During the market crash on Friday morning last week, a friend instant messaged me.
“Almost every stock I’ve looked at this week is overbought (i.e. 14-day RSI above 70) and has been for over a week. I wonder if there is a filter we can use to see how many stocks of the S&P 500 are overbought. (RSI stands for Relative Strength Index, a key measure of a stock’s upward momentum.)
But my friend had found something. In a matter of minutes, it would execute the filter in question. He was right: A sizable chunk of the S&P 500 had been rising much faster than usual…nearly 40% of the companies in the index at the end of January.
That made me think. What do historical fluctuations in the proportion of S&P 500 companies with high RSIs tell us?
What I found is sinister.
too much of a good thing
Sometimes momentum is a bad thing… too much suggests the market may be irrationally optimistic. A historical look at the RSI suggests that this is one of those times.
A stock’s relative strength index (RSI) compares the magnitude of recent gains and losses over a given period: 14 days is most common. Basically, it measures the value of a stock impulseeither up or down.
Technical analysts use the RSI to assess whether a stock is overbought or oversold. RSI values of 70 or higher suggest that a stock is becoming overbought or overvalued and is therefore at risk of a correction. An RSI of 30 or below indicates the opposite: oversold or undervalued. It could be a profit opportunity.
The key term is “become”. RSI measures the speed change in the average price of a stock. When the RSI is high, it means there is an unusual amount of buying activity during a given period compared to “normal” conditions.
How big is the RSI match?
There is nothing unusual about a high RSI for an individual stock. For example, when the market learns that a company is a merger target, buyers want to own its shares before it happens, leading to a high RSI.
Similarly, we might see high RSI measures for a group of stocks in a sector (energy, for example) when the market thinks that sector is going to boom.
But given that there are 500 individual companies in the S&P 500, covering all sectors of the economy, it is unusual for a large portion of them to enjoy high RSI at the same time.
There was a percentage of companies in the S&P 500 whose average RSI was above 70 in the previous month, from 1990 to today. I will call it the “Market RSI” level.
The median figure seems to be between 5% and 10%. But the RSI level of the market can go much higher.
For example, after the 1990-1991 and 2001-2002 recessions, 30% to 40% of S&P 500 companies had an average monthly RSI greater than 70. That makes sense, since we expect stock prices to stocks rise quickly when we are coming out of a recession.
In contrast, during prolonged economic expansions, market RSI levels fluctuate in a range of 5% to 10%, with regular spikes of around 20% during quarterly earnings reports.
Conversely, market RSI levels tend to be lower than normal when investors seek yield in other ways. It happened during the IPO boom before the dot-com bust, and again when Americans were flipping houses and refinancing like crazy during the run-up to the 2008 financial crisis.
We live in interesting times
Two historically unusual conditions began in late 2016.
First, each “low” in the market’s RSI measure is higher than the previous one. That suggests that the market’s average monthly RSI level is trending upwards for an extended period. There is none of that in previous decades.
Second, the January spike in the monthly average level of the market’s RSI is the highest it has ever been outside of a recession recovery.
When we change to a daily average measure of the RSI market level, we see regular swings between about 5% and 25% since the end of 2016.
But beginning in the late summer of last year, we again saw a steady increase in trend.
We also see a rise in the RSI market level, to almost 40%, just before the big pullback last week.
RSI: good for the trees, bad for the forest
High RSI for individual stocks? well, for too many at once? Dangerous.
Here is my interpretation. Starting in late 2016, two things happened.
- Optimism about a Trump presidency dispelled the small clouds of caution that hang over investors, even in a bull market. As this sunny outlook grew, it snowballed (sorry for mixing metaphors) giving way to the “euphoria” part of the market cycle. It seems that we reached the height of the euphoria at the end of January, when the daily average RSI of the market almost hit 40%…just before last week’s pullback.
- The massive growth of exchange-traded funds (ETFs) in recent years has distorted average market RSI levels by boosting the share prices of “undeserving” companies included in sector ETFs. The rising tide of ETFs lifted all boats…preventing market RSI levels from falling back to historical norms.
Any way you look at it folks, this is not normal. And if history is any guide, it’s not going to end well…