The collapse of the market is an ominous sign

During the market crash on Friday morning last week a friend sent me an instant message.

“Almost all the stocks I’ve watched this week are trading overbought (i.e. 14-day RSI above 70) and it’s been over a week. I wonder if there is a filter we can use to see how many shares of the S&P 500 have been repurchased. ” (RSI stands for Relative Strength Index, a key indicator of stock momentum growth.)

But my friend came across something. A few minutes later I launched the filter in question. He was right: much of the S&P 500 grew much faster than usual … almost 40% of firms in the index in late January.

It made me think. What do the historical fluctuations in the share of S&P 500 firms with high RSI tell us?

What I found is sinister.

Too much good

Sometimes the momentum is bad … too much of it suggests that the market can be irrationally optimistic. A historical look at the RSI suggests that this is one such point.

The stock’s Relative Strength Index (RSI) compares the value of recent gains and losses over a given period – most often 14 days. In essence, it measures stocks impulse, up or down.

Technical analysts use RSI to assess whether a stock is being repurchased or resold. RSI values ​​of 70 or higher indicate that the stock is overbought or overvalued, and thus is at risk of adjustment. An RSI of 30 or below signals the opposite – oversold or undervalued. It can be a profit opportunity.

The key term is “attitude”. RSI measures speed changes in the average stock price. If the RSI is high, it means that during this period there is an unusual amount of purchasing activity compared to “normal” conditions.

How big is the RSI party?

There is nothing unusual in high RSI for individual capital. For example, when a market learns that a company is the target of a merger, buyers want to own its shares before it happens, leading to a high RSI.

Similarly, we can see high RSI rates for a group of stocks in a sector – such as energy – if the market thinks the sector will boom.

But given that the S&P 500 has 500 individual firms covering all sectors of the economy, it is unusual for most of them to receive high RSIs at the same time.

There was a percentage of firms in the S&P 500 whose average RSI was over 70 in the previous month, from 1990 to the present. I’ll call it “market RSI”.

The average seems to be between 5% and 10%. But the RSI market level could 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 above 70. This makes sense because we expect stock prices to rise rapidly if we exit the recession .

In contrast, during sustained economic growth, the level of RSI in the market ranges from 5% to 10%, with regular jumps of about 20% during quarterly earnings reports.

In contrast, RSI market levels tend to be lower than usual when investors seek returns in other ways. It happened during the boom of the initial public offering (IPO) before the collapse of the dotcoms, and again when Americans, like crazy, overturned homes and refinanced during the 2008 financial crisis.

We live in interesting times

At the end of 2016, two historically unusual conditions began.

First, every “low” figure in the RSI market is higher than the last. This suggests that the average monthly RSI level in the market tends to be higher over the long term. There has been nothing like this in previous decades.

Second, the January surge in the average monthly RSI market level is the highest ever since coming out of the recession.

When we move on to Fr. daily average RSI market level, we see regular fluctuations between about 5% and 25% since the end of 2016.

But since the end of last summer, we have again seen a steady growth trend.

We also see a surge in the RSI market level – by almost 40% – just before the big pullback last week.

RSI: good for trees, bad for forest

High RSI for individual stocks? Good. Too much at once? Dangerous.

Here is my interpretation. Since the end of 2016, two things have happened.

  • Optimism about Trump’s presidency has blown small clouds of caution hovering around investors, even in the bull market. As this sunny prospect grew, it slipped into a snowball – sorry if I mix metaphors – revealing part of the “euphoria” of the market cycle. We seem to have reached the peak of euphoria in late January, when the average daily market RSI reached almost 40% … shortly before last week’s rollback.
  • The massive growth of exchange-traded funds (ETFs) over the past few years has distorted the average market levels of RSIs due to rising stock prices of “unworthy” firms included in sectoral ETFs. The rising tide of the ETF has lifted all boats … preventing RSI market levels from falling to historical norms.

No matter how you look at it, people, it’s abnormal. And if the story is a guide, it will not end well …