The S&P 500 Overbought at RSI 81, Signals 2.21% Decline Ahead

S&P 500's RSI above 81 for first time since 2023, signaling potential 2.21% decline in 15 days.

By Barry Stearns

7/11, 12:38 EDT
S&P 500
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Key Takeaway

  • The S&P 500's RSI closed above 81, indicating overbought conditions and potential for a pullback.
  • Historically, an RSI above 81 has led to an average decline of 2.21% in the following 15 days.
  • Traders reacted by taking profits, causing the S&P 500 to drop 0.9% on Thursday from its all-time highs.

Overbought Conditions Signal Potential Pullback

The S&P 500's recent rally to record levels has raised concerns among market analysts, particularly due to its 14-day relative strength index (RSI) closing above 81 on Wednesday. This marks the first time the S&P 500 has closed above 5,600. An RSI above 70 typically indicates that an asset is overbought and may be due for a pullback, while a reading below 30 suggests oversold conditions that often precede a bounce. The RSI gauge ranges between zero and 100.

Cantor Fitzgerald's head of equity derivatives, Eric Johnston, highlighted that the S&P 500 has closed with an RSI above 81 only 12 times in the last 40 years. Historically, these instances have been followed by sharp declines in the index. Johnston's data shows that after entering such overbought conditions, the S&P 500 has averaged a decline of 2.21% in the following 15 days and 1.27% over 20 days. Additionally, 50% of the time, the drawdown over the next month was at least 3%, and 25% of the time, the index fell by at least 6%.

On Thursday, traders took some profits off the table, with the S&P 500 losing 0.9%, pulling back from the all-time highs reached in the previous session.

Stretched Valuations Amid Economic Concerns

The S&P 500's gains and valuations appear increasingly stretched as the market heads into a challenging earnings season. The index's 12-month forward price-to-earnings (P/E) ratio is about 21.5, the highest since the end of 2021, despite some disappointing economic data. The Bloomberg Economic Surprise Index is negative and at its lowest since 2015, indicating that economic data has been consistently underperforming expectations.

Many investors are concerned about the S&P 500's heavy reliance on big tech companies, which have driven much of the market's gains due to their superior earnings growth, industry dominance, and enthusiasm for artificial intelligence (AI). AI stocks are notably expensive relative to the broader S&P 500, raising comparisons to the dot-com bubble.

Companies face a higher bar to impress investors this earnings season due to these elevated valuations. During the first quarter, the average S&P 500 company that beat earnings per share (EPS) estimates trailed the market. Earnings growth for the "Magnificent Seven" tech companies is expected to slow to 18% in the second quarter, about half of last year's average rate, according to Bloomberg Intelligence data. The rest of the S&P 500's companies are expected to post the first positive profit growth in at least six quarters, with potential double-digit expansion by the fourth quarter.

Hedging Challenges in a High Market

The rally driven by artificial intelligence has pushed stocks to fresh all-time highs, making hedging these gains increasingly challenging. According to JPMorgan Chase & Co., traders are finding it difficult to hedge any potential downturn without betting directly against the broader market momentum and the AI trade. Matt Reiner, JPMorgan's Cash Equity Trader, noted in a client note, "Shorts are getting torched. Investors are more and more looking to balance their books with short equal-weighted S&P 500 Index as a last resort."

The S&P 500 Index has gained 18% this year, with most of that advance reliant on major tech companies like Nvidia Corp., Microsoft Corp., Alphabet Inc., Inc., Meta Platforms Inc., and Apple Inc. In contrast, the equal-weighted version of the S&P 500 is up just 4.6% in the same period. Trading data for options and other derivatives for the equal-weight US benchmark is thin, and many of these hedges might be done via non-listed instruments and over-the-counter (OTC) positions. The Invesco S&P 500 Equal Weight ETF, which has about $55 billion in assets, has seen short interest rise to about 5% from nearly 1% in December.

On Wednesday, the S&P 500 gained 1%, marking its largest single-session jump in more than a month and its seventh consecutive session of gains. The Nasdaq 100 rose 1.1%, bolstered by the megacap tech firms that have propelled the benchmark gauge to 37 records this year.

Street Views

  • Eric Johnston, Cantor Fitzgerald (Bearish on the S&P 500):

    "The S&P 500 has closed with an RSI above 81 only 12 other times in the last 40 years. Those instances have historically been followed by sharp declines for the broad market index."