What happens next to the DOW when this indicator gets low?

While tech has rallied to new All-Time-Highs over the past weeks (see for example my updates on the NAS and NDX here and here), the Dow Jones Industrial Average (DJIA) is down YTD (-0.36% at writing). So will tech take a breather now that it has hit some key levels, and will the DJIA rally? This one indicator, the daily 5-day Relative Strength Index (RSI-5), suggests we may indeed see a rally soon as it closed at 12.86 yesterday June 21.

Developed by J. Welles Wilder, the RSI is a momentum oscillator. It measures the speed and change of price movements and oscillates between 0 and 100. Traditionally, and according to Wilder, RSI is considered overbought when above 70 and oversold when below 30. It is better to interpret overbought as price having strength and oversold as price being weak. In Bull markets price tends to stay overbought much longer than oversold as price is in a strong uptrend. Thus, identifying oversold conditions may result in great buying opportunities and why yesterday close of the RSI-5 at 12.86 is important as it is obviously a very oversold reading.

The chart below shows the DJIA since the all important March-2009 low was struck with the daily RSI5. Here I’ve identified all RSI-5 readings below 13, as well as even below 10 (extremely oversold). When the RSI-5 closed below 10, I marked it with a red line. When the RSI5 closed below 13, but not below 10, I marked it with a green line.

dow daily RSI5

What I find are only six occasions with an RSI-5 close <10 and 12 occasions (including yesterday’s) occasions with an RSI-5 close <13 but >10. Hence, indeed oversold conditions in a Bull market are rare. On average the DJIA has only been extremely oversold once every one and a half year, and very oversold four times every three years.

What is even more obvious is that all these oversold readings coincided with (right at or close to) important to very important market lows. All leading to multi-week to multi-month 1000s of points rallies; only April 2012 saw a small rally first, before a much larger decline to a lower low, and December 2015 saw only a one-week rally followed by a decline to a lower low, before the next one-week rally to a higher high started. The August 2014 low was followed by a lower low in October, but due to the 6% rally in the  6 weeks following the low I exclude it from the “failure” list.

In conclusion, with yesterday’s RSI5 reading of 12.86, odds favor an important low is in or very close (days). If the RSI5 drops further and below 10, history tells us a fantastic buying opportunity is presented to us, as this Bull has likely 1 to 2 more years to run.

Arnout, Ph.D.

2014-06-10 17.07.27-small

Founder and President Intelligent Investing, LLC

Vice President NorthPost Partners, LP

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