Find the Top or Bottom of the market using RSI Divergence
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Over the last year markets have had a torrid time, with many well-known stocks losing more than 60% of their value. At the same time, some popular, inexperienced Youtube channels have cost their followers significantly, ignoring risk management completely.
The same gurus, followed by mainstream media, are now trying to second guess the market bottom to save their blushes. But whilst nobody can be sure where the bottom lies, we can make some educated analysis to move the probability of finding the market bottom into our favour.
In a previous video we looked at dollar cost averaging into market declines which were greater than 25%, in this video however we look at finding the market bottom using the Relative Strength Indicator, whilst comparing the tactic to other past market declines, the findings may pleasantly surprise you. As always If you find value please hit the like button and consider subscribing.
Before we look at the approach to find the market bottom, we need to determine which market declines we intend to compare. For this exercise we will look at the dot com bubble and the great financial crisis, whilst comparing where we are today in 2022. Both major crashes were chosen due to the orderly fashion in which they declined over many months, similar to how the current market is declining. The pandemic decline on the other hand was a rather freakish event unlike any other.
The approach we are going to use is the Relative Strength Divergence technique. Before moving onto the charts lets simplify what a divergence looks like. The relative strength index on its own offers guidance on whether prices are overbought or oversold, the common metric suggests that when the RSI line crosses below 30 it is oversold, and when the line crosses above 70 it is overbought.
For our analysis however we are not going to use the indicator in its purest form, we are simply looking for divergence. If for example the RSI line is rising, determined by higher lows, whilst the price of the asset was in decline, this is referred to as a divergence. In other words, the RSI indicator might display a positive change in momentum before a corresponding change in price, such a divergence is classed as bullish and is how we intend to find a bottoming in the market.
Let’s first look at the approach against the dot com bubble era, using the S&P 500 as the benchmark on a weekly timeframe. The peak was seen in the year 2000 and found its bottom in late 2002, declining around 50%. Anyone using leverage without any risk management would likely have lost everything during that period, whilst others who were able to protect some cash were searching for a market bottom to re-enter.
At the bottom of the chart we have the RSI indicator, and it is where we could have focused to call the market bottom. If we look at the first significant portion of the decline, we can see that the market lows are also met with lows on the RSI, therefore no divergence, and confirms that a decrease in price is met by a decrease in momentum. The same can be seen on the next portion, a lower low reflected by a lower low on the RSI, again no divergence. The next low is again equally matched with lower lows on the RSI. It is only on the next price lows that we finally see a divergence when the RSI instead made a higher low and marked the bottom of the market. What is also interesting is that we could have used similar divergence to find the market top prior to the decline, for example, here we see prices making a few higher highs, however it is met with the RSI making lower highs, confirming a bearish divergence, thereby suggesting that the rising prices were losing momentum.
Next, we use the same process but this time for the great financial crisis. Prices peaked in October 2007 and declined around 50% by March 2009, marking a 17-month bear market. This time let’s start with the market top, here we see a few higher highs at the peak, whereas the RSI provided lower highs over the same period, this again confirmed a bearish divergence and could have provided a great opportunity to exit the market.
The market bottom could have been called too early on this chart, although still near to the bottom. The first attempt would have been here where a lower low in price is met by a higher low on the RSI, confirming divergence but not quite the bottom. The next divergence marked the bottom of the market when we saw a new low in price followed by a higher low on the RSI, a great opportunity to start taking up positions.
Before we move onto 2022, let’s quickly look at the pandemic in early 2020. Due to the dramatic fall in just 4 weeks, it would have been difficult to mark the bottom, remember, we are analysing orderly declines which this certainly was not.
Interestingly however, we could have marked the exact top prior to the decline, we can see here that the market made an orderly all-time high, however at the same time the RSI made a lower high, confirming a bearish divergence, we could have therefore exited right at the top, prior to the first week of decline.
Next, we use the same process but look at 2022 to see if we can find the bottom, or if you’re viewing the video later, did we find the bottom?. As of today, the S&P 500 is down approximately 22% although it achieved a prior low of around 27%. If we start with the market top prior to this year’s decline, we can see once again that the market made an all-time peak with a higher high, whilst at the same time the RSI made a lower high, this marked a bearish divergence and could have been a great time to exit the market. Next, we look for the bottom, we can see that price made a lower low, whilst the RSI made higher lows, confirming a bullish divergence, but will it confirm the market bottom?.
Regardless of whether the divergence does mark the market bottom or not, we can’t argue that the probability has been moved into our favour. Finding the bottom does not however stop here, there are other metrics we can use to gain some confluence with the divergence approach. For instance, If we look at the S&P 500 monthly chart, we can see that price has been showing support off the 50 month moving average, a point at which prices are currently sat. If we look at the recession indicator I presented in our blog previously, we can see that since 1988 as soon as the recession probability line reaches 90% or more, the market bottom is achieved, the only real anomaly was seen during the dot com bubble here, the indicator made a high, but the stock market was only half way through its decent, however at the same time we did not see a bullish RSI divergence, it was only the very bottom that we did get the RSI divergence, aligned with a recession peak. The financial crisis saw a peak in recession probability and a bullish RSI divergence, whilst the market hit a bottom, in 2022 we have the same peak recession probability, and a bullish RSI divergence.
We can never be sure when the bottom will be in, but the RSI divergence technique certainly adds confidence. I have personally built a few positions in the indexes, whilst my trading approach will act accordingly to the market conditions.
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