Don't Fear an Overbought Stock Market Yet

The S&P 500 Index (SPX) has been ripping higher since Christmas, gaining 15% since then. The index just had its best month since October 2015, and its best January since 1987. As a result of these gains, the Relative Strength Indicator (RSI) is getting close to overbought territory.

The RSI is a popular overbought/oversold indicator. It’s an oscillator that ranges from zero to 100. A level at or above 70 is commonly considered overbought, while a level at or below 30 is considered oversold. Based on the chart below, it’s likely we’ll soon hit that overbought level of 70. This week, I’m going to look at the actual numbers to see if a simple reading of this popular indicator can tell us if the market is, in fact, vulnerable when we touch 70 on the SPX RSI.

RSI and S&P 500

Here's one simple way of quantifying the RSI indicator: Going back to 1953 -- the date of the first signal -- I looked at the one-month SPX returns based on the reading of the RSI. I bolded the column showing returns after overbought readings, even though we’re not quite at that level yet.

An RSI of 70 doesn’t look like something to be afraid of. The S&P 500 averaged a return of 0.80% when the RSI was at an overbought level. That lags the average return when the RSI was at an oversold level, but it’s better than a moderate reading of the indicator. Also, there was a better chance of a positive return in the next month after the RSI showed an overbought reading; 66.4% of the returns were positive after an RSI of 70, compared to 60.4% otherwise.

Zooming In on RSI since 2010

This next table is the same type of analysis, but it looks at more recent data. It goes back to 2010, so it might better represent the current environment. This data is not as encouraging.

Since 2010, when the RSI is showing overbought levels on the S&P 500, the index averaged a gain of 0.44%, which lags the other two brackets. Unlike the longer-term data we saw above, the percent positive was also the lowest when the indicator was at overbought levels. In simple terms, since 2010, the RSI has performed well as an overbought/oversold indicator.

SPX After 100 Days Between Overbought Readings

Here’s another way I looked at it: The SPX RSI hasn't seen 70 in just over 100 trading days (since August of last year). Going back to 1950, there were 43 occasions when the RSI crossed 70 for the first time in 100 trading days or more. The table below summarizes the returns at different time frames after these occurrences. The second table shows anytime returns for comparison.

To summarize, the index generated very strong returns in the short term after these signals. The average return two weeks after a signal was about 1%, which is three times higher than a typical two-week return. After a cross above 70, the S&P 500 was higher 74% of the time two weeks later, compared to 58% at any time.

Below, I again look at the data only going back to 2010. The short-term returns still beat typical returns over the same time frame. The two-week and one-month average returns and the percent positive were significantly better after overbought RSI readings, when compared to anytime returns. The outperformance disappears when you get further out than a month, though.

From this analysis, I would conclude that the RSI can be a cautionary overbought signal when it shows a reading above 70. This has been especially true since 2010. When it first crosses this level, however, it’s not a reason to be afraid. In fact, based on the last couple of tables, it might be a short-term buy signal because SPX momentum is strong.