WASHINGTON, July 27, 2015 – Part of the current problem we’re experiencing in the stock market this summer is that by many definitions, stocks have gotten overbought, sometimes badly so. An “overbought” condition simply means that the market or a given stock has become overpriced, which generally means that at some point soon, either the given stock or stock market average is going to be sold off, causing a decline in value.
Reading stock charts can often make such a crucial inflection point more clear, enabling you to exit an investment before it’s too late.
Another clue that things are getting a bit out of hand is the almost absurd widening of bid-ask spreads in many stocks, making it tough to find a fair price at which to buy and sell.
Let’s try to describe what’s going on in each of these situations, both of which are important to grasp if you plan to either trade or invest in stocks and bonds.
“Parabolic,” or “Going Parabolic”
The best clue that a given stock or instrument is being “overbought,” or bid much higher in price than it’s really worth, is to note when the chart of that stock, ETF, or stock market average “goes parabolic,” just as the charts for major Chinese markets recently did.
In stock trading jargon, the term “parabolic” derives from mathematics. It describes the shape or trajectory of a slope-intercept curve on a chart that gets so steep it begins to look very much like a vertical line. When you see a similar pattern appearing on the chart of a stock, an ETF, or a market average, it’s a virtual certainty hat sometime soon, the end of the trend will occur, often with considerable violence.
For example, here’s that chart of Chinese markets we also displayed in today’s companion article in our other column, “Market Maven:”
If the current parabolic price trend of a stock is sharply up, the parabolic rise will quickly top and then begin a precipitous decline. If that parabolic trend is down, then the parabolic drop will finally bottom, allowing the market to begin a (hopefully) more sane move back up again at some point, often after a long period of “flatlining.”
When you see one or more parabolic upward moves develop in stocks or markets, it’s best to plan a very quick exit strategy, usually by means of putting in “good ‘til canceled” orders that will execute more or less at a set price one the reversal begins, even if you’re not at your computer.
The Chinese market chart we’ve reproduced above gives you a pretty good idea as to how a parabolic usually resolves: quickly and violently, but not entirely without warning. When you see a parabolic occurring anywhere, particularly if that chart describes a stock or ETF sector that you’re in, you need to get ready to exit, and fast. That’s because parabolics never end easily or happily.
What Bid-Ask spreads can tell you
In most markets, when you access a stock listing on your computer, you’ll see two prices: a bid (the one on the left) and an ask (the one on the right). At this very second, for example, shares of IBM are “bid” at $159.01 per share, while the “ask” is $159.03. That simply means that if someone wants to buy your IBM, they don’t want to pay any more than $159.01 per share: their “bid,” or offer. Contrariwise, if you’re selling it, you’re telling prospective buyers you don’t want to sell it to them for any less than $159.03: your “ask,” or what you’re asking. The space in between these numbers—in this case a penny—is called “the spread.”
If neither of you budge, the stock will just sit there. But say someone comes in and offers that penny that’s sitting in the middle of the spread, offering you $159.02 per share. If you want or need to sell your shares and you’re not getting a better bid, you can simply sell it at $159.02 and get out. It’s still a better price than $159.02.
In other words, the stock market really is an auction market, even though these days, when millions of trades are executed in nanoseconds, it doesn’t seem like it is.
(And, yes, and this action is also being manipulated at times by High-Frequency Traders (HFTs), but that’s another discussion entirely. Let’s keep this one simple.)
The big problem in current markets, though, is that while that 1 penny give and take is a normal and good way of doing business, particularly in larger stocks, in bad times, bidders dry up and the spread widens to sometimes ridiculous amounts.
Let’s say on a given day that we want to sell that IBM but see the bid-ask spread is something like this:
Granted, a stock as big as IBM will likely never boast such an absurdly wide spread. But you’ll see spreads like this in thinly traded or smaller companies, particularly when potential buyers (bidders) are being scared away by market conditions such as those we’re now experiencing.
Well, a spread like this one is a mess. If you want to sell and cave in to that absurdly low bid, you’ll be getting $1.65 less for your shares than you were hoping to get. For the standard 100 share, or “round” lot, that means $165 less. That would get even the likes of mega-wealthy Carl Icahn pretty irritated.
In a situation like this, unfortunately, if you really want to sell, you have to go fishing. Maybe you start dropping your price a nickel at a time, until you find someone who’s willing to meet you in the middle. But if too many players have been scared away, pretty soon you’ll be approaching that other guy’s bid, and you may not want that. The only thing to do here is cancel what you’re asking and maybe come back later or in a few days.
That’s perfectly legit. But in a fast, waterfall decline, the next time you come back, the bid might be $2-3 dollars lower meaning you’ll lose even more money from the amount you’d originally hoped to get.
This is the kind of dilemma no one likes. But if, for whatever reason, an investor absolutely needs to get out of a stock, he’ll eventually have to settle for whatever that canny bidder is offering, even if it stinks.
And this is the problem with markets that have succeeded in scaring out too many investors. By the time you’re scared off, too, you may really have to sell that stock for a really bad price.
The lesson here: If you’re seeing markets where a great many stocks are experiencing lower trading volumes and wider bid-ask spreads, it’s either time to get out; or, if you’re more of a long-term investor, stick it out, take the sickening decline, and perhaps even average into more of the stock as it continues its decline. By “averaging down,” you effectively lower your over all purchase price.
But that presents another problem: If a stock is in a lot worse shape than anyone lets on, it can keep declining to zero, and where does that leave you? It’s a dilemma, and there’s no pat answer other than to do your research before you buy anything, particularly in this market.
The basic bid-ask rule the Prudent Man usually imposes on himself is this: avoid thinly traded stocks with wide bid-ask spreads, as they can be exceedingly treacherous. In addition: be leery of markets where a great many usually heavily traded stocks are experiencing severe volume declines as well as widening bid-ask spreads.
After all, if you want to unload something and no one wants to pay you a decent price for it, that can be a big problem. So seeing the danger signs, like parabolic rises and widening bid-ask spreads on shrinking volume, may be giving you an important clue that it’s best to go cash now, take that summer vacation, and come home relaxed, de-pressurized, and perhaps ready to take advantage of a calmer market where some real bargains may now be available.
In general, that’s how Prudent Investing is supposed to work.