Stocks are trying to put 2022 in the rearview mirror. The S&P 500 is up 4% more than halfway through the first month of 2023, bolstered by hopes that central banks may not keep raising rates as aggressively as they did last year. But a potential earnings slowdown and the possibility of an official recession are among the reasons to be worried that the momentum may not continue.
What are the charts saying? One technical indicator—Bollinger Bands—suggests that US stocks, broadly speaking, may be overbought on a short-term basis.
Using Bollinger Bands
How do you determine what a good price is for an investment? Is a stock that is trading at $50 per share expensive, or is it cheap? You may have done your research and decided to buy or sell. But when is the best time to pull the trigger?
Bollinger Bands are a short-term trading tool that can help you decide when to make your move by assessing the relative strength—or momentum—of a stock investment. You can even apply them to the broad market. This indicator looks like an envelope that forms an upper and lower band around the price. Between the 2 bands is a moving average, typically a 20-day simple moving average (SMA).* John Bollinger, who created this indicator, considers the price relatively low (attractive) if it is near the lower band, and relatively high (overvalued) if it's near the upper band.
What the bands say about stocks now
Recently, the S&P 500 has been in the upper part of the band, which suggests US stocks are overvalued on a short-term basis (see Bollinger Bands applied to the S&P 500® Index chart).
Bollinger Bands applied to the S&P 500® Index
In addition to these "high" and "low" relative assessments, there are other trading signals that are generated by how the price interacts with the bands. For example, when the stock breaks through the upper band, some traders believe this generates a buy signal (breaking through a resistance level). When it breaks below the lower band, some traders believe this is a sell signal (breaking through a support level). According to this interpretation, if the S&P 500 continues to rise, it could break above the upper part of the band to generate a buy signal. It’s worth noting that Bollinger believes a close either above the band or below the band is not necessarily a reversal signal, but rather a continuation pattern.
Volatility and the bands
Bollinger Bands can also help assess volatility. Narrowing Bollinger Bands (i.e., when the bands move closer together) could suggest that volatility is decreasing—as investor sentiment potentially becomes more optimistic or complacent. As the chart above shows, this is not the case for the S&P 500 as the bands have actually widened a bit since mid-December 2022.
Another pattern of note is a Bollinger Band "squeeze." This occurs when volatility reaches a relative low in the context of recent price action. This squeeze can frequently be followed by a period of increased volatility, and may result in a significant move by the stock to the upside or the downside. A squeeze has not occurred recently.
Advanced use of Bollinger Bands
An advanced application of Bollinger Bands involves another indicator: the relative strength index (RSI). Bollinger Bands can be applied around the RSI line to assess additional buy and sell signals.
When RSI is near an extreme high (~100) or low (~0), and is touching either the high part of the upper band or the low part of the lower band, the RSI line could pull back sharply from the band. Bollinger Band analysis holds that a failure of RSI to touch the upper band on a second try generates a sell signal. At extreme lows, a failure of RSI to reach the lower band triggers a buy signal. This is similar to double top and double bottom patterns, respectively, that can occur for the price. Currently, RSI is not near extreme highs or lows.
Another tool in the toolbox
It goes without saying that you shouldn’t make investing decisions based only on the signals given by a single indicator or data point. Bollinger Bands can be used in combination with different indicators, like RSI, as well as support and resistance, moving averages, and any other research tools that may support your analysis.
It's always important to consider fundamental stock research and your particular goals, time horizon, and risk tolerance before making an investing decision. There are reasons to be bullish and bearish right now based on both the charts and the fundamentals of the global economy. If you actively trade, now is a good time to keep a close eye on as much information as you can—including what’s happening in the charts.