RSI Data Shows How to Trade the Sell-Off

The Relative Strength Indicator (RSI) can help predict rallies

Senior Quantitative Analyst
Aug 7, 2019 at 6:18 AM
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The S&P 500 Index (SPX) had its worst day of the year on Monday of this week. This sent the Relative Strength Indicator (RSI) crashing, indicating an oversold market. The RSI is a popular technical indicator that oscillates between zero and 100. A level above 70 is often considered overbought, while a level below 30 is considered oversold.

Based on this simple interpretation, the RSI reading below 30 should be a good sign that stocks are now due for a bounce. The problem with simple interpretations of popular indicators is that their actual implications -- based on actual numbers -- doesn’t often match with the prevailing view. In the analysis below, I’ll show you the actual numbers of how stocks have performed after previous oversold readings. Also, I’ll see if a collapse of the indicator, rather than a slower march lower, has had different consequences.

                          SPX RSI

General RSI Numbers

Here’s a simple measure of how the S&P 500 has performed over the next month based on the RSI reading. I went back to 1950 and found the one-month return of the index based on whether the RSI was below 30, above 70, or somewhere in between. The index has in fact had the highest average return when the RSI reading was below 30. In that case, the S&P 500 has averaged a 1.17% return over the next month. Otherwise, the average return has been 0.69% when the indicator is between extremes, and 0.79% when it has been above 70. The problem with the below 30 reading is a higher than usual standard deviation and a percent positive that is less than average. So, the returns have been good, but volatility has increased.

RSI 1 Month 1950

When looking at the returns since 2010, which gets us past the financial crisis, the indicator has performed terrific. When the RSI reading has been below 30, the S&P 500 has returned an average of 3.74% over the next month, with almost 80% of the returns positive. When the indicator has flashed an overbought signal, the index has gained just 0.33% with 62% of the returns positive.

RSI 1 Month 2010

RSI Crosses Below 30

One thing about that analysis above is that it is guaranteed to capture the rebound when the RSI moves higher. The RSI can move into oversold territory and stay there for some time during which the market struggles, sending the RSI even lower. When stocks rebound, they tend to do so quickly. The RSI then turns higher and takes some time to move above 30. The returns in the analysis above are capturing all that and then the next month going forward. So, here’s another way of looking at it.

The table below looks at how the S&P 500 has performed after the RSI falls below 30 for the first time in a month. It only looks at returns after that initial close below 30. In this case, you can see the returns are not nearly as bullish. In fact, the index has tended to struggle in the short-term. The average return has been negative over the next two weeks, with only half of the returns positive. Over the next month, the time frame that showed to be bullish in the analysis above, in this case has underperformed typical market returns. The longer-term returns -- three and six months -- are broadly in line with typical market returns.

RSI Below 30

Looking at the recent results of these crosses below 30, however, is encouraging. Since 2010, the returns after these initial drops below 30 are bullish across all time frames. There’s no short-term bearishness and the average returns beat normal market returns at each time frame.

RSI Below 30 2010

Finally, here’s another way to look at it. I noted above how the RSI didn’t just march down to the 30 level. It was at a rather high level a short time ago and then it suddenly caved below the oversold level. In a week, the RSI went from about 60 all the way below 30. Since 1950, there were only 12 other occasions when the RSI was below 30 after being above 50 at some point over the last week.

The table below summarizes the returns after these occurrences. There’s still short-term weakness, with the S&P 500 averaging a loss over the next two weeks with only about 40% of the returns positive. After that, however, the index has performed very well. Three months after these signals, the S&P 500 has gained an average of 3.82% with 83% of the returns positive.

RSI Swings

Everything considered, the analysis above seems to indicate a good chance at bullish returns in the medium-term with potential bearishness in the short-term.

 

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