Relative Strength Investing

Relative Strength Investing: The Concept of Relative Strength
A Daily Reckoning Whitepaper Report
By Mark Bail — Editor, The Sleuth (Sign up for FREE!)
Hello again, Sleuths,

This sure has been a rough couple of months for equities. Since making highs for 2006 back in the early part of May, all of the major broad-based indexes have taken it on the chin.

Fortunately, in MST Trader we’ve been focusing on the short side for the last couple of months. But some traders — and most investors — don’t like to consider playing the short side of the market. Most people are more comfortable buying things. Heck, even in MST Trader we BUY puts to position ourselves on the short side of the market.

So, most people do have a bias to buying — as opposed to shorting — when trading or investing. I’m not completely sure why that is. It could be rooted in the fact that, despite frequent ups and downs, over time our economy does continue to expand. And the stock market is a great reflection of the health of our economy.

The reason most people would rather buy than short could be even simpler than that. Many people just do not understand the concept of shorting. It’s counter-intuitive. I know I’ve wracked my brain trying to come up with a simple, clear explanation for shorting a stock. I still have yet to come up with one that’s universally successful.

Relative Strength Investing: What to Do in a Rough Market?

The bottom line is that people are much more inclined to buy stocks than they are to short them. So, if you are one of those folks, what do you do when the environment for equities has been as rough as it’s been for the past 11 weeks?

One thing you could do is cut back on your holdings and wait for a more favorable climate before putting more of your cash to work.

But what if you want to be fully invested? That’s a little trickier. I’m a big believer in following the trend. And let’s face it — the trend has clearly been pointing down. I’ve read estimates that approximately 75% of stocks move in the same general direction as the overall market. So, in times like these, by staying fully invested you are fighting an uphill battle.

Still, what if you want to find out where the most advantageous place is to invest right now? Not every single stock follows the overall market. After all, if 75% of equities are going down, that still leaves 25%, right? Where is one likely to find them?

Relative Strength Investing: Not Investing Based on Absolutes

I decided to employ the concept of “Relative Strength” to locate some of these contrary gems. Relative Strength is a term used by practitioners of technical analysis to evaluate how a stock or a group of stocks are performing in comparison to either another group of stocks or the broad market as a whole. In other words, a stock’s Relative Strength measures how it is performing on a relative, as opposed to on an absolute, basis.

I put the concept of Relative Strength into action by comparing the overall performance of several different stock market sectors. In order to conduct my examination, I looked at the performance of the nine Select Sector SPDRs that trade on the American Stock Exchange.

These SPDRs are exchange-traded funds (ETFs) that consist of separate baskets of stocks selected from each of nine general segments of the market. I chose to use the Select Sector SPDRs because, taken together, these nine ETFs represent a broad cross-section of the equities market. And each one fairly reflects the price performance of the stocks in their particular market segment. Here are the nine Select Sector SPDRs I used:

  • Consumer Discretionary Select Sector SPDR (AMEX:XLY)
  • Consumer Staples Select Sector SPDR (AMEX:XLP)
  • Energy Select Sector SPDR (AMEX:XLE)
  • Financial Select Sector SPDR (AMEX:XLF)
  • Health Care Select Sector SPDR (AMEX:XLV)
  • Industrials Select Sector SPDR (AMEX:XLI)
  • Materials Select Sector SPDR (AMEX:XLB)
  • Technology Select Sector SPDR (AMEX:XLK)
  • Utilities Select Sector SPDR (AMEX:XLU)

The technical condition of the market changed dramatically in early May. I’m sure any of you Sleuthers who take a buy-and-hold approach can attest to that.

Relative Strength Investing: The Best Places to Invest, According to Relative Strength

Now, let’s rank each of these nine Sector Select SPDRs by their percentage return since May 9. This will show us the Relative Strength of each of these nine broad market sectors. With this information, we’ll be able to assess what’s been working in this challenging market environment. Here are the percentage returns through the close of trading on Monday, July 24:

  • Utilities Select Sector SPDR (AMEX:XLU)                             +6.7%
  • Health Care Select Sector SPDR (AMEX:XLV)                       +3.3%
  • Consumer Staples Select Sector SPDR (AMEX:XLP)             +1.5%
  • Financial Select Sector SPDR (AMEX:XLF)                           -4.0%
  • Energy Select Sector SPDR (AMEX:XLE)                              -4.8%
  • Consumer Discretionary Select Sector SPDR (AMEX:XLY)     -7.9%
  • Industrials Select Sector SPDR (AMEX:XLI)                           -9.6%
  • Technology Select Sector SPDR (AMEX:XLK)                       -11.8%
  • Materials Select Sector SPDR (AMEX:XLB)                          -12.9%

As you can see, in the current market downturn the best places to have been are utilities, health care, and consumer staples issues. Now, once conditions change we could well see other sectors assume leadership roles. But right now, if I were looking to invest over the short term, those top three sectors listed above would be a good place to hunt for potential winners. And if you are considering adjusting your portfolio, you could do worse in this current climate than to give more weight to your portfolio with stocks in those top three groups.

By employing the concept of Relative Strength, you are able to hone in on the best performing areas of the equities world. At the same time, by measuring the Relative Strength of different market sectors, you are able to discern which areas to trim back on and which to avoid altogether. And in this market environment, there are way too many stocks in that last group.

So, when trying to decide where to invest some cash, consider using the concept of Relative Strength. It might just help you sidestep a few bumps in the road.

Trade well,

Mark Bail
The Sleuth
P.S.: Be sure to sign up for a FREE subscription to The Sleuth, written by some of the smartest researchers in the field of small-cap stocks.  The Sleuth explores the tiniest investments out there…at least tiny for now…that have the biggest potential for profitability. Don’t miss out on your chance to read about current and upcoming trends in microcaps every weekday, delivered straight to your e-mail inbox!

Here are some other Sleuth articles about Relative Strength Investing:

So What’s All This Buzz About Volatility? by Mark Bail
“…But if you’re new to investing — or just unfamiliar with some of the market jargon frequently spouted by the financial media — you may think that’s something you ought to know about. Well, should you? And more importantly, will becoming familiar with the concept of volatility help you improve your investment results?…”

Taking the Market’s Temperature by Mark Bail
“…I think we’re at a very interesting juncture in the market right now. We had a bullish first third of the year, with all of the major indexes scoring solid gains. That was followed by a severe sell-off that began in early May and lasted throughout nearly all of June. That sell-off wiped out most, and in some cases all, of the hard won profits earned in 2006’s first four months…”

The VIX by Mark Bail
“…With the large gyrations we’ve been witnessing recently in the major stock indexes, there has been a lot of talk in the financial media about ‘volatility’ becoming more a part of the everyday market. Although it pains me to say it, the purveyors of business news, gossip, and opinions are right this time. I guess that just validates the ‘broken clock’ and ‘blind squirrel’ theories…”

The VIX: What It All Meansby Mark Bail
“…The two primary emotions that drive market traders and investors are fear and greed. And that’s exactly what the VIX reading conveys. The VIX is an excellent measure of the current level of fear and greed – or, to be a bit more accurate, fear and complacency — in the market. In fact, the VIX is often referred to as the ‘fear gauge’…”

Here are some resources about Relative Strength Investing:

About.com Why checking a stock’s relative strength is so important before investing in it.

Fool.com A Q&A session about relative strength and how investors can make a profit from using it.

Investopedia The definition of the Relative Strength Index (RSI) and how to read it.

UOutPerform Using relative strength to enhance trading results.

Yahoo! Finance Get stock quotes, market news, mortgage rates, currency info and much more about market downturns.

The Daily Reckoning