Two weeks ago, I wrote a note to my Cycle 9 Alert subscribers warning that “short-term momentum [is/was] due for a pause.”
I’d noticed how a popular momentum indicator had red-lined… and stayed there.
You see, the Relative Strength Indicator (RSI) is a tool that traders use when trying to answer the question: Is near-term momentum excessively high (or low)?
This indicator ranges from 0 to 100. Any momentum reading above 70 is considered “excessively high.”
Typically, this momentum indicator will jump briefly above 70… and then fall back into the middle of its range.
But, sometimes, it will stay above 70 for an extended period of time.
That was the case two weeks ago, on January 23rd.
RSI on the S&P 500 had been above 70 ever since the second trading day of the year – for 15 consecutive days.
I ran a quick study on the forward returns of the S&P 500, following historical instances of this scenario. And here’s what I found…
For one, this occurrence is rare – happening just 27 times in nearly 60 years.
Second, these long bouts of excessively high momentum don’t typically kill bull market rallies.
In fact, following this signal, the average two-week return of the S&P 500 tends to be well above average… for at least another year.
The average two-week return after excessively high momentum readings comes in at 0.8%, versus a milder baseline return of just 0.3%.
However, there has typically been a “soft spot” in stock prices in the one to two weeks immediately following this signal. Specifically, the S&P has averaged a loss of 0.1% over this period, with price drops more common than price increases.
So, what does all this mean?
As I explained to my Cycle 9’ers, it simply means that:
- Momentum in stocks grew “excessively high” by the end of January.
- That’s typically a good thing for stocks (over the following 12 months).
- But, prices usually soften for a few weeks first.
- So, you should wait patiently before making any new trades. (And it’s a good thing we did as markets hit that soft spot last week.)
As I’ve explained before, just as momentum in market prices waxes and wanes… so too does the number of new buy signals that my Cycle 9 algorithm generates.
For example, the last buy signal we acted on was in late November of last year.
We took advantage of the late-year run-up, taking triple-digit profits on three positions along the way.
We also made two risk management exits early last week, just before stocks sold off sharply.
And now… we’re completely out of the market, simply waiting for the sell-off to resolve and for the next good set of opportunities to rise up.
It’s important to realize that the back and forth nature of momentum in market prices is perfectly normal.
It just means that, in times like these, you should maintain discipline and patience. Wait for the right opportunities. Don’t just jump at any opportunities.
With markets down a few percent in the last two weeks – and markets whipsawing on Monday – I’ll give you the same advice I gave my Cycle 9’ers two weeks ago: For now, sit tight and let the market cool off before making any bold (or fear-motivated) moves.
History shows that January’s excessively high momentum could still lead to a strong year of returns in 2018.
But we’ll have to sit through this sell-off first.