Most overbought in 15 years
As a result of its flying start, the FTSE 100 has reached very stretched levels according to probably the most widely followed and reliable indicator of market momentum. The FTSE's daily relative strength index (RSI) this week registered a reading of 83.9. The rule of thumb with the RSI is that a reading over 70 counts as overbought. A reading of more than 80 such as today's counts as extremely overbought.
Overboughtness at recent tops
Overboughtness matters as it often occurs at or in advance of the end of a rally. The peaks in the FTSE 100 that gave way to the big sell-offs of summer 2010 and 2011 were both preceded by RSI readings in excess of 70. Understandably, then, there are quite a few market watchers who believe that today's extremely overbought momentum reading means that a commensurately large pullback is in the offing. But is this assumption correct?
Very high momentum readings such as the current one are a rare occurrence. The last one was back in 1997. Indeed, since its creation in 1984, the FTSE 100 has sported a daily RSI reading above 80 on just 54 days - or just 0.7 per cent of the time. These 54 days were all essentially bunched around just nine occasions, all during the secular bull market of the 1980s and 1990s.
A rarely seen milestone
I would not want to draw sweeping conclusions from such a limited data-set. However, there is no evidence that extreme overboughtness is a warning of imminent danger. Had you bought the FTSE on the day after the peak in the RSI index on each of these occasions, your average return one week later would have been -0.2 per cent. Sixty days later, you'd typically have made a gain of 2.5 per cent, and only suffered losses on two occasions out of nine.
Overboughtness ahead of a high
Peak readings in the FTSE's relative strength index often do not mark the high in the FTSE 100 itself. The normal pattern is for the market to continue to rise for a few days after the extreme in momentum is reached. Measuring the performance from the subsequent highs in price, the losses are not generally that troubling either. Typically, the market has come off by around 6 per cent from peak to trough. Hardly a bloodbath, at any rate.
Personally, I would welcome such a pullback in the FTSE in the coming weeks. I believe the bull market is good to go higher in the medium- to long-term. From a technical perspective, there is clearly scope for this to occur. Fundamentally, I believe there is an excellent case for UK equities, which are cheap in their own right, but especially so when compared with bonds. That's a story for someone else to tell, though. I expect to renew my long positions after whatever pullback we do get.
