Can the Stock Market Be “Oversold” and “Overvalued”?

Executive Summary

With last week’s drastic market decline, many have heard financial pundits proclaim the stock market is “oversold.” Briefly, oversold is the term used by technical analysts to describe a sell-off too far and too fast, based on various technical indicators, and thus likely to bounce. However, oversold does not indicate price being undervalued. The second graph shows the Shiller P/E of the S&P 500 Index, a valuation metric, at 31.3. Historically only higher during the Technology Bubble and the Covid Peaks. It is important to understand the difference and expect increased volatility in the markets.

For further analysis, continue to read The Details below for more information.

“Things are not always as they seem; the first appearance deceives many.”
–Phaedrus by Plato

The Details

With the economy slowing, and fear that in the near-term growth could slow further due to the current tariff negotiations, investors have been selling stocks. The selling accelerated rapidly last week with huge down days on Thursday and Friday. During the morning of Monday, April 7, the S&P 500 had fallen 20% from its previous peak. This type of drop typically ushers in a bear market. Listening or reading financial pundits’ comments, one might have heard that the market is extremely “oversold” and should bounce higher. It is important for investors to know the difference between “oversold” and “undervalued.”

“Oversold” is a term used by those who perform technical analysis. In essence, it means a stock or stock index has sold off too far too fast and therefore is likely going to bounce from that level. There are many indicators that give traders this technical information. For example, the RSI or Relative Strength Index is a technical indicator that measures the speed and magnitude of price changes. A reading below 30 typically means the stock is oversold. In the graph below, from Stockcharts.com, it shows the 5-year, daily, RSI of the S&P 500 at the top of the graph and the price at the bottom. One can see the recent drop in price and the corresponding drop in the RSI below 30, highlighted in yellow.

Being categorized as oversold by no means indicates the price is undervalued or even reasonable. It merely means to day-traders the market has moved rapidly and in sufficient magnitude to result in an oversold status. Valuation on the other hand shows whether the price is reasonable based upon underlying revenues and earnings. The market can remain overvalued or undervalued for an extended period of time. This is not a good timing mechanism. However, valuation can put things in perspective. For instance, the graph below from www.multpl.com shows the Shiller P/E of the S&P 500 Index. The long-term median of the Shiller P/E is 16. The current reading, even after the recent sell-off, is 31.3. The current reading is comparable to the peak achieved just prior to the 1929 stock market crash and subsequent depression. This level was only surpassed in the Technology Bubble of the late1990’s and the craziness surrounding Covid.

So, while the technical analysis shows the market is oversold and could bounce – which is always a possibility, valuation measures indicate a significantly overvalued market, even after the recent 20% pullback. All of this means that in the short run, market volatility will remain high. But before getting too excited to “buy-the-dip” remember the market has many influences. And a drop of 50% in the current market would only bring prices back to the long-term median valuation.

The S&P 500 Index closed at 5,074, down 9.1% for the week. The yield on the 10-year Treasury Note fell to 3.99%. Oil prices decreased to $62 per barrel, and the national average price of gasoline according to AAA rose to $3.26 per gallon.