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Trading Overbought Stocks
Stocks become overbought for a number of reasons. Sometimes the promise of a new product seduces investors. They forget to do technical analysis and they buy the promise without considering that the stock price may soon correct. At times the market comes to believe that a stock “will just keep going up.” Thus, investors will keep buying the stock, even at exorbitantly high price to earnings ratios. Sometimes, like recently, the market has crashed. Investors and traders are looking for something that will exhibit growth potential or at least a little price action. When there are not a lot of choices the market sometimes jumps on mediocre opportunity as the only perceived choice. Any of these scenarios will lead to over priced stocks. Almost inevitably such over priced stocks will correct. Sometimes the whole market will, after a fledgling rally. Trading overbought stocks can be very profitable when the market corrects.
As the market rally pauses, and even takes a horrendous mid day dip, it is time to consider that a game plan for trading market recovery may well be finding and trading overbought stocks. It is a sad fact than many long term investors will commonly pay too much for the “promise” of forward earnings potential. A prime example is a number of hotel stocks. Occupancy numbers have risen with a number of hotel chains. Experts credit economic recovery as well as lack of new bed capacity due to the recession. Some of these stocks appear overbought with P/E rations nearing twenty at a time when it appears that the economic recovery will continue to slow. Another issue with trading overbought stocks in the hotel arena is that those with a large overseas presence seem to have rosier prospects than those with solely domestic exposure, by about a 30% better growth rate.
Trading the rallies and retreats of the stock market is not limited to overbought hotel stocks. Considering that the S&P 500 remains below its year 2000 level there are a lot of stocks that are “moving sideways.” That is to say if you look at their technical analysis charts you see a flat line. If a company does not have a strong overseas presence, of fantastic new product, a strong R&D department churning out new technology and making it applicable, it may just “flat line” into the distant future. To the degree that a number of “flat line” stocks have been bid up the on general promise of market recovery they are over bought. Trading overbought stocks in virtually any market sector will take a mixture of fundamental analysis of stock prospects and technical analysis of short and medium term price direction.