We’re entering the back half of December, which is one of the slowest times of the year in terms of market trading volume. And lower volume means higher volatility, as just a few traders can move a stock sharply if there’s no one around for the counter trade. That means this is no time to be complacent — especially when a key stock market indicator is signaling potential trouble.

The Relative Strength Index (RSI), which helps investors determine whether the market is undervalued or overvalued in the near-term, is sending a clear signal: the market is sharply overbought.

The RSI compares recent gains with recent losses, dividing the trading days with gains by trading days with losses, and also accounts for the magnitude of those moves. [See our definition  in InvestingAnswers.com for more] After an extended period of mostly losing sessions, the RSI will slump, sometime below 30, which is used by many as a clear buying signal (also known as when the market is “oversold”). And when the market is steadily rising, this index moves well higher, and investors generally become concerned that we’re “overbought.” They use that term when the RSI moves above 70. Well, for the first time in a month, we’ve just moved north of that crucial level. (I’m talking about the 14-day RSI here, but the 90-day RSI is also well above average.)

The RSI approach works well the majority of the time, but can also miss the mark sometimes. It hit a three-year high of 99.3 in mid-March, but the S&P 500 rose yet another +4% during the next month. After that, the market showed a strong pullback.

A confluence of positives
In hindsight, it’s easy to see why the market has made such an impressive recent move: the S&P 500 has risen from 1,047 on August 26 to a recent 1,244 — an 18% gain that works out to be a 60% gain when annualized. The Fed‘s QE2 is seen as a major liquidity source for stocks, third-quarter results were solid and consumers are looking slightly more confident.



But there’s a reason why many big investors take all of the fundamental factors with a grain of salt. They know that a market rally is often simply the result of investors following other investors. Many major financial blogs are filled with commentary about how other investors are reacting to specific bits of news. So they buy into rallies as long as they think their peers will be doing the same. Conversely, when their peers start to take profits, they do as well, pushing the market back down.

That’s precisely what happened this past summer. After moving above 1,200 in late April, the S&P 500 slowly began to weaken. Investors feared that other investors were growing bearish, so they did the same, and the losses started accelerating. By early June, the S&P 500 had slumped to a 13% loss in just five weeks.

Action to Take –> The key takeaway: the market is a herd of cattle, and you can’t go against the herd.

The overbought RSI signal is now being closely watched. Investors aren’t ready to sell just yet. After all, the RSI can indeed still move higher. But they’re ready to move quickly if necessary. That means that a few downbeat trading sessions could very well start to trigger an exodus, especially since trading volume will be so light in the coming weeks.

This is a great time to separate your long-term holdings from your near-term trades. Sit tight with your holdings, but be prepared to take profits in your shorter-term ideas, especially if they have already made a sold recent upward move.