This article was published on Business Times’ column “ChartPoint” on 18 September 2017. 

STI Weekly chart                                                                                                                                    Source: Bloomberg, PSR

After a week’s break from missile test on 3 September, North Korea did it again. It tested an intermediate range ballistic missile that flew over Japan on 15 September 2017, causing the general market to remain depressed especially the Straits Times Index (STI).

The bullish momentum in the STI only began accelerating since the start of 2017 after the STI broke above the 2964 resistance area. Since then, the bullish momentum raged on until recently in July 2017 where some weakness appeared. The confluence of 78.6% Fibonacci retracement level and 3357 resistance area seemed to be causing some obstacle for the bulls as the STI failed to break above it. Moreover, the rally since the start of the year has resulted in the Relative Strength Index (RSI) entering into overbought territory in July implying a high possibility of a deeper correction.

Relative Strength Index (RSI) provide a reliable signal to spot for reversal point when the RSI is at either extreme. An RSI reading above 70 shows overbought conditions where a reversal to the downside is expected while an RSI reading below 30 highlights oversold conditions where a reversal to the upside is expected.

Things to look out for in a reversal with an overbought RSI:

• RSI exceeding 70 overbought region (prior uptrend getting exhausted)
• Bearish price action to spot for the reversal point
• RSI to fall back below 70 to confirm the mean reversion

An overbought RSI works best in conjunction with bearish price action to confirm the reversal point. For instance, in the week ended 22 March 2013, that was when the RSI first proceeded into the overbought condition at 70 signalling danger ahead. The reversal top only came in four weeks later after a Bearish Engulfing Bar confirmed the mean reversion in RSI is taking place as the RSI dipped back below 70. As a result, the STI fell 9% subsequently in the following four weeks.

Another good example to showcase the overbought RSI happened in the November 2010. In the week ended 5 November 2010, the RSI re-entered into the overbought territory signaling a top is near.  One week later, a shooting star formed which happened to be the reversal top. The confirmation of the correction came another week later after the RSI fell back below the 70 overbought region to confirm the mean reversion property as the STI fell 8.5% subsequently.

In total, there were 14 RSI overbought signals generated since 1995. Out of the 14 signals, only three failed to signal a significant reversal in July 1999, February 2005 and August 2009. The average correction from the confirmation of the mean reversion is – 7.7% and the largest drawdown happened in January 2000 where the STI fell 23% after the overbought RSI signal was triggered.

With the recent rally since the start of 2017, the RSI has fulfilled the overbought criteria again since March 2017 and more recently in July 2017 where the RSI hit an extreme high of 72.6. Since then, some bearish price action began appearing with the formation of an evening star bearish pattern in the week ended 11 August 2017. Moreover, the bearish price action has also led the RSI to mean revert back below the 70 overbought region implying a deeper correction is about to happen. A further sign of weakness can be seen by the bearish break of the uptrend line since November 2016 in the week ended 18 August 2017.

If the overbought RSI signal holds, we believe the STI is in the midst of a correction phase with the reversal top formed in the week ended 28 July 2017 at 3354 high. The key area to watch currently is the 3189 support area. That area held the STI up relentlessly since May 2017. If the STI was to break below the 3189 support area, we believe the current correction will get more severe as the STI search out for the next support area at 3114 followed by 3000.