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Identifying Market Trends: The Relative Strength Index
What happens when the S&P 500 Index enters oversold territory? Does the market reverse, or continue on this trend?
A widely-used momentum indicator, the relative strength index (RSI) may offer some insight. The RSI is an indicator that may show when a stock or index is overbought or oversold during a specific period of time, indicating a potential buying opportunity.
This Markets in a Minute from New York Life Investments looks at the RSI of the S&P 500 Index over the last three decades to show how the market performed after different periods of overbought or oversold conditions
What is the Relative Strength Index?
The RSI measures the scale of price movements of a stock or index. In short, the RSI is used to calculate the average gains of a stock divided by the average losses over a certain time period. These are then tracked across a scale of 0 to 100. Broadly speaking, a stock is considered overbought if it reads 70 or above and it is considered oversold if it is 30 or below.
For example, when the S&P 500 Index has a RSI of 85, an investor may consider it overbought and sell their shares. Conversely, if the RSI hits 25, an investor may buy the S&P 500 thinking the market will bounce back.
The RSI is often used with other indicators to identify market trends.
The Relative Strength Index and S&P 500 Returns
Below, we show the 12-month returns of the S&P 500 Index after key ‘overbought’ or ‘oversold’ conditions in the market as indicated by the RSI:
Date | RSI | Shiller PE Ratio* | S&P 500 Index 12-Month Return |
Jul 15 2002 | 20 | 23 | 9.4% |
Dec 4 2006 | 73 | 27 | 4.5% |
Oct 13 2008 | 15 | 16 | 7.3% |
Feb 7 2011 | 75 | 23 | 1.9% |
May 13 2013 | 75 | 23 | 16.1% |
Jan 8 2018 | 89 | 33 | -7.2% |
Mar 16 2020 | 22 | 25 | 66.3% |
May 3 2021 | 72 | 37 | 0.0% |
*Measured by the average inflation-adjusted earnings of the S&P over 10 years
As the above table shows, following each period of extremely oversold territory in the RSI, the S&P 500 Index had positive returns.
In fact, the S&P 500 Index had the strongest one-year returns following the COVID-19 crisis of March 2020, with over 66% 12-month returns. During the time of extreme fear, the RSI sank to deeply oversold territory before sharply rebounding.
Interestingly, following periods of extremely overbought conditions in the market there was a range of positive and negative performance. Most recently, before the peak of the last cycle in 2021, the S&P 500 Index spent roughly 9 months in ‘overbought’ territory before declining into 2022.
The Relative Strength Index in 2022
With the economy in uncertain territory, how does the RSI look today?
In early June, following a bleak consumer sentiment announcement, the RSI fell to 30, hovering on oversold territory. Since then, it has risen closer to 40 as consumer sentiment and perspectives on economic conditions have slightly improved.
However, whether or not the RSI will continue on this uptrend remains to be seen.
For the remainder of 2022, market sentiment, which may be shaped by the coming GDP and inflation figures, could push RSI into oversold territory once again. As a bright spot this may be good news—reinforcing a turning point in the market.