairly valued means that you think it’s worth three times as much as it was in 1996. The logic there is difficult to discover.

Whether we’re oversold or not isn’t what matters, then. What matters is whether investors’ underlying assumptions about stock prices and corporate earnings have changed or will change. Everything else is just short-term noise.