During the market crash on Friday morning last week, a friend IM sent me.
“Almost all of the stocks I've reviewed this week are trading overbought (that is, a 14-day RSI above 70), and have been for over a week. Wondering if there is a filter we can use to see how many stocks in the S&P 500 are overbought. "(RSI stands for Relative Strength Index, a key measure of bullish momentum in the S&P 500? ;an action.)
But my friend had stumbled upon something. Within minutes I was running the filter in question. He was right: a significant portion of the S&P 500 had risen much faster than usual … almost 40% of the companies in the index by the end of January.
It got me thinking. What do historical fluctuations in the proportion of S&P 500 companies with high RSI tell us?
What I have found is disturbing.
Too many good things
Sometimes momentum is a bad thing … too much of it suggests that the market may be irrationally optimistic. A historical look at RSI suggests this is one of those times.
A stock's Relative Strength Index (RSI) compares the magnitude of recent gains and losses over a period of time – 14 days are the most common. Basically it measures a stock momentum, whether up or down.
Technical analysts use RSI to assess whether a stock is being overbought or oversold. RSI values of 70 or more suggest that a stock is becoming overbought or overvalued, and therefore at risk of a correction. An RSI of 30 or less signals the opposite – oversold or undervalued. It could be a profit opportunity.
The key term is “to become”. RSI measures the speed change in the average price of a share. When the RSI is high, it means that there is unusual buying activity over a period of time compared to "normal" conditions.
How big is the RSI party?
There is nothing unusual about a high RSI for an individual action. For example, when the market learns that a company is a target for a merger, buyers want to own its shares before that happens, resulting in a high ROI.
Likewise, we might see high RSI metrics for a group of stocks in a sector – energy, for example – when the market thinks that sector is going to explode.
But given that there are 500 individual companies in the S&P 500, spanning all sectors of the economy, it's unusual for a large chunk of them to benefit from a high ROI at the same time.
There was a percentage of companies in the S&P 500 with an average RSI above 70 in the previous month, 1990 to present. I will call it the "Market RSI" level.
The median figure appears to be between 5% and 10%. But the market's RSI level can go much higher.
For example, after the recessions of 1990-1991 and 2001-2002, 30% to 40% of companies in the S&P 500 had an average monthly RSI above 70. This makes sense, as we predict that stock prices will rise rapidly when we are emerging from a recession.
In contrast, during long economic expansions, market RSI levels fluctuate between 5% and 10%, with regular peaks of around 20% during quarterly earnings reports.
In contrast, the market's RSI levels tend to be below normal when investors seek return through other means. This happened during the initial public offering (IPO) boom before the dot-com crisis, and again when Americans were flipping homes and refinancing like mad during the financial crisis. from 2008.
We live in interesting times
Two historically unusual conditions began at the end of 2016.
First, each "weak" measure of the market's ROI is higher than the last. This suggests that the average monthly level of the market's RSI is on the rise over an extended period. There was nothing like it in previous decades.
Second, January's peak in the monthly average market RSI level is the highest on record outside of a post-recession recovery.
When we turn to a Daily As an average measure of the market level of the RSI, we have observed regular oscillations between around 5% and 25% since the end of 2016.
But from the end of the summer of last year, we again saw a steady rise in the trend.
We are also seeing a spike in the market level of the RSI – to nearly 40% – just before the big pullback last week.
RSI: good for trees, bad for the forest
High ROI for individual stocks? Well. For too many people at once? Dangerous.
Here is my interpretation. From the end of 2016, two things happened.
Optimism about the Trump presidency has swept away the small clouds of caution that hover around investors, even in a bull market. As this sunny outlook developed, it snowballed – sorry to mix up the metaphors – ushering in the “euphoria” part of the market cycle. It looks like we hit a peak of euphoria at the end of January when the market's average daily RSI almost hit 40% … just before last week's pullback.
The massive growth of exchange-traded funds (ETFs) over the past few years has skewed average market RSI levels by raising the stock prices of the “undeserving” companies included in sector ETFs. The rising tide of ETFs has lifted all boats … preventing market RSI levels from falling back to historic norms.
Either way, you see, guys, it's not normal. And if the story is any guide it won't end well …