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Overbought Stock Market Conditions Are Not as Persistent as in Past

After reading recent articles in financial and social media, one may get the impression that prolonged overbought conditions in the stock market are a recent phenomenon, usually attributed to central bank manipulation and herd behavior. These are false impressions according to the chart below.

The above S&P 500 chart since 01/1950 shows the number of days in a row the RSI(14) has remained above 70. It may be seen that until the 1990s, the index had frequent periods of prolonged overbought price action. That changed after the 1990s uptrend.

The maximum number of days in a row that the S&P 500 RSI(14) has stayed above 70 is 32, in 1950s. There has been a downtrend since. The current period is 11 days and although it is longer on the average in the last 17 years, it is nevertheless much shorter than occurrences before the 1990s.

One reason that overbought conditions are not as persistent as in the past is the disappearance of 1-lag autocorrelation of daily returns, as shown in the chart below.

It may be seen that despite the resent post-election rally, the 1-lag, 252-day autocorrelation of returns remains negative and in early January this was also significant (autocorrelation crossed below lower significance band.)

Note that markets can form long uptrends even when autocorrelation is negative but mean-reversion may intensify pullbacks, as in 2000 and 2008. A trigger in the form of an unexpected event is needed for the mean-reversion to start.

Furthermore, the switch from positive to negative autocorrelation in late 1990s is the main factor that the bulk of classical technical analysis has stopped working.

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

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Charting and backtesting program: Amibroker


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