Crude oil surges into overbought territory

Key points:

• The Relative Strength Index (RSI) for crude oil rose above 77, indicating an overbought status
• Similar overbought conditions suggest oil could struggle over a medium-term horizon
• Energy stocks tend to exhibit somewhat weak returns over the next month

Momentum in crude oil lifts the Relative Strength Index into overbought territory

The Relative Strength Index (RSI), developed by J. Welles Wilder Jr., is a popular technical analysis indicator that measures market momentum. As per the classical interpretation, when the RSI reading reaches 70 or higher, it denotes an overbought scenario, whereas a reading of 30 or lower signifies an oversold condition. 

In previous reports, I've demonstrated the significance of an overbought RSI condition as a potential indication of bullish price momentum, a signal that traders should embrace, especially for stocks.

Unlike stocks, commodities are known for their tendency to revert to the mean. Hence, the sustainability of overbought conditions is generally lower. 

For the first time in more than 18 months, the Relative Strength Index (RSI) for crude oil rose above 77, a condition achieved only 1% of the time since 1983. While the sample size is small, annualized returns are extremely unfavorable when the RSI increases to the current level.

Similar overbought conditions led to an unfavorable outlook 

When the RSI for crude oil cycles from less than 30 to greater than 77, the commodity tends to encounter difficulties over short and medium-term horizons. In 19 out of 22 precedents, oil experienced negative returns at some point within the next two months. 

Additional context

When the RSI for oil exceeds 77 for the first time after a 1-year low, the commodity tends to digest the recent gains over the next few weeks. However, with bullish medium and long-term results, we must be mindful that a short-term dip could represent a pause in the early stages of a new uptrend.

My colleague, Jay Kaeppel, published a research report on the term structure for crude oil, pointing out the potential for weak returns due to backwardation. Let's include the term structure condition for oil with our previous study conditions. 

So, we will now identify instances when the RSI was above 77 for the first time after a 1-year low, and the term structure was 1.07 or greater.

The outlook for crude oil doesn't look promising across any time horizon. 

What about energy stocks?

The S&P 500 energy sector shows sluggish results over the subsequent month for each of our crude oil studies. However, the overbought condition in oil leans bullish over long-term horizons.

What the research tells us...

The Relative Strenth Index (RSI) for crude oil increased into overbought territory for the first time after an annual low with the term structure in backwardation. Similar conditions suggest the recent bullish price momentum could reverse course. If history rhymes, energy stocks will struggle in the near term.