Technical Tuesday - How Relative Strength Gets You Profitable Trades

I can remember generating my first million dollars, trading in my very early 20s (in the mid 1990s), after making “relative strength” my main focus. 

Of course, it was early in the tech boom and lots of people were making money by being in the right place at the right time. 

But what’s important to note is that the vast majority of stocks started trading lower in April of 1998, which means that the single most important thing relative strength investing/trading did for me was keep me away from bullish positions on that group.

The second most important thing it did was to keep me bullish, not only on just anything “tech” or just anything “dot-com”, but the strongest parts of the strongest industries within the strongest sectors.

Dare I preface with “even more importantly”, I was able to get in very early in the trends.  We played relative strength SIGNALS immediately, as the current shifted (from e-commerce to e-media companies, from e-media to e-advertizing companies, from e-advertizing to wireless technology, from wireless technology to semiconductors, and then the fastest growing part of semiconductors at the time, “slurries”). 


The company above, Cabot Microelectronics, is the stock that dominated that slurries industry within the semi-conductor sector.  Does this look like the typical tech stock on the NASDAQ from April 2000 - February 2001?

Bouncing around from “tech strong” to “tech stronger” was the theme in the 1990s, but relative strength strategies also had me in the right sectors over all -- and more importantly, out of the wrong ones. 

Tracking relative strength also had members of my trading service bearish on Wall Street stocks and bullish on commodities in mid-2007 through the end of 2008.

WHAT IS RELATIVE STRENGTH?

In its most basic form, the definition of relative strength is when one security or index outperforms another security or index.  Typically a benchmark is employed, such as the S&P 500 for stocks, or crude oil to measure the relative strength of natural gas, heating oil or gasoline.

If XYZ stock is up more than the S&P 500 over a given period, it’s outperforming.  If XYZ stock is down, but down by a lesser percentage than the S&P 500, it’s still outperforming.  This is called positive relative strength, and using this knowledge we can create relative strength “buy signals” and “sell signals” as soon as the relative strength relationship changes by a significant enough amount.

The reason this works so well is that prices fluctuate and move in trends for a reason -- not randomly.

Isaac Newton’s law of motion, which is the general premise for technical analysis (“A body in motion tends to stay in motion unless acted on by an outside force”), is what makes relative strength investing so successful. It's the reason why this approach is an enormously effective way to keep you in a winning position, instead of selling early out of fear of losing a profit.

Trends are created when major shifts in the economy cause institutions to continue buying or selling an asset for a prolonged period of time.  Some trends last longer than others, and therefore relative strength strategies work best in trending markets. But over long periods of time (5-10 years), relative strength strategies always seem to outperform the market by a wide margin.

I read articles in The Wall Street Journal comparing investing in small caps versus large caps, or investing in equal-weighted indices (like the equal-weighted S&P 500) versus cap-weighted indices (like the S&P 500).  They talk about how it’s best to be in equal-weighted S&P 500 names when small caps are outperforming.  But meanwhile, they are still talking about investing in large cap companies, because all S&P 500 stocks are large cap stocks.

You can use relative strength strategies to know as soon as small caps start to outperform, and then start to underperform, and focus your portfolio on the right group.   But just by using relative strength to be in the right sectors (of which there are over 40 in the stock market), you don’t have to worry about whether large caps or small caps are in favor because, either way, you’ll be in the group of stocks that, by definition, are outperforming.

CAN I GET IN ON THE ACTION?  HOW?

There are many ways to use relative strength investing, but however you decide to use it, the concept is simple:  For bullish positions, buy the financial markets’ top performers and sell out of those that are not the top performers (not to be confused with selling the financial markets’ worst performers).  For bearish positions, sell (short) the markets’ worst performers (as in, initiate bearish positions) and exit those that are not the worst performers.

FOR PASSIVE INVESTORS

The implication from many of the 30 or 40 academic studies I’ve read is that even investors who are not hands on can significantly beat the market averages by taking action once per quarter.  The action is as simple as rebalancing their portfolios so that they only own the Exchange Traded Funds (or no-load mutual funds, but my preference, by far, is ETFs) that were among the top 10% of performers over the last 3 - 6 months.

The same studies show more hands on investors can rebalance once per month (still, based on the last 3 - 6 months) and get slightly better results.

This is as easy as sorting a list of all funds in order of performance over a given period of time.  It’s sort of “ad hoc” if you ask me, but since relative strength is so powerful, it still works over time if you consistently use this “quick and dirty” method.

FOR HANDS ON ACTIVE TRADERS/INVESTORS

Personally, I want to know at the end of each week how the relative strength relationships within the markets have changed.  (Daily seems to be a bit much, especially since I enjoy having a personal life too.)

But my "Technical Analysis Millionaire" subscribers know how to use relative strength charts to signal when the shift has begun.  Remember, owning something that goes up isn’t good enough when we consider the risk of the stock market.  We want to be compensated for our risk, especially since one day we will deal with losing streaks.  It’s inevitable, so when we are in the winners, we want to be in the biggest winners possible and we want to stay in those winners.

In "Technical Analysis Millionaire" I talk about one very simple relative strength technique for the laid back, hands off investor.  I get emails all the time from investors and traders alike, telling me how their new knowledge of relative strength investing has changed their lives, and that is probably the most rewarding part of what I do.

This enormously durable and robust technique should be a huge part of any trader’s/investor’s investment program.

Chris Rowe
Chief Investment Officer
Technical Analysis Millionaire