Why The U.S. Stock Market Is Overbought And Overvalued

Jan. 23, 2018 3:27 PM ETSPY, DIA, XLE, XLU19 Comments
Matthew Yates profile picture
Matthew Yates
108 Followers

Summary

  • The monthly relative strength index (RSI) on the Dow Jones Industrial Average is at a record high and is at near record levels for the S&P 500.
  • High RSI values indicate extremely overbought conditions with an increased risk of a market decline.
  • The cyclically adjusted price-earnings (CAPE) ratio of the S&P 500 is well above historical means, indicating overvalued stock prices.
  • CAPE values corrected using alternate inflation data indicate downside risk is significant.
  • Investors may consider protecting themselves by increasing allocation to less overvalued sectors, such as energy and utilities, or investing outside the United States.

Currently, one of the most stunning indications of the overbought conditions in the stock market is the record levels of the monthly relative strength index (RSI). For the Dow Jones Industrial average, the monthly RSI is higher than it has ever been in the past 100 years:

(chart courtesy of stockcharts.com)

A similar plot of the S&P 500 going back as far as 1925 also reveals near record levels for the monthly RSI:

(chart courtesy of stockcharts.com)

The record highest levels for the monthly RSI on the S&P index occurred in the years 1927-1929 just before the Great Depression began. We are not at those extreme levels for the RSI on the S&P 500 yet, but could be quite soon if stock prices continue to climb as they have recently.

The high RSI value indicates strong upward price momentum and overbought conditions. Similarly high RSI values were observed in the months leading up to all major market crashes, including the Black Tuesday crash of 1929, the Black Monday crash of 1987, the popping of the tech bubble in 2000, and the 2008 crash following the great financial crisis.

What is the RSI and how good of a predictor is it?

The RSI is a widely used technical indicator originally proposed by J. W. Wilder in the book New Concepts in Technical Trading Systems, published in 1978. The value of the RSI provides information on the direction and magnitude of price movements. The RSI varies from 0 to 100, with values below 50 indicating prices declining and values above 50 indicating prices increasing. The RSI is based only on price versus time, so it does not take into account numerous other important factors affecting stock prices. Even though the RSI is based on very limited information, it has proven very valuable as a tool to indicate overbought and

This article was written by

Matthew Yates profile picture
108 Followers
I'm a professional Chemical Engineering Professor and amateur technical analyst.

Disclosure: I am/we are long VGENX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Recommended For You

Comments (19)

To ensure this doesn’t happen in the future, please enable Javascript and cookies in your browser.
Is this happening to you frequently? Please report it on our feedback forum.
If you have an ad-blocker enabled you may be blocked from proceeding. Please disable your ad-blocker and refresh.