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When to Expect S&P 500 Underperformance

The S&P 500 Index (SPX) has been strong over the past several months, except for a brief pullback in April. Thus, the Relative Strength Indicator (RSI) has risen above 75, which is well into overbought territory.

The RSI is a widely used indicator that measures overbought and oversold levels, ranging from zero to 100. A reading above 70 is generally considered overbought, while a reading below 30 is considered oversold. This week, I will analyze historical data to examine how the market behaves when this indicator reaches such levels.

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Historical Data to Watch

The table below shows SPX returns since 1950, organized by the level of the RSI. Note that the RSI has been above 75 only about 4% of the time since 1950. Unfortunately, the data does support the RSI as a reliable overbought signal at these levels, at least in the short term.

Over the next two weeks, with the RSI above 75, the index averaged a return of 0.19% compared to a 0.35% return overall (not shown). As you extend the timeframe, the returns get less bearish until they match overall market returns at 12 months. It’s also worth noting that the RSI, at extremely low levels, has been a good oversold indicator.

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I found the data in the next table surprising and encouraging. I created a signal using this data, alongside the criteria of RSI crosses above the 75 level for the first in at least 10 trading days. From this, I got 127 signals going back to 1950. Despite the data above, these specific signals show bullish returns going forward. The SPX averages a two-week return of 0.55% with 70% of the returns positive after the signals, compared to 0.35% average return and 59% positive anytime.

Also, there’s a lot less volatility after these signals based on the magnitude of average positive and negative following the signals compared to anytime. In other words, when we first get a signal (technically, this signaled at the close last Friday), the SPX tends to stay higher over the next couple of weeks. But the longer the index stays above the overbought RSI level of 75, the more you can expect some underperformance.

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Finally, here’s a similar table as above, but looking at one-month returns instead of two-week returns. There’s still some outperformance, but not nearly as much. Based on the RSI levels and historical data, it wouldn’t be surprising to see some more gains in the short term, but a slowdown could be right around the corner.

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