It tells whether the price rises slowly and sustainably, or too fast. A divergence between price and oscillator is one of the very few indications that have predictive value. The other oscillators and moving averages follow the price but a divergence in the RSI actually leads the price.
Let's look at the example in the form of Absa Bank.
During 1998 the price made a new high around R50. The RSI at that stage did not make a new high along with the price, this setup is known as a divergence between RSI and price and warns of a correction or consolidation in price.
The price did make the subsequent 50% drop to R25, but what is more important in this case is the long-term consolidation or sideways movement that followed. The price moved sideways for 6 years (rectangle -2-) before the break of line -1-, at arrow -5-, signalled the start of a new surge in momentum and a rising trend.
We see a similar setup within rectangle -4-, where the resistance line -3- over the momentum indicator acts to suppress a surge in price. A break of line -3- will signal the start of a new trend and surge in momentum, similar to the 275% rise in price between 2004 and 2007. In the meanwhile there are better investment opportunities elsewhere on the JSE. We monitor line -3- as a timing indicator to move into the banking sector.
By analyzing investment opportunities in this way we apply capital where the potential for appreciation is greatest.
If you are willing to listen, the RSI can tell you more stuff, more accurately than a heap of fundamental analysts ever can.
