Overbought Conditions Meet Overhead Resistance

Adam Turnquist | Chief Technical Strategist

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Key Takeaways

  • An impressive November rally left the S&P 500 overbought and hanging just below key resistance at 4,600.
  • Cyclical sectors have led the charge higher and are the most overbought. LPL Research views this as a constructive sign for a healthy and sustainable bull market recovery.
  • While overbought does not mean over, the degree of overbought conditions reached this month is historically rare, and based on forward returns from comparable periods, stocks could be subject to underwhelming short-term performance but impressive longer-term gains.

Last month’s 8.9% rally on the S&P 500 repaired a lot of technical damage across the broader market and left the index just below key overhead resistance at 4,600—a level tracing back to the early 2022 highs and a spot where the summer rally struggled. The sharp rate of change off the October 27 low, including nearly a 12% rally in 24 days, also created widespread overbought conditions. On December 1, roughly one-third of the S&P 500 was overbought based on a Relative Strength Index (RSI) reading of 70 or higher. For reference, RSI measures the velocity of price action by comparing cumulative average gains/losses over a select time frame. The momentum indicator oscillates between zero and 100, with 70 and 30 generally considered overbought and oversold readings, respectively.

The chart below illustrates the S&P 500 stalling at the 4,600 overhead resistance level. The index’s RSI climbed back above 70 on December 1, along with 32% of its constituents, a rare occurrence as +30% overbought readings have occurred in only 0.6% of all trading days since 1990.

Overbought Conditions Meet Overhead Resistance

LPL Research analyzed the S&P 500's overbought conditions and RSI levels and discovered roughly one-third was overbought on an RSI reading of 70 or higher.

Source: LPL Research, Bloomberg 12/06/23

Disclosures: Past performance is no guarantee of future results.

All indexes are unmanaged and can’t be invested into directly.

Overbought Does Not Mean Over

Overbought conditions are a good sign in a bull market as they represent periods of building momentum, increased investor confidence, and elevated levels of sustained buying interest. Understanding where the buying pressure is concentrated is also important to determine if the rally is more offensive or defensive-driven. The table below breaks down the degree of overbought conditions across sectors as of December 1, along with each sector’s S&P 500 weight. Regarding the latest rally, the more cyclical or offensive-oriented areas of the market have the highest percentage of overbought stocks, a constructive sign for the health of this recovery.

LPL broke down overbought conditions across S&P 500 sectors and found cyclical areas of the market have the highest percentage of overbought stocks.

Source: LPL Research, Bloomberg 12/01/23

Disclosures: Past performance is no guarantee of future results.

All indexes are unmanaged and can’t be invested into directly.

Can the Rally Continue?

The table below highlights S&P 500 performance after overbought conditions reached historically high levels. We defined ‘historically high’ as periods when the percentage of S&P 500 stocks with RSI readings of 70 or higher crossed above the 30% threshold (we filtered out overlapping signals occurring less than one week apart). Of the 18 previous overbought signals generated since 1990, average one- and three-month returns were underwhelming. However, over the next 12 months, the average S&P 500 return was 12.2%, with only one period generating a negative return.

LPL Research highlighted S&P 500 performance after overbought conditions reached historically high levels and discovered the average S&P 500 return was 12.2%.

Source: LPL Research, Bloomberg 12/07/23

Disclosures: Past performance is no guarantee of future results.

All indexes are unmanaged and can’t be invested into directly.

Summary

Despite the recent overbought conditions, LPL Research believes the rally in stocks can continue next year. The technical setup for the broader market continues to improve, including the recent broadening of participation beyond the ‘Magnificent Seven’ stocks. The macro backdrop has also become less complicated, with rates and the dollar rolling over and the narrative surrounding monetary policy shifting from rate hikes to rate cuts. While we remain impressed with this rally's momentum and cyclical tilt, history suggests the market could be subject to some short-term pain/consolidation before any longer-term gains.

Important Disclosures

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Adam Turnquist

Adam Turnquist oversees the management and development of technical research at LPL Financial. His investment career spans over 15 years.