The Failed “Market Is Technically Overbought” Narrative

The S&P 500 is overbought in the last three days according to a popular indicator. Shorting a technically overbought S&P 500 has been a losing strategy in the last 57 years as shown in this article. Yet, the “market is technically overbought” narrative dominated technical analysis headline for many years.

Untested technical analysis was the perfect wealth-redistribution tool. Brokers and market makers along with other well-informed professionals, such as CTAs, were the beneficiaries of the majority of trades believing the untested claims of some “experts” who wrote books on how to trade with technical analysis. Essentially, untested technical analysis claims acted as a massive wealth-redistribution mechanism from naive traders to market professionals. Surprisingly enough, some follow these rules even nowadays without testing them. They are the ones that still make contributions of cash in a market were dumb money supply is rapidly decreasing.

One of the worst narratives was “the market is technically overbought”. One could hear it often in early financial news networks. Usually the geniuses involved would pronounce a market overbought after the RSI(14) broke above 70 for a couple of days. Some would even look at divergences from price to come up with a more convincing narrative while professionals were laughing on the floor.

The S&P 500 is overbought in the last three days according to RSI(14) because this indicator has stayed above 70, as shown in the chart below:

Below is a backtest of a strategy in S&P 500 daily data since 1960 that goes short at the next open after three consecutive days with RSI(14) > 70 and exits when the RSI(14) falls below 50.

It may be seen that this baseline strategy was a disaster, especially during the early years when the untested “overbought market” narrative was influencing the decisions of many retail traders.

Next we repeat the backtest but instead of an exit based on RSI(14) falling below 50 we use a 5-day time exit.

It may be seen that the overall disastrous performance of this strategy did not change. Actually that was good money in the pockets of market professionals coming from naive traders who believed the narrative (some still do because they do not want to admit they have been fooled just like that.)

But what about divergence? The usual response of failed technical analysts is that the narrative is correct, just the application is wrong and must first look for confirmation.

Below we repeat the backtest with the additional requirement that while RSI(14) is above 70 three days in a row, price decreases for three days in a row, diverging from the indicator.

The behavior of the strategy with added divergence is the same. There is nothing of value here in the case of S&P 500 . In fact, the baseline strategy discussed above has also failed in NASDAQ-100 and Russell 2000, as shown below. Click to enlarge.

It may be further discovered that the baseline strategy tested above has not also worked in currencies and commodities, maybe with a few random exceptions. For example, below is a test on EUR/USD spot.

Obviously, trading forex with such a simplistic strategy would be a mistake to start with and a sure ticket to ruin.

The conclusion is that this untested “market is technically overbought” narrative has failed in the case of stock market indexes unless several other factors were also taken into account. However, in our opinion this narrative has served its purpose of financing the lavish stylist of some market professionals at the expense of naive retail traders.

If you found this article interesting, I invite you follow this blog via any of these methods: RSS or Email, or follow us on Twitter

If you have any questions or comments, happy to connect on Twitter: @mikeharrisNY

Charting and backtesting program: Amibroker

Disclaimer

Technical and quantitative analysis of Dow-30 stocks and 30 popular ETFs is included in our Weekly Premium Report. Market signals for longer-term traders are offered by our premium Market Signals service. Mean-reversion signals for short-term SPY traders are provided in our Mean Reversion report.

Copyright Notice

This entry was posted in Technical Analysis and tagged , , , . Bookmark the permalink.

Leave a Reply