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Caution: The Market Looks Dangerously ‘Overbought’

Posted by Larry Doyle on April 6, 2010 8:48 AM |

Is the equity market overbought? Am I supposed to be allocating capital to the equity market after this enormous runup? Is there value in the market, or is this simply one massive momentum trade? Why is overall equity volume so light? Is that an indicator that the market is operating on borrowed time?

All great questions. If I had the exact answers and told you so, I’d be a certifiable liar. These questions can only be addressed on a relative basis. On that note, one of the best measuring sticks that I’ve always used in assessing overall market strength and direction is known as Relative Strength Index, or RSI. What is that?

Our friendly Investing Primer defines RSI as:

A technical momentum indicator that compares the magnitude of recent gains to recent losses in an attempt to determine overbought and oversold conditions of an asset. It is calculated using the following formula:

RSI = 100 – 100/(1 + RS)
RS = Average of x days’ up closes / Average of x days’ down closes

As you can see from the chart below, the RSI ranges from 0 to 100. An asset is deemed to be overbought once the RSI approaches the 70 level, meaning that it may be getting overvalued and is a good candidate for a pullback. Likewise, if the RSI approaches 30, it is an indication that the asset may be getting oversold and therefore likely to become undervalued.

Relative Strength Index (RSI)

The RSI is a great contrarian indicator. When too many people are bullish, the market is poised for a pullback. Similarly, if too many people are bearish, the market will likely do better.

Markets can correct an overbought or oversold condition by price (that is, the value of the equity indices moves up or down in corrective fashion) or time (the market runs in place with little further upward or downward movement).

Hopefully, this makes ‘sense on cents’ for those reading. What about today’s market? Are we overbought? Let’s look at the RSI for the S&P 500 (h/t to Seeking Alpha):

The RSI of 84.00 is an indication that we are not only overbought, but we are approaching a dangerously overbought condition. The last two times we approached this level of the RSI (October 2009 and January 2010) we had 3-5% pullbacks. I am not stating that will necessarily happen again, but we disregard the RSI at our peril.

Who will step in to further drive the market from here?

Navigate accordingly.


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