Is an Overbought Condition Necessarily Bad for the Stock Market?

The term overbought comes up a lot on the media, especially in times like now when stocks have been rallying.  Overbought is a technical condition that occurs when prices have potentially moved too high too fast and may be vulnerable to a move lower. Overbought conditions can be analyzed by using a daily price chart’s internal indicators, such as the Relative Strength Index (RSI-14) or the percent of companies in the S&P 500 Index that are above their 50-day simple moving average (SMA). An index or security is considered overbought when the RSI-14 exceeds 70 and when the percent of the S&P 500 companies above their 50-day SMA exceeds 80. It is important to note that overbought conditions are not always indicating that stocks will move lower; in fact, many times overbought conditions translate into continued bullish momentum, resulting in prices moving higher over the intermediate- to long-term time horizon.

Looking at historical data going back to 1995, when the daily RSI-14 on the S&P 500 Index exceeds 70 and triggers an overbought condition, subsequent returns on the index can potentially be volatile for up to three months; however, the index tends to move higher from 3–12 months (see the table below). Since 1995, this happened 306 times. Three months later, the S&P 500 was higher 77% of the time with average and median returns of 2.4% and 3.0%. Going out 6 months, the returns are higher 79% percent of the time with average and median returns of 4.9% and 6.0%. Looking out over 12 months, the returns were higher 93% of the time with average and median returns of 13.6% and 13.4%.

When the percentage of S&P 500 companies above their 50-day SMA exceeds 80% and triggers an overbought condition, similar to the study above; subsequent returns on the index are potentially volatile from 1–3 months, but stocks tend to move higher 3–12 months later (as shown in the table). Since 1995, this happened approximately 836 times. Three months later the S&P 500 was higher 80% of the time with average and median returns of 3.3% and 3.9%. Going out 6 months, returns are higher 80 percent of the time with average and median returns of 5.9% and 6.4%. Looking out over 12 months, the returns were higher 93% of the time with average and median returns of 12.6% and 12.3%.

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The S&P 500 Index has moved approximately 8% higher off its June 27 lows and is teetering on an overbought condition. The daily RSI-14 indicator, although not officially overbought, reached as high as 67 on July 20; and the percent of S&P 500 companies above their 50-day SMA has been in an overbought condition since July 12, exceeding the 80% threshold. Are these potentially overbought conditions necessarily bad for the U.S. equity markets? Well, over short-term time horizons, it is possible to see some increased volatility as overbought relief sets in, resulting in the indicators and index price moving lower. However, the fact that the S&P 500 Index is close to an overbought condition simply means that on balance, the index possesses bullish price momentum, which, based on historical data, may be sustained over the intermediate- to long-term time horizon.

 

IMPORTANT DISCLOSURES
Past performance is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment.

The economic forecasts set forth in the presentation may not develop as predicted.

The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual security.

Stock investing involves risk including loss of principal.

The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

Overbought condition. This term identifies a scenario in which the price of the S&P 500 Index has moved too high and too fast reaching an extreme limit, increasing the likelihood that the price moves lower in the form of a pullback. Overbought conditions can be measured using the following technical indicators: 1) Price versus its 50-day simple moving average; 2) Relative Strength Index (RSI (14)) oscillator; and, 3) Percent of S&P 500 companies that are above their 50-day simple moving averages.

Oversold condition. This term identifies a scenario in which the price of the S&P 500 Index has moved too low and too fast reaching an extreme limit, increasing the likelihood that the price moves higher in the form of an oversold bounce.  Oversold conditions can be measured using the following technical indicators: 1) Price versus its 50-day simple moving average; 2) Relative Strength Index (RSI (14)) oscillator; and, 3) Percent of S&P 500 companies that are above their 50-day simple moving averages.

Relative Strength Index (RSI-14) oscillator is a momentum oscillator which measures the rate of the rise or fall in price. It is typically used over a 14-period look back time period and measured on a scale from 0–100, with overbought levels marked above 70 and oversold levels marked below 30.

Number of S&P 500 Index companies trading above their 50-day simple moving average is a market breadth oscillator and can be used to identify overbought and oversold conditions. It is measured on a scale of 0-100, with overbought levels marked above 80 and oversold levels marked below 30.

This research material has been prepared by LPL Financial LLC.

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