Are extremely overbought conditions good or bad?

Over the past 3 weeks the market has rallied unabated. The Russell 2000 (small caps) has rallied so much that the 5-day Relative Strength Index (RSI5) has reached over 95 and closed today at 97; that’s serious market strength! See chart below. We went back 20 years in time to see when such extreme readings (RSI5 >95) were reached as well and what the market did after.

Figure 1. Russell 2000 hits extremely overbought conditions

rut-daily-rsi5

Below is a daily chart of the Russell 2000 over the past 20 years with the RSI5 values of 95 and 97 highlighted by the same horizontal lines as in Figure 1. What we instantly can observe is that these extreme readings only occurred a handful of times. The last one was early 2010.

Figure 2. Russell 2000 over past 20 years with RSI5 >95 and 97

rut daily RSI5 20yrs.png

 

Prior to that was an extreme reading in mid-2003 and there were several during the late 1990s and early 200s. The 8 green solid vertical lines show the market rallied unabated for several more weeks to years, whereas the 2 red solid line shows the market peaked, corrected and then rallied again. There’s only one occasion (late-2000) where the market was already trending down (red dotted line), hence why the line is dotted as the prior move into the extreme reading is opposite and we can discard this occasion.

This means chances are 4 to 1 the market will continue higher over the coming weeks to months. There will be corrections along the way, but those will likely be bought.

Soul

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