As it happens, I am hopeful that the turnaround in stocks on Tuesday 14 January will mark the start of the next leg upwards that I have been calling for. I have been especially heartened by the ongoing advance of the FTSE 250 index. The rally on Friday 10 January was a sight to behold.
FTSE 250 soars
Still, I have read a couple of leading market-timing bloggers this week who reckon that the S&P 500 topped on 31 December 2013. Among the reasons cited for the likelihood of a major decline is that the index is above its 100-week average by a record amount. The S&P closed at 1839 on Tuesday 14 January, while its 100-week average lay at 1536, some 303 points below.
S&P's 'record' extreme
This is not so much a bearish argument as a bovine one, however. Points-based comparisons across time are utterly meaningless. In the 1930s, the index value was less than five at one stage. Today it is near to its all-time high of 1849, so of course there are going to be many more points involved. In percentage terms, the index is currently 19.7 per cent above its 100-week average. It's been as high as 48.6 per cent in the past.
Not so extreme
Overbought – at first glance
Distance above a moving average is basically a measurement of overboughtness. I prefer using the relative strength index (RSI) for this purpose. The S&P 500's monthly RSI currently stands at 76.3 per cent. Readings above 70 per cent are said to be 'overbought', as a rule of thumb.
A quick glance at the long-term chart of the S&P seems to show that overboughtness like today's foretold or came alongside previous major highs. For example, the RSI reading hit 79.6 per cent in May 2007, after which the market began a five-month long topping process leading to the savage bear market of 2007-09, where it shed half its value.
This is a good example of how simply eye-balling charts can lead us astray. We need to look at the numbers behind them. For trading purposes, a high monthly RSI reading such as the present one has little bearing. Almost 60 per cent of the time in the past, the S&P has gone up in the following month. That's pretty much as we'd expect it, really: a long-term indicator tells us nothing about the near term.
But what about the outlook for the next 12 months after similar 'overboughtness'? Going back to 1928, an RSI reading between 73 and 78 has been associated with ongoing gains over the coming year about two-thirds of the time. The average price move in the market has typically been a positive 5.5 per cent. A bear market has occurred during that time in less than one-fifth of cases.
If anything, therefore, today's monthly RSI reading offers more comfort for the bulls than for the bears. I am more than happy to keep playing the long side here.
