During the market crash on Friday morning of last week, a friend sent me an instant message.

“Almost every stock I have looked at this week is trading overbought (ie 14 day RSI above 70), and has been for over a week. I wonder if there is a filter we can use to see how many S&P 500 shares are overbought. ” (RSI stands for Relative Strength Index, a key measure of a stock’s bullish momentum.)

But my friend had hit something. In a matter of minutes, I ran the filter in question. He was right: A sizable chunk of the S&P 500 had risen much faster than usual … nearly 40% of the companies in the index at the end of January.

That made me think. What do historical fluctuations in the proportion of S&P 500 companies with high RSI tell us?

What I found is ominous.

Too much of a good thing

Sometimes momentum is a bad thing … too much suggests that the market may be irrationally optimistic. A historical look at RSI suggests that this is one of those times.

The Relative Strength Index (RSI) of a stock compares the magnitude of recent gains and losses over a given period; the most common is 14 days. Fundamentally, it measures the impulseEither up or down.

Technical analysts use RSI to assess whether a stock is being overbought or oversold. RSI values ​​of 70 or more suggest that a stock is being overbought or overvalued and therefore is at risk of a correction. An RSI of 30 or less indicates the opposite: oversold or undervalued. It could be a profit opportunity.

The key term is “convert”. RSI measures the velocity of change in the average price of a share. When the RSI is high, it means that there is an unusual amount of buying activity during a given period compared to “normal” conditions.

How big is the RSI party?

There is nothing unusual about a high RSI for an individual equity. For example, when the market learns that a company is a target for a merger, buyers want to own its shares before it happens, leading to a high RSI.

Similarly, we might see high RSI measurements for a group of stocks in a sector (energy, for example) when the market believes that sector is going to grow.

But given that there are 500 individual companies in the S&P 500, covering all sectors of the economy, it is unusual for a large chunk of them to enjoy a high RSI at the same time.

There was a percentage of companies in the S&P 500 whose average RSI was above 70 in the previous month, from 1990 to today. I’ll call it the “market RSI” level.

The median figure appears to be between 5% and 10%. But the RSI level of the market can go much higher.

For example, after the recessions of 1990-1991 and 2001-2002, 30% to 40% of companies in the S&P 500 had an average monthly RSI above 70. That makes sense, since we expect equity prices to rise rapidly when we are emerging from a recession.

In contrast, during prolonged economic expansions, market RSI levels fluctuate in the range of 5% to 10%, with regular spikes of around 20% during quarterly earnings reports.

In contrast, market RSI levels tend to be lower than normal when investors seek performance in other ways. It happened during the initial public offering (IPO) boom before the dot-com crash, and again when Americans were flipping houses and refinancing like crazy in the run-up to the 2008 financial crisis.

We live in interesting times

Two historically unusual conditions began in late 2016.

First, each “low” in the measure of the market’s RSI is higher than the previous one. That suggests that the average monthly market RSI level is trending upward for an extended period. There is nothing like it in previous decades.

Second, the January peak in the market’s monthly average RSI level is the highest it has ever been outside of a recession recovery.

When we change to a daily Average measure of RSI market level, we see regular swings between about 5% and 25% since late 2016.

But starting in late summer of last year, we again saw a steady rise in trend.

We also see a rise in the RSI market level, to almost 40%, just before last week’s big pullback.

RSI: good for the trees, bad for the forest

High RSI for individual stocks? Well. For too many at once? Dangerous.

This is my interpretation. Starting in late 2016, two things happened.

• Optimism about the Trump presidency cleared away the small clouds of caution hovering over investors, even in a bull market. As this sunny outlook grew it snowballed, sorry to mix up metaphors, giving way to the “euphoria” part of the market cycle. We seem to have reached the peak of euphoria at the end of January, when the market’s average daily RSI almost reached 40% … just before last week’s pullback.
• The massive growth of exchange-traded funds (ETFs) over the past few years has distorted average market RSI levels by driving up the share prices of “undeserving” companies included in sector ETFs. The rising tide of ETFs lifted all boats … preventing market RSI levels from falling back to historical norms.

Any way you look at it, folks, this is not normal. And if history is any guide, it will not end well …