While many investors have been focused on the “narrow” leadership of the FAANG names, the Health Care sector has quietly become a top performer for 2018. While the extreme overbought condition suggests a short-term pullback, it also suggests that much further highs are in store.
After pulling back to the $79 level in February, the XLV tested that support area two more times through the spring months. In early June, the Health Care ETF broke to new swing highs before testing moving average support into the 4th of July holiday.
Since that pullback, the XLV has remained in an uptrend above two upward sloping moving averages. While Health Care became overbought in early August, the RSI has now become “extremely overbought” with a reading above 80.
Many novice traders treat an overbought condition as a negative indicator. However, a security becoming overbought simply means that the price has been going up, which tends to be a good thing!
So how do we make sense of the current RSI condition?
Looking at the last two years, you can see that the XLV first became overbought in early 2017, and again became overbought in June and September of that year. The first two instances saw the RSI move above the crucial 80 level, and while each observation saw a short-term pullback, the long-term uptrend soon resumed.
As a trend progresses, excess demand can push the RSI to an extremely overbought reading, which often tells you that there is plenty of pent-up demand to continue the bullish trend.
In early 2018, we had another extremely overbought reading when the RSI went above 80. Late in an established uptrend, you will often see one final extreme overbought reading. However, this can often serve as a sign of trend exhaustion, with one final climactic swell of buying that often signals the end of the move.
At some point in the near future, the XLV will likely pull back due to the overbought reading. Based on historical data, I would expect this to be a short-term pullback before a resumption of the uptrend.
What else can we do to confirm this is the case?
Look again at the chart, and now focus on the RSI after the extreme overbought readings.
In the first two occurrences, the subsequent correction pushed the RSI down to around 40, which often serves as support during a bull phase. The uptrend continued soon after.
In early 2018, the correction after the extreme overbought reading pushed the RSI down to 30, which can often signal a transition to a bearish phase. In this case, the corrective period continued until a break to new swing highs in June.
When a correction occurs for the Health Care sector, I will be watching for the RSI to stay above the 40 level. This would suggest a resumption of the uptrend and higher highs in store.
David Keller, CMT
Sierra Alpha Research LLC
David Keller, CMT is President of Sierra Alpha Research LLC, a boutique investment research firm focused on managing risk through market awareness. He is a Past President of the Chartered Market Technicians Association and most recently served as a Subject Matter Expert for Behavioral Finance. David was formerly a Managing Director of Research at Fidelity Investments in Boston as well as a technical analysis specialist for Bloomberg in New York. You can follow his thinking at marketmisbehavior.com.
Disclaimer: This blog is for educational purposes only and should not be construed as financial advice. The ideas and strategies should never be used without first assessing your own personal and financial situation, or without consulting a financial professional.
The author does not have a position in mentioned securities at the time of publication. Any opinions expressed herein are solely those of the author, and do not in any way represent the views or opinions of any other person or entity.