Saturday, March 23, 2013

Using Relative Strength to Beat the Market

Relative strength is one of the most important concepts in technical analysis, especially when markets are as anxiety-ridden as they are now -- but it's also one of the most misunderstood. In this Technical Primer, we'll take a look at what relative strength really is, as well as what it isn't.

More importantly, we'll look at how this concept can help you beat the market, even in challenging conditions.

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For starters, relative strength isn't the same thing as RSI. RSI, the initialism for Relative Strength Index, is a momentum indicator based on a stock's recent gains and losses. It measures one point in time vs. another for a single stock. Relative strength, on the other hand, is simply the relationship between two securities. Not surprisingly, the fact that these two separate concepts have nearly the same name is a major cause for confusion for aspiring technicians. At its core, relative strength (also sometimes referred to just as RS) is a tool for measuring a market's potency just as RSI is, but the key difference is in how they go about doing it. RS gets its name because it measures the strength of one security relative to another -- as a result of that, it's primarily a screening and selection tool. The simplest way to compute relative strength is by taking a stock's price and dividing it by the price of another security -- most often a broad market index. The resulting ratio doesn't mean anything in and of itself (after all, you're dividing one price by another unrelated price), but a plot of relative strength does. An increasing relative strength line tells us that a security is outperforming its denominator security, while a dropping line tells us that it's underperforming.The key word in the name is "relative" -- a rising relative strength line doesn't mean that a stock is increasing in value. It only tells us that it's outperforming the broad market. We'll get back to that in a bit.The Value of Relative StrengthSo does plotting the ratio of one security to another really have any value? According to academic studies, the answer is a resounding "yes." According to a number of academic research studies compiled by Professors Charles Kirkpatrick and Julie Dahlquist in their texbook, Technical Analysis: The Complete Resource for Financial Market Technicians, using positive relative strength to pick stocks has historically been a viable strategy that produces outperformance over the broad market.

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In brief, stocks that are outperforming tend to continue to outperform in the future.

As an investor or trader, that's a valuable piece of information, particularly when the broad market isn't offering many compelling trades. Obviously, outperformers aren't going to continue to beat the broad market forever -- time horizon is also an important consideration. In general, positive relative strength trends led to positive returns on a three-to-10-month time horizon in the studies compiled by Kirkpatrick and Dahlquist.

How to Use Relative StrengthRelative strength is most often used as a subchart alongside a stock's price action. Like other indicators (including momentum), RS can be used to find divergences and confirmation with a stock's price. Plots of relative strength can also have technical annotations such as trend lines applied to them much in the same way price charts can. A trend line break in a stock's relative strength chart is often an indication that its outperformance is starting to wane. Because RS is a ratio, it's also a good metric to put to work when using a quantitative screen to generate investment ideas.You don't need to calculate relative strength manually. Most charting packages are capable of determining relative strength, and popular sites such as can chart relative strength of a stock -- let's say the ticker symbol is ABC, for example -- vs. the S&P 500 by inputting ABC:$SPX into the ticker field. Keep in mind that relative strength measures the relationship between two securities. That's helpful to remember when you're trying to find RS in your charting package; if you're not prompted to enter a second security as the denominator, chances are you're getting a chart of RSI instead.As a tool, relative strength can also be applied to a number of different types of markets. Relative strength can be the cornerstone for a long-term asset rotation strategy, identifying asset classes that are outperforming stocks (popular methods combine RS and moving average crossover signals) and signaling when it's time to shift into a different asset class. It's also a valuable way to determine which sectors offer the most upside -- which in turn can help to identify which stage of the investment cycle we're in at any given time.

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Because RS is a numerical ratio, it can also easily be used as a condition in a quantitative trading system to limit its investment universe to outperforming names. That versatility makes relative strength a must-have part of any trader's toolbox.

There is one major caveat, however. Keep in mind that relative strength is relative, not absolute. So a sector can be outperforming the S&P 500 but still be losing money. Like most technical analysis concepts, it's crucial to go back to price to determine if an investment makes sense.

On the quantitative side, one easy workaround is to require positive relative strength versus cash, or to add a risk-free asset (such as treasuries) to the system's investment universe. That ensures that sectors that are only "less bad" don't make their way into your portfolio.As the market continues to lack decisive or directional signals, tools like relative strength will likely become increasingly popular -- after all, the current research tells us that RS is one of the best ways to identify future outperformance. Next time, we'll add to your technical repertoire with another primer that will bring you closer to implementing technical analysis for your portfolio.In the meantime, do you have a burning technical analysis question? Get it answered by heading to Stockpickr Answers.Follow Stockpickr on Twitter and become a fan on Facebook.

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