Echoing Rob Hanna at Quantifiable Edges, extended overbought readings like this were much more likely in the last century when the market was momentum-driven (i.e. up days tended to beget more up days), but are a rarity in today’s mean-reverting market (read more).
Prior to this month, this century had only seen one instance of a 7-day RSI(2) run over 90 – we’re now at 9-days and counting.
Where does the market go from here?
I’m hedging my bets.
The bearish side of me says that by almost any quantitative measure, probability favors a pullback. But hell, I would have said the same thing most of last week.
The cautious side of me says that this market is temporarily being driven by completely non-normal forces. Our abnormal market filter (AMF) stands at 78% and we’ve been slowly pairing down position sizes in our YK and Scotty strategies since July 15th as a result – I do not want to want to be picking up nickels in front of a bulldozer with a drunk man at the wheel.
The graph below shows the abnormal market filter (red) vs the S&P 500 (grey) MTD. As the filter creeps up, we ratchet down exposure (note: the AMF is available daily in the detail box of the free State of the Market report):
Click to enlarge:
There is no bullish side of me – I think long and strong at this moment is just begging for a roundhouse kick to the face.
What about RH and the original MS strategies? The original MS strategies are long-only and don’t trade even remotely overbought markets – they’ve been in cash most of the month. RH is a product of our Timer Seeds program, and because I’m not the developer, it doesn’t make use of the AMF. Yes, it’s been fighting the trend, and yes, it’s getting butchered this month.
One last note, because of the nature of how RSI(2) is calculated, basically any close down from here takes us back below 90. To be specific, if the S&P 500 closes below 978.46 on Monday, we’re under the threshold. 90 isn’t a magic number, just a reference point, so treat it for what it’s worth.