Investment & Financial Articles
Title: Stock market is overbought
Author: Al Amzin
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STOCK MARKET IS OVERBOUGHT. TOO LATE TO INVEST!
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, 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.
[illustrations]
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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