Analyzing the Markets Using Price Alone
Using the Relative Strength Index (RSI) to analyze S&P 500 returns
Hey everyone, welcome back to another edition of the 5i Research newsletter. In this post, we are going to go analyze where the markets have come from and where they might be going based solely on the price.
Let’s dive in!
Using the Relative Strength Index (RSI)
As most of us are aware, analyzing a stock or the market based solely on price is a good way to be let down, but while the market doesn’t repeat, it does rhyme. We are going to be looking at the one-year RSI indicator of the S&P 500. RSI is a momentum indicator that is traditionally used in technical analysis and aims to determine if a stock is overbought or oversold.
Below is a chart of the S&P 500 (in blue) over the past 30+ years and its one-year RSI indicator (in orange). We can see the RSI indicator oscillates between the green and red bands over time and its correlation with S&P 500 price increases/decreases.
In June of 2022, the one-year RSI reached a low of ~48, which it has only seen happen a total of nine times in over 30 years. We have outlined in green circles the instances where the RSI reached ~48 or below. Just by eyeballing these specific instances, we can see that the majority would have represented great buying opportunities. The exception to this is of course 2001 and 2008, where the markets continued to decline on a shorter timeframe (1-2 years), but over a long period of time would have still represented good entry points.
Past and Forward Returns Below 48 RSI
Now that we have seen the general price movement in the S&P 500 over time against its RSI indicator and knowing that RSI readings of 48 or less have happened nine times in 38 years (roughly once every four years), we will look at the past and forward returns following such instances. Below, we look at the past and forward returns when the S&P 500 RSI has historically reached 48 or less on a 3-month, 6-month, 1-year, 3-year, and 5-year basis.
When the RSI reading has hit 48 or less, over the previous three and six months, and one year, the returns have been quite negative (-18%, -16%, and -10%). This makes sense given that for the RSI to reach that low, the price would need to decline.
Now switching to the forward returns in these instances, the three months following an RSI reading of 48 or less have historically returned 12% on average, six months averaged 14%, and one year averaged 17%. One of the key messages in this data is that when the RSI reaches these low levels, the recent pain typically does not continue, and the near-term forward gains are usually significant, but not sustainable. This is the importance of staying invested when the market bottoms and turns around, as missing out on a ~12% gain in a matter of three months can be detrimental to one’s portfolio.
The forward returns across all timeframes at a 48 RSI level are quite encouraging - with an average six-month forward return of 14%, one year of 17%, three year of 43%, and five year of 65%. We can see that following June 2022, the forward three-month return of 12% was in line with the average, the forward six-month return of 5% was below the average of 14%, and the forward one-year return of 13%, which is still in progress, is nearing in on the average of 17%.
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Graphing All Forward Returns Across Time
Now that we have demonstrated that the forward returns are on average quite attractive at a 48 RSI level, we have overlaid how the S&P 500 trades following a reading of 48. The grey lines represent all previous instances of how the market traded following a 48 RSI reading, the orange line is how the S&P 500 has traded since June 2022 when a 48 RSI reading was reached, and the green line is the average of all prior instances.
Aside from the secular bear markets of 2001 and 2008, the market has so far traded in line with the average forward returns following a 48 RSI reading.
Time will tell how the markets will continue to trade, although, given the data and research, we believe that the RSI reading of 48 in June 2022 represented a good long-term buying opportunity for investors.
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