RSI Extremes: What Goes Up Must Come Down

September 20, 2024

By Michael Salvatore, Editor, TradeSmith Daily

In This Digest:

Why mean reversion is an essential concept for traders…
An interesting set-up in big pharma…
“Sell the news” action in this sector is a gift…
Keep quality in focus…
A brand-new benefit when you upgrade to TradeSmith Platinum…

What goes up must come down…

When you decided to devote yourself to the markets, you probably found yourself aligning with one of the two major cliques:

The investors whose time horizon is somewhere between 10 years and “forever”…
Or the traders who want to make money over the next week, day, or even hour.

No matter your time horizon, though, your stocks are bound to experience the phenomenon of mean reversion.

Mean reversion is kind of like Newton’s Laws of physics, but for financial markets: When assets get overextended in either direction, the eventually revert back to the mean – or average.

This is constantly happening in markets. And focusing on these setups can give you a huge edge. Trading oversold assets to the upside with call options, and overbought assets to the downside with put options, are simple tactics to take advantage of volatility.

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As we’ve been not-so-subtly suggesting for weeks, we think volatility is coming over the next couple weeks. Volatility means lots of movement in both directions.

We’ve harnessed this concept at TradeSmith with our (for now) internal report we call RSI Extremes.

This report shows the values of the Relative Strength Index for some of the most actively traded exchange-traded funds (ETFs) in the market… as well as all of the S&P 500 stocks seeing overbought or oversold conditions.

Not only that, it shows how far away these assets are from their 50-day moving average – another good measure of these conditions.

One interesting setup I noticed is Gilead Sciences (GILD)…

GILD is currently sitting at a 78 on its Relative Strength Index and is trading more than 11% above its 50-day moving average.

Just looking at the chart, it’s also running into stiff overhead resistance running all the way back to 2022:

If GILD is going to continue its long-term slow downtrend, this would be a place for a reversal.

Setups like these are way harder to find if you don’t have scanners out in the market pulling them to the forefront for you. So, stay tuned to TradeSmith Daily for more ideas from this report…

One rate-sensitive sector is facing a “sell the news” moment…

One sector set to do really well as the Fed keeps cutting rates is Real Estate, and particularly Real Estate Investment Trusts (REITs).

REITs are special companies that hold large real-estate portfolios. They generate income on these portfolios and pay out the majority of it to shareholders.

They’re known for having high yields – making them especially attractive when the risk-free yield you can get in Treasurys goes down.

Interestingly, the reaction from the market after the Fed’s “go big” 50-basis-point cut on Wednesday was to sell off REITs by about 0.5%.

That seems counterintuitive given how well real-estate stocks are set up in a lower-rate environment.

But one look at the chart of the Real Estate Select Sector SPDR ETF (XLRE) shows us what’s going on.

XLRE is coming off a pretty strong overbought condition, with its RSI clocking at 80 earlier this month. After all, this rate cut was being hyped up for months before the Fed actually made its move.

As you see in the purple shaded box below, the RSI also crossed below its 14-day moving average, a sell signal:

This is another mean reversion worth watching. Real Estate stocks may be facing a bit of “sell the news” response from traders, but they’re a good longer term buy if (really when) the risk-free rate continues to fall.

No matter what you buy, make sure it’s quality…

Here’s something for the longer-term oriented investors out there.

In Inside TradeSmith, our in-house options expert Mike Burnick highlighted a smart way to quickly sift through the markets for high-quality stocks to add to your watchlist using TradeSmith’s screener tool.

By focusing on TradeSmith’s proprietary Business Quality Score, the Free Cash Flow Yield, and strong seasonality, Mike curated a great watchlist for the weeks to come.

Here’s Mike with the details in Tuesday’s Inside TradeSmith so you can see which stocks came up – and how he did it, through a blend of different TradeSmith tools/subscriptions:

Here’s a breakdown of the filters I used for this screener:

Country of Exchange & Asset Type: I start by casting a wide net by including all U.S. stocks. However, you could easily narrow your results further by focusing on just small-cap stocks, only large-cap, or anywhere in between.

Business Quality Score (BQS): This comprehensive TradeSmith formula ranks all stocks by quality based on various metrics – including growth, valuation, safety, and payout. It helps you find the “best of the best.” I set this filter to 80 and above to get only the top 20% of stocks we’ve ranked.

Free Cash Flow Yield (FCF): Free Cash Flow Yield is one of my favorite metrics to judge stocks by – and it’s a great guide to find outperforming stocks. Cash is KING when markets are uncertain, after all. Here, I’m looking for stocks with FCF yields above 6%. That’s twice the S&P 500 Index’s average FCF of just over 3% – so it’s a good starting point. You can always adjust lower or higher for more or less results if you wish.

Seasonality: The next four filters are based on the seasonal trading patterns identified by our TradeSmith algorithms after scanning thousands of stocks on the market. I start with a Seasonality Pattern Accuracy Rate greater than 80%, to find consistent patterns based on historical performance. Next, I set Seasonality Pattern Average Return to more than 5%. Again, you can adjust this higher for fewer results.

Seasonality Years Under Review: I set this filter to search across All Years, to cast a wider net, and Days to Seasonality Pattern Start Date I set between 0 (that’s today) and 45 days out.

Running this screener gave me 57 stocks to examine based on my filter settings. I’ve included a screenshot of the top 10 stocks in the list below:

This list is sorted by descending BQS – to get the highest-quality stocks at the top of the list. But you could just as easily sort by any metric like FCF yield, dividend yield, or any other filter. You might consider sorting by Market Cap, to zero in on just the small-cap stocks that perform particularly well when interest rates decline.

There are plenty of recognizable names on this list – including energy MLP Antero Midstream (AM), asset manager T. Rowe Price (TROW), and tech-giant Alphabet (GOOGL), just to name a few.

This is a great showcase of how TradeSmith turns up the best buying opportunities out there. Not only are the above stocks high-quality with strong free cash flow yields, our seasonality metrics point to them having the highest odds of rising over the next 45 days – while other stocks are poised for one of the worst stretches of returns all year long.

Like all our analysts, Mike has access to all of TradeSmith’s tools and research; he even builds new screeners when inspiration strikes, especially for our TradeSmith Platinum users.

Right now you can upgrade to Platinum, too, and with access to absolutely all of TradeSmith – now and in the future – you can create your own “house blend” to enjoy each morning in the markets.

To keep your TradeSmith experience simple and easy, though, you’ll get our Platinum Roundup each Saturday, which lists all the new upgrades and research in one brief email.

Then the Platinum Analytics dashboard lets you check the latest rankings of stocks with the best Business Quality Score…the most oversold (or overbought)…highest Free Cash Flow…and more. (And our CEO Keith Kaplan just announced another big benefit for TradeSmith Platinum folks.)

We opened the doors to new members this week alongside Keith’s announcement, but Platinum closes again today at midnight. Click here as Keith lays out all the reasons you’ll want to be a Platinum Partner going forward.

To your health and wealth,