(Bloomberg Opinion) -- The benchmark S&P 500 Index has been on quite a rally, having risen 24% since October. At a level of about 4,433, its 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.
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%.
S&P 500 average next-month returns fall steadily as RSI increases — with an exception that RSIs from 70% to 80% have about unconditional average returns — while standard deviation falls. So, buying when RSI is below 40% seems attractive but risky. At high RSIs the S&P 500 seems relatively safe but unexciting.
It’s important to understand that RSI is based on the total gain from up days of the S&P 500 divided by the total loss from down days. In the long run total gains are 10% to 20% larger than losses, which results in average RSIs from 52% to 54%. It would take a major financial restructuring for averages to deviate much from these values because if gains were not significantly larger than losses no one would buy stocks, and if gains were even larger relative to losses, the market would never go down. Therefore, it’s a safe bet that RSI will always revert to values a little over 50%, a bet that has always paid off in the past.
The current RSI value of is due to total gains being 3.2 times losses over recent weeks. That tells investors two things: (1) that the market is going up, and will likely continue up for some time, and (2) that RSI must revert to 53% or so, which will require either a crash or a sustained period of mostly negative daily returns. On average, the S&P 500 must decline about 20% as much as the RSI declines, so if RSI loses 25%, going from 76.1% to a more normal 51.1%, the S&P 500 will have to fall 5%. This is more a conclusion of mathematics than economics. Of course, the S&P 500 may increase quite a bit - more than 5% — before it starts to decline. But the more it goes up before starting to decline, the higher RSI is and the larger the decline that follows.
For most technical investors, an RSI going above 70% is a signal to buy, but to use other technical indicators to try to guess when the inevitable decline has begun. For all the mathematics and colorful charts, this is exactly what unsophisticated investors do, which is jump in after prices have gone up to take advantage of a trend, but get nervous the higher prices go, and sell quickly when prices stop rising rapidly.
Wilder was an engineer who rode the silver bubble in the 1970s and spent the rest of his life writing and speaking about technical analysis, without conspicuous documented trading success. His main principle was to take the emotion out of trading and his many innovations, like RSI, systematize what emotional investors do naturally. In my opinion, their popularity comes from telling people to do what they feel like doing anyway, and also because their dual natures make it easy to explain away failures.
But whether there is any value to RSI, it exerts a powerful influence on the market, especially because emotional investors are doing the same thing, and many institutions have similar tendencies. RSI did not create bubbles and crashes, but it fuels them with some mathematics.
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