RSI signals caution on stocks

The relative strength index suggests some caution over the short term. See why.

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  • The relative strength index (RSI) provides short-term buy and sell signals.
  • Low RSI levels (below 30) generate buy signals. High RSI levels (above 70) generate sell signals.
  • The S&P 500's RSI may be approaching a cautionary signal.

With another relatively strong earnings season coming to a close, stocks are once again trading near all-time highs. Potentially lofty valuations, supply chain problems, the Fed telegraphing that it’s pulling back some economic support, and other risks have not been able to keep stocks down.

These factors, along with COVID-19 developments and the economic fallout, will help drive market direction over the short term. With that said, if you make shorter-term trades (i.e., trades that you plan to close within days, weeks, or months) in your portfolio, the relative strength index can help you evaluate which direction stocks may head over the short term. Here’s why RSI says investors may want to exercise some caution now.

What is RSI?

RSI in context

It's important to begin your investment process with a long-term plan that is built upon your individual goals, risk tolerance, time horizon, liquidity requirements, and tax constraints. Picking your investments should start with careful fundamental analysis. As an adjunct to fundamental analysis, technical analysis can play a role in identifying entry or exit points for a stock, in spotting emerging changes that may not yet be reflected in fundamental estimates for a company or industry, and as a reality check on fundamental expectations about a stock, an industry, and, at times, even the broad market as a whole.

Among the many technical tools that you can use to complement your analysis of stocks and other investment opportunities is RSI, which measures the speed and change of price movements. It is intended to evaluate the relative value of a stock, index, or other investment—based on its recent price history. Among technical indicators, RSI is one of the more commonly used due to the relatively simple, straightforward signals that it generates.

RSI is a momentum oscillator, a type of technical indicator that fluctuates in a range, usually from 0 to 100. RSI is used primarily to determine whether an investment is overbought or oversold. It is calculated using the average gain and average loss over a defined period of time.

Like other oscillators, RSI is most helpful in non-trending markets. A non-trending market exists when a stock, index, or other investment's price is fluctuating in a range between 2 prices. Non-trending markets might be identified by a broad market index, such as the S&P 500, failing to reach new highs or lows over a period of time—such as several weeks or months.

In the chart above, RSI is the blue line in the section below the S&P 500 price. Investors using RSI generally stick to a couple of simple rules. First, low RSI levels, typically below 30 (red line), indicate oversold conditions—generating a potential buy signal. Conversely, high RSI levels, typically above 70 (green line), indicate overbought conditions—generating a potential sell signal.

Some users of RSI and other indicators adjust the rules based on their own preferences and analysis. Instead of using 30 and 70 as oversold and overbought levels, one common modification that you might employ is to widen the parameters to 20 and 80. Here, if RSI were to drop to 20, that would generate a buy signal. Alternatively, if RSI were to rise to 80, this would generate a sell signal.

Trading signals generated by RSI are generally thought to be most valid when values reach an extreme reading near the upper or lower end of the boundaries. Thus, an RSI reading near 100 (the top of the RSI scale) would be greater evidence of overbought conditions (a sell signal), while an RSI reading near 0 (the bottom of the RSI scale) would suggest oversold conditions (a buy signal). Trading signals generated by RSI are also given more credence when the reading rises above 70 and stays above that level for an extended period of time, or drops below 30 and stays below that level for an extended period of time.

What RSI says about stocks now

Looking at the chart above of the S&P 500® Index, you can see that large-cap stocks have trended higher for most of the year, with a couple of minor corrections mixed in. As of mid-November, the S&P 500 has gained roughly 34% on a total return basis (i.e., including dividends) to climb above 4,700.

Meanwhile, RSI has trended higher since late October, approaching a 70 reading. Recall that a rise above 70 might be interpreted as a sell signal. Looking at the RSI portion of the chart reveals that, during the most recent instance when it climbed above 70 at the beginning of November, that was followed by a short-term decline for the S&P 500.

Of course, this reading is nowhere close to an extreme point on the RSI scale. Moreover, the signals given by technical indicators are not always correct, and the capacity of COVID-19 developments and other factors to shift market sentiment has resulted in several instances this year where the signals generated by RSI have been off. Utilize indicators like RSI with extra caution during times like these.

Advanced tips

It is worth noting as well that RSI can remain in overbought or oversold territory for an extended period of time (weeks or even months). That is, if RSI were to eventually move above 70 or below 30, it would not be uncommon for it to remain above or below those levels for some period of time without retreating back to neutral territory.

In addition to the overbought and oversold signals that RSI can generate, it is possible to dig a little deeper into the relationship between RSI and the price action of the stock or index. A positive RSI reversal, for example, might occur when RSI makes a lower low (a relative low point on the chart that is below the most recent previous low) but the price is starting to make a higher low (a relative low on the chart that is higher than the most recent previous low). This would be a bullish move, generating a buy signal. A negative reversal could occur when RSI forms a higher high, but the price forms a lower high. This would be a bearish move, generating a sell signal. The S&P 500 has not recently exhibited a positive or negative reversal.

RSI in action

Basing trading decisions solely on any one indicator could result in poor analysis. Most technical analysts use RSI in conjunction with other technical indicators, fundamental analysis, and business cycle analysis. Consider using multiple indicators along with RSI, such as support and resistance, moving averages, and volume, to confirm the signals sent by RSI. And, most importantly, keep an eye on COVID-19 trends, the global supply chain situation, and the other key factors that could drive market direction for the remainder of 2021. That way, you'll have more evidence to support your analysis, potentially resulting in better trades.

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