Greetings, fellow Pro-fundity team members -
9-21-01 Page Background music:

A. This weeks picks (remember the basis of our stock picks: a) sound fundamentals, b) supportive technicals, c) possible near-term buy, and d) positive news):

B. This Week's Guidepost

Market Momentum Analysts have suggested that today’s market is extremely oversold. These comments came before the tragedy on September 11th, which made matters even worse. What does this mean and how does it affect our trading activity? Let’s review the question this week as we focus on an important indicator, Wilder’s Relative Strength Index (RSI).

  1. The price of a stock should be a good proxy for the value of the stock. That makes good business sense. However, we all know a stock’s price can cycle above and below what might be deemed its true value. Buyer’s greed, seller’s fear, market emotions, all combine to skew the common sense of “how it should be!” This presents us with opportunities to buy good stocks wholesale, then turn around and unload them at retail. Lets relate this to the two conditions termed “momentum characteristics.”

  2. Momentum refers to the velocity of a price trend. That is, how fast the price is changing. Indicators used to measure this momentum are called oscillators. Technical oscillators cycle back and forth, from one extreme to another, as the price moves up and down between trends. The important indicator we will focus on here is called Wilder’s Relative Strength Index (RSI). The RSI is calculated strictly from price information for the stock or index being used. Basically, it compares the number of “up-closes” to “down-closes,” thereby signaling changes in momentum. The extremes of these up and down cycles are termed Overbought, at the top, and Oversold, at the bottom.

  3. An “overbought” stock is one that has been rising quickly in price, but where its momentum is slowing near the top and is likely to see a short-term decline in the near future. The opposite is true on the down-side. A declining stock is “over-sold” when its rate of fall slows and readies for a turn at the bottom, likely to see a short term increase. RSI let’s us quantify these two conditions.

  4. The main purpose of the RSI oscillator is to find when a stock (or a market index) has reached either an overbought or an oversold condition. The RSI cycles in a range between a minimum of 0% and a maximum of 100%. When in exceeds 70%, it is considered overbought. In this condition, we might say the stock is over-valued (time to sell?). When it falls below 30% it is considered oversold (under-valued, perhaps at a bargain price). This provides us with convenient limits to gauge the current momentum of the price change. Look at the following chart as an example. This measure the RSI on the NASDAQ Composite Index over the past six months, until last Friday’s date.


  5. The RSI plot is laid over the price chart for easy comparison. However, notice that the RSI scale is not related to the price scale. That is, the noted 30% and 70% lines, which represent the default overbought and oversold lines, are not related to the price-bars. We see in this chart how the index is in an oversold condition (below the 30% line) the first week in September. That is why the opening paragraph referred to an oversold market prior to the September 11th tragedy. We also see how the tragedy worsened the condition. The next chart shows the conditions for the DJI.


  6. In this case, the Dow hadn’t fallen to an oversold condition until after the tragedy. Notice how in the July-August time frame, as the index moved sideways, the RSI stayed away from its limits. In quiet markets like this, the RSI indicator provides little information. In fact, the RSI earns its way best when giving clues about trend reversals. When the indicator crosses its limits, it is saying the momentum is slowing and a trend reversal is possible.

    Point: When the RSI signals an overbought or oversold condition, it does not mean a trend reversal is imminent. It is merely a clue that prices have the potential for a reversal.

  7. Okay, we’ve seen a couple of examples with major indexes. How do we use the RSI on individual stocks? The following chart on GM shows how the trend reversal feature of RSI might be used. In April and May the stock didn’t do much, but in June it began a strong up-trend. The RSI signaled in late June an overbought condition, saying “Hey, this can’t go on forever!” The RSI then began a downward trend that the price subsequently followed. Note: The RSI led the price action. This is a powerful indicator.


  8. As powerful as this “trend-reversal” feature is, there is yet another even more powerful use of the RSI. The next chart shows how we use the RSI to spot divergences between the price pattern and price momentum. When the price moves to a new high, but is not supported by a new high in the RSI, we call that a divergence. Notice in the chart below how the price achieved a new high in the first quarter of the year, but the correspond RSI went down. The two dashed lines connect the price highs and the RSI highs. However, the lines are not going the same way. This is a divergence. When this occurs, the price usually corrects in the direction of the RSI. Notice the subsequent price action following the divergence.


  9. The next two charts are two of our picks this week. Consider the RSI plotted with the price patterns for helpful messages as we prepare our trades. We will discuss these next week. To summarize, we have studied Wilder’s Relative Strength Index and its use as a trend-reversal and divergence indicator. There are other features of this oscillator we will discuss next week, as well as some important cautions about its use. Additionally, we showed both daily and weekly price charts with the RSI in this GP. An important relationship between these two views will be covered next week.



  10. The important thing to come away with is an understanding of the bargains that are out there now, in this grossly over-sold market. We will examine these opportunities going forward. Stay tuned.