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. All these questions can only be addressed on a relative basis. On that note, one of the best measuring sticks that I always used in assessing overall market strength and direction is known as an RSI, that is a Relative Strength Index. 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, 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.

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 (that is 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, 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?

About Larry Doyle 522 Articles

Larry Doyle embarked on his Wall Street career in 1983 as a mortgage-backed securities trader for The First Boston Corporation. He was involved in the growth and development of the secondary mortgage market from its near infancy.

After close to 7 years at First Boston, Larry joined Bear Stearns in early 1990 as a mortgage trader. In 1993, Larry was named a Senior Managing Director at the firm. He left Bear to join Union Bank of Switzerland in late 1996 as Head of Mortgage Trading.

In 1998, after 15 years of trading and precipitated by Swiss Bank’s takeover of UBS, Larry moved from trading to sales as a senior salesperson at Bank of America. His move into sales led him to the role as National Sales Manager for Securitized Products at JP Morgan Chase in 2000. He was integrally involved in developing the department, hiring 40 salespeople, and generating $300 million in sales revenue. He left JP Morgan in 2006.

Throughout his career, Larry eagerly engaged clients and colleagues. He has mentored dozens of junior colleagues, recruited at a number of colleges and universities, and interviewed hundreds. He has also had extensive public speaking experience. Additionally, Larry served as Chair of the Mortgage Trading Committee for the Public Securities Association (PSA) in the mid-90s.

Larry graduated Cum Laude, Phi Beta Kappa in 1983 from the College of the Holy Cross.

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