I get lots of questions from readers regarding the various technical indicators discussed in our “Technically Speaking” posts and in our weekly Real Investment Reports. While we often discuss the signals these technical signals are indicating, there are often questions involving exactly what these indicators are measuring.
This article will be the first of several in an attempt to clearly define some of the more common technical indicators we use in our own portfolio management practice and how we apply them.
We are going to start our journey with the Relative Strength Index.
But actually, I will “one-up” Adam on this. This is not only the highest level for RSI on a “weekly” basis but also one of the highest levels on a “4-year quarterly” basis as well.
But exactly what is RSI and how is it calculated?
The relative strength index (RSI) is a “price” momentum indicator that measures the magnitude of recent gains and losses over a specified period of time. It is essentially a measurement of the “speed” of price gains, or losses.
“Market crashes are an ’emotionally’ driven imbalance in supply and demand. You will commonly hear that ‘for every buyer, there must be a seller.’ This is absolutely true. The issue becomes at ‘what price.’ What moves prices up and down, in a normal market environment, is the price level at which a buyer and seller complete a transaction.
At some point, buyers and sellers reach a point of “exhaustion” or more commonly termed “overbought” or “oversold” conditions. This is simply the point at which buyers are unwilling to pay “higher” prices, or sellers are unwilling to accept “lower” prices. Historically, these “overbought” and “oversold” conditions have represented better “entry” or “exit” points for investment capital.
The “average” number of periods, usually 14-days, can be any length of period chosen by the investor. The longer the “average” the “slower” the movement of the index. This is where it becomes important to “marry” the duration of the index to your investment horizon. Since our portfolios are “long-term” in nature, our example uses a 16-period quarterly chart (4-years).
Regardless of the “period” used, RSI values of 70 or above indicate that a security is becoming overbought or overvalued, and therefore may be primed for a trend reversal or corrective pullback in price. On the other side of RSI values, an RSI reading of 30 or below is commonly interpreted as indicating an oversold or undervalued condition that may signal a trend change or corrective price reversal to the upside.
RSI is a “tool” that can be used to help identify better entry or exit points for investor capital. However, like any tool, if used improperly it will provide poor results. It is for this specific reason that most investors deem “technical analysis” to be nothing more than “voodoo” and disregard it entirely. But should you?
In our own practice, our portfolios are designed for longer-term holding periods. Therefore, outside of short-term trading opportunities, we are more interested in the overall “trend” of the market. Our major concern is a more “major” change in the overall trend that could lead to large losses of capital during the portfolio investment horizon. This is why our focus is primarily on monthly and quarterly measures which provide a better “match” to our overall investment goals.
They try and use too many different indicators which create contradicting signals which leads to investment “paralysis.” Keep it simple.
Currently, the RSI index is registering a level that has only been seen a few times previously throughout history. However, given the longer-term time frames of the indicators we use, these “warning” signals can take some time to “play out” within the markets.
I agree with Adam’s assessment that we are most likely headed for a 5-10% correction sometime this year which would be “healthy” for the markets and provide a “buying” opportunity for the time being. The problem is that it has been so long since investors have even seen a 2-3% correction, a correction of 5%, or more, will “feel” much worse than it actually is which will lead to “emotionally driven” mistakes.
But therein lies the real “value” of technical analysis.
Over the coming months, we will exploure Bollinger Bands, Williams %R, Trendlines, and more. You may not agree with our methods, but it is what works for us in our process. I hope you find it useful to yours.