Never Short a Sharp Market

By TradeSmith Research Team

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The beatings keep coming for the bears. Stocks, bonds, and just about every other asset class are booming.

But after sitting through an ice age where stocks went nowhere from October 2021 to July of this year, investors are in disbelief of the rally.

Especially in the mainstream financial media, you’re seeing fancy technical jargon meant to discourage the bulls…

Words like “thrust,” “exuberance,” “overbought,” “expanding breadth”… All of which reference the speed of the latest rally in stocks.

Suggesting we’re witnessing a strong rally is an understatement. To give you an idea, earlier this week stocks reached a widely followed technical milestone that’s getting a lot of attention.

We haven’t seen this milestone in over three years. And folks tend to think stocks fall after it happens.

It’s important to understand how it can impact the rally. So today, we’re going to unpack this signal and understand what it means for us. Then we’ll travel back through history to see if this rare signal is a good a reason to unload stocks…

Or if it telegraphs another bullish stocking-stuffer heading into the new year.

The Most Overbought Level in 3 Years

When I got my start on Wall Street back in 2006, the first concept I learned was to identify the overall trend of stocks.

Getting on the right side of a trend is critical. Fighting a rising tide is a surefire way to lose a lot of money…and fast!

Momentum is one of the strongest indicators of the health and direction of the market. And one widely used momentum indicator that measures the overall relative trend of an asset is the Relative Strength Index (RSI).

Developed by mechanical engineer-turned-market technician J. Welles Wilder, this momentum oscillator measures the rate of change in price action. Most often, traders use the previous 14 days of data.

With the S&P 500 up a staggering 16% since Oct. 27, this face-melter lines up with an ultra-positive rise in the RSI (at the bottom) to above 80 earlier this week:
One look at this chart reveals that it takes a mammoth-sized rally to take the RSI to these nosebleed levels — the first such levels since Sept. 2, 2020.

But the million-dollar question remains:

Does an 80-plus RSI mean it’s time to duck and run? Or does it signal joy and prosperity into the new year?

On Wall Street, they like to say you should never short a dull market.

They should also say you should never short a sharp market.

Here’s why…

A Super Rare Signal, But Not One to Fear

An 80-plus RSI is super rare.

Looking back 30 years, there have only been 42 days with an RSI at 80 or higher.

Here’s the bad news: A month after an 80-plus RSI, the S&P 500 drops an average of 1%.

But, don’t get all negative just yet. Even the Grinch that stole Christmas eventually cracked a smile…

When you look out further on the horizon, monster green tends to follow:

Three months later, stocks jump 2.3%.

Six months after, you’re looking at 7.7% gains.

And better yet, the 12-month performance ramps to 14.5% — far more than a typical year:
Notice how a string of red came during 2018 in particular. Remember that the Fed hiked interest rates four times beginning in March of that year.

Given we all witnessed 2022’s rate-hike regime, it’s no wonder stocks faltered back then.

Today’s environment is facing the opposite situation, where the Fed is set to cut interest rates in 2024. As shown earlier this week, a rate cutting cycle where we avoid a recession is about as bullish as it gets.

Look, there’s always a reason the media will tell you to sell stocks. But looking at history, an overbought RSI just isn’t one of them. Not if you’re a long-term investor, as we are.

Because we do know that staying above 80 won’t last forever. Momentum will surely dial back.

And that’s actually a blessing in disguise — a healthy pullback is an opportunity you’ll want to buy into.

It means market-leading stocks will be poised to soar after any short-lived pullback.

Which is where TradeSmith shines: Evidence-based research wins in the end.

Here’s to wishing your family a Merry Christmas and Happy Holiday Season. Signs are pointing to a great year in 2024.


Lucas Downey
Contributing Editor, TradeSmith Daily