The S&P 500 Index (SPX) has shown resilience over the past few months, with only a minor setback in April. As a result, the Relative Strength Indicator (RSI) has climbed above 75, signaling an overbought market. This week, we will delve into historical data to understand the market behavior when the RSI reaches such elevated levels.
The RSI is a commonly used indicator that ranges from 0 to 100, with readings above 70 indicating overbought conditions and readings below 30 indicating oversold conditions. Since 1950, the RSI has been above 75 only about 4% of the time. Surprisingly, the data does not fully support the RSI as a reliable overbought signal in the short term.
When the RSI is above 75, the SPX has historically averaged a return of 0.19% over the next two weeks, compared to the overall average return of 0.35%. However, as the time frame extends, the bearish returns diminish until they align with the overall market returns at 12 months. Interestingly, the RSI has been more effective as an oversold indicator at extremely low levels.
A deeper analysis of the data reveals an intriguing trend. By creating a signal based on the RSI crossing above 75 for the first time in at least 10 trading days, we observed 127 signals dating back to 1950. Despite the general data indicating otherwise, these specific signals showed bullish returns going forward. After such signals, the SPX recorded an average two-week return of 0.55%, with 70% of the returns being positive, outperforming the overall average returns and positive outcomes.
Moreover, there was less volatility post-signal, with smaller fluctuations in average positive and negative returns compared to any other time. While the market tends to stay higher in the weeks following a signal, an extended period above the overbought RSI level of 75 could lead to underperformance.
Looking at one-month returns instead of two-week returns, we still observe some outperformance, albeit to a lesser extent. Based on the RSI levels and historical data, we may anticipate further gains in the short term, although a potential slowdown could be on the horizon.
In conclusion, while the RSI may not always be a foolproof indicator of market conditions, combining it with other criteria can potentially provide valuable insights for investors. Stay tuned to Extreme Investor Network for more in-depth analysis and strategies to navigate the dynamic world of finance and investments.