When Overbought is Bullish

John Lynch Chief Investment Strategist, LPL Financial

Written by 
 Boone Wealth Advisors

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The bull market continues to march higher. The S&P 500 Index is near one of the most overbought levels in history and this has many wondering how much longer the rally can continue. The longer-term technical indicators continue to look strong, but sentiment is flashing some warning signs suggesting market volatility could finally be heating up.

Most Overbought in 22 Years

How can we sum up the events of 2017? Although our favorite story might be that the world’s largest snowball fight was canceled because of too much snow, this year will be remembered for being one of the least volatile years in history. In other words, this is another reminder that nearly anything is possible when it comes to markets. Put simply, we are currently in the midst of the longest streak ever without a 3% correction for the S&P 500, and potentially the first year in the history of the S&P 500 to have a total return monthly gain all 12 months. Add it all up and equities are the most overbought they’ve been in 22 years.

The Relative Strength Index (RSI) is a popular momentum indicator and as Figure 1 shows, it is the most overbought it has been since 1995. This has many market participants suggesting equity markets are ripe for a substantial pullback at any time. Here’s where things get interesting. There’s an old technical analysis saying that “the most bullish thing a market can do is get overbought and stay that way.” Sure enough, when the S&P 500 weekly RSI has gotten over the historically super overbought level of 80 (like recently), the returns have been better over the longer term.

We’ll be the first to admit that a normal correction of 5–10% could happen at any time given how long it has been since the last pullback. But it is important to note that any pullbacks could be a nice opportunity to add to positions. As seen in Figure 2, the S&P 500 has reached this overbought level only 13 other times dating back to 1950.* Somewhat surprisingly, the future returns are actually stronger after such periods of overbought natures. For instance, a year after being overbought, the S&P 500 is up 12.8% on average versus the average gain of 8.8% and higher 12 out of 13 times, which suggests there may be a good chance for solid market returns next year.

The Relative Strength Index

The RSI is a very popular momentum indicator that was developed by J. Welles Wilder. It measures the speed and change of price movements and oscillates between 0 and 100. It is widely accepted that a measurement above 70 is overbought, while a measurement below 30 is oversold. The calculation is based on 14 periods, as suggested by Wilder

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