Markets came to a roaring close in July, inking their best month since 2020.
The S&P 500 closed up 9.11%. The Dow gained 6.73%. And the Nasdaq Composite closed up 12.35%.
That was just in the month of July.
And Outlier Insights readers may recall… We knew it was coming.
The Big Money Index (BMI) officially went oversold on July 14.
But the effects of an oversold market cascaded into a largely successful month for stocks in July:
Remember, going oversold isn’t a bad thing. It just means “buys” made up fewer than 25% of all institutional signals my system identifies.
As I’ve shared previously, this is historically a very bullish near-term sign for stocks.
Going oversold is a rare event averaging just once every year and a half for the past 30 years.
So the fact that it went oversold two times this year is worth talking about.
How the BMI Works
As a refresher, I developed the BMI to track when markets hit oversold (or overbought). I take all institutional buy and sell signals and plot them on a 25-day moving average.
This way, we can see money either moving in or out of markets trending over a period of multiple weeks. That gives us a great idea of near-term trends when looking at the movements of Big Money (my term for institutional buyers and sellers).
I’ll show you how it works…
Here we see a chart of the BMI for 2020 placed atop the SPDR S&P 500 ETF Trust (SPY).
The light blue line is the BMI. And it shows that as money moves in, markets trend higher. And as money moves out, markets tend to trend lower.
The red line on top marks when 80% or more of all signals are buys within the past 25 days. When the BMI eclipses the red line, buying becomes unsustainable and markets are deemed to be overbought.
Conversely, when the BMI plunges below the green line, 25% or less of all signals are buys over the last 25 days. When this happens, selling is unsustainable, and the market is deemed oversold.
Big institutional accounts have been selling stocks at an unsustainable pace twice this year now. And when selling is unsustainable, markets tend to rocket higher once the selling concludes.
After all, when prices for stocks get cheap, investors just can’t stay away from all the good deals.
And that sends markets back higher…
It’s Happened Twice This Year
The first time the BMI went oversold this year was on May 24, and it stayed oversold for two days. On July 14, our most recent occurrence, we stayed oversold for just a day.
Going oversold twice in one year is extremely rare… Since 1990, it’s only happened two times previously.
The good news is, these oversold signals should be setting us up for some pretty great performance in the coming months.
After the BMI goes oversold, the forward returns are historically excellent:
Source: Map Signals
Now there are a lot of numbers on there. But this table is telling us one simple thing: Oversold markets on average result in very positive returns for stocks in the future.
Just look at the average forward returns:
One month: 2.7%
Three months: 5.2%
Six months: 9.2%
Nine months: 9.6%
12 months: 15.3%
24 months: 29.8%
The returns that follow oversold markets are all positive on average. And not just by a little but by a sizable amount.
This includes recessions, periods of higher and lower interest rates, September 11th, the Great Financial Crisis, COVID, and so on.
So while it may take some time before we hit new highs, history says that’s where we’re ultimately headed.
Focus on the Fourth Quarter
This summer has been characterized by heavy volatility.
In May when markets went oversold, we saw a short-term bounce in the markets before they ultimately reverted and we went oversold again.
So as good as the performance in July was, it wouldn’t surprise me if it was a short-term blip before another brief pullback once again…
That’s because there’s a lot of unpredictability at play in the economy right now. Raging inflation, interest rate hikes, and consumers’ uncertainty over a possible recession are making markets turbulent.
But as inflation slowly abates and uncertainty eases, we should wrap up the rest of this year in much better shape. The prospect for that looks good as we continue to get more clarity from the Fed and should see energy prices drop seasonally – which would improve the inflation numbers we see.
In fact, Fed chair Jerome Powell has already hinted at smoother sailing into Q4 and even the potential for rate drops and the “soft landing” in Q1 2023.
Here’s what that means for us as investors…
Given the forward returns after going oversold, now isn’t a bad time to buy. If we have been waiting eagerly for the right moment to add to our portfolios, the average returns should reward us over the next 24 months.
Yet for even better timing, my advice is to wait out the summer volatility and keep our focus on Q4 – which I think will be really great for markets.
That way, we can avoid some of the anxiety-inducing ups and downs and still take advantage of the improving market dynamics that are just around the corner.
Editor, Outlier Insights