The Stock Market Has Momentum - Maybe Too Much

The benchmark S&P 500 Index has been on quite a rally, having risen 24% since October. At a level of about 4,433, it's already above the median year-end target of 4,100 in a Bloomberg News survey of 23 Wall Street strategists. The stock market has what investors like to call momentum. That is clearly seen in what is known as the Relative Strength Index, which has risen around 77%, the highest since September 2020. Readings above 70 generally indicate an asset has been overbought, and readings below 30 suggest something has been oversold. So, this metric is getting a lot of attention at the moment, but what does it really mean? Perhaps not what you may think.

RSI is a key technical indicator – and a confusing one. It’s called a “ momentum oscillator,” which is an oxymoron since momentum trends while oscillators oscillate. Investment strategies based on momentum buy things that have gone up in price recently, while oscillator strategies bet that what just went up, must come down.

Too Much, Too Soon? | The S&P 500's Relative Strength Index has exploded above 70, a level generally considered where stocks are overbought

A lot of writing about RSI is a bit messy due to this dual nature, and analysts frequently give it opposite interpretations. As it pertains to the S&P 500, RSI is a momentum indicator because it’s above 50% when the index has gone up over the last few weeks (it has a “half-life” of 9.3 trading days, meaning the S&P 500 return from nine days ago has half the weight in the indicator as what happened yesterday, while the return from 18 days ago has one-quarter the weight, and so on) and below 50% when the index has gone down.

Its simplest use in a momentum strategy is to buy when the RSI goes above 70% for the first time (that is when it was below 30% more recently than the last time it was above 70%), and short the market when it goes below 30% for the first time. Since technical analyst J. Welles Wilder Jr. introduced RSI in 1978, there have been 40 buy signals, with the average S&P 500 total return in the subsequent month at 1.3% with a standard deviation of 3.9%, versus an overall average monthly return of 0.9% and a standard deviation of 4.7%. So, you get somewhat higher average return, with somewhat less risk. Alternatively, there have been 41 sell signals, after which the S&P had an average monthly return of 0.7% with a standard deviation of 5.3%.

But remember that RSI is also an oscillator. When it’s high it has a strong tendency to fall, and when it’s low it has a strong tendency to rise. The only way for it to fall is for the S&P 500 to drop, and the only way for it to rise is for the index to increase. Therefore, to use it as an oscillator you go long the S&P 500 when the RSI is below 30% -- not as a one-time trade when it crosses below but maintained until it goes above 30% -- and go short when the RSI is above 70% and stay short until it goes below 70%.

How Good an Indicator? | Average next-month returns for the S&P 500 since 1978 vary depending on the level of the RSI