Widely followed signal on Street shows tech stocks are rising too fast

We have seen a classic midday dip in the markets Thursday because certain sectors are absurdly overbought, and the volumes have been thin. When bids are very light because there is not a lot of interest in bidding up the market at these prices, very small drops can cascade into larger drops. It always starts with the leaders, in this case the Apples and the Googles, along with biotech (look at IBB), then secondary leadership like materials stocks, which have done well this month (look at US Steel midday).

I’ll give you an example of absurdly overbought: one of the most widely followed metrics of market momentum is the RSI (Relative Strength Index) which charts the momentum of an index or stock over a short period of time, in this case usually 14 days, on a scale of 1 to 100. A reading above 70 is considered overbought, below 40 is oversold.

Right now, the Nasdaq composite index has an RSI of 99.33. I have never seen this reading in 20 years, although I am not sure if it is an historic high. Regardless: a reading of 99.33 on a large index is absurdly overbought.

Nasdaq Composite, 2-day intraday with RSI (14) in lower panel

Source: FactSet

There’s many other ways you can illustrate the overbought nature of the market. The Nasdaq is 12 percent above its 200-day moving average, and almost 4 percent above its 50-day moving average. These are well above norms, particularly for indexes, and in the past when these tend to reach these kinds of levels they usually pull back. It’s called reversion to the mean.

I’m not trying to turn anyone into a technical analyst; I’m well aware of the aversion many of my fundamental friends have to this way of looking at the markets. But the markets have gone nowhere but straight up for the past three weeks, and in this case technical talk is a useful way to illustrate an old adage: no tree grows to the sky forever.