The Only Stocks That Look Cheap in This Overbought Market

Stocks are overbought. The S&P 500 was up 5% in January, and another 1% on the first day of February. More than 90% of stocks are trading above their 50-day moving averages. Investor sentiment is overwhelmingly bullish.
 
The New York Stock Exchange and Nasdaq Summation Indexes — intermediate-term measures of overbought and oversold conditions — are extended and are flashing “warning signs.” And the bullish percent indexes for the financial and energy sectors are overbought and on the verge of rolling over.

It sure looks like the market is ripe for a correction. But here’s the thing, it looked the same way this time last year, too, and stocks just kept running higher.

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In 2010 and 2011, stocks became overbought early on. Then they suffered a modest pullback before moving even higher and making short-term tops in May both years.
 
So even though all the signs are in place for a decent market correction, the seasonal influences are just too bullish this time of year to try to make money on the short side. Stocks generally move higher between December and April. That’s just how it goes. Stocks can pull back during this time, but declines are usually shallow and short-lived. That makes it tough for all but the most nimble of traders to profit from betting on the downside this time of year.

Of course, it’s also tough trying to chase stocks higher into overbought conditions. There’s more risk than potential reward when buying into extended sectors like banks, energy and transportation stocks. The odds favor those stocks moving even higher, but if you’re wrong, the results could be disastrous.

Today, traders are faced with the “too early to short, but too risky to buy” dilemma.

The best strategy in this situation is to look for stocks that haven’t yet participated in the run-up like the rest of the market has. They don’t have any “frothy” gains to give back if the market suffers a broad-based correction. And they’re likely to play “catch up” if the market continues higher.

That’s why it’s time to buy “Big Tech.” Tech stocks usually lead the market, but that hasn’t been the case so far in 2013. The market has run away without them. Take a look at this chart of the Dow Jones U.S. Technology Index:

Dow Jones U.S. Technology Index Chart

Tech stocks haven’t done anything in 2013. They’re trading at basically where they started the year.

If the market starts to fall at this point, tech stocks don’t have a lot of gains to give back. So the risk is limited relative to the rest of the market. And if stocks are going to run higher for the next couple months, tech stocks are going to have to play “catch up,” which could lead to huge gains.
 
This is the epitome of a low-risk/high-reward trade setup. There are no guarantees, of course. Even tech stocks will fall if we get hit with a correction. But if stocks are going to continue higher — as they’ve done for each of the past three years — stocks in the sector are going to outperform.