The Dow Jones Industrial Average has stayed overbought for 21 days, which is the longest period this technical condition has persisted in 31 years. As the analysis below shows, the index has moved higher in the following 60 days with 90% win rate.
Although in my opinion it is arbitrary, technical analysts call a market overbought if the 14-day RSI is above 70. As mentioned many times in this blog, the RSI is a momentum indicator and its use as an overbought/oversold indicator makes sense only in the presence of mean-reversion. If momentum is strong, such use can result in severe losses because markets can stay overbought or oversold for long periods of time. This is exactly what is happening in the case of DJIA currently.
As shown in the daily DJIA chart below, the RSI(14) has stayed above 70 in the last 21 days.
In fact, 21 days overbought is the longest period since 1985, as show below:
Below are the results of a backtest of a strategy that buys the index if the RSI(14) has stayed above 70 for more than 15 days and exits after 60 days.
There is only one small losing trade in 1992 and in 8 out of 9 cases the index moved higher in the next 60 days.
Obviously, the sample is small but validation is hard. For example, the last time there was a similar pattern in S&P 500 was in 1970.
It may be seen that especially after the 1990s, there are no long overbought periods in S&P 500. This makes the pattern in DJIA interesting. Are we going back to momentum markets, leaving mean-reversion behind?
The Fed has assisted in minimizing the negative effects of mean-reverting markets. But my opinion is that without further stimulus there cannot be a shift from mean-reversion to momentum unless there is substantial growth. And on growth they trust those who are driving stocks higher now. However, I am skeptical; I am afraid a lot of people will find themselves in an awkward position soon. I hope I am wrong here. I was bullish in 2010, 2011 and 2012 when most analysts that are now bullish were extremely bearish. But this economy is very sensitive to shocks. I believe that growth expectations are unrealistic and too speculative. However, no one can predict the future. Buy and hold investors and trend followers just sit there and pray nothing will go wrong. When bullish sentiment is so strong, short-term trading makes more sense.
If you have any questions or comments, happy to connect on Twitter: @mikeharrisNY
Charting and backtesting program: Amibroker
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