(by Michael Carr)
Whether you have a $1,000 or you manage billions, the relative strength (RS) technique is a popular and useful tool for comparing one investment against the overall market. But few individuals ever manage to use the technique effectively, because they fail to incorporate RS into a comprehensive trading strategy. In this article, we define relative strength, explain why it works and demonstrate how individual investors can employ RS strategies. This versatile tool can be applied to stocks, exchange traded funds (ETFs) or mutual funds.
The goal of investing is to sell something at a price that's higher than what the investor paid to buy it. The problem investors face is determining when prices are low enough to indicate a buy and high enough to decide that selling is the best choice. Relative strength addresses this problem by quantifying how a stock is performing compared to other stocks. The idea is to buy the strongest stocks (as measured against the performance of the overall market), hold these stocks while capital gains accumulate, and sell them when their performance deteriorates to the point where they are among the weakest performers.
Relative strength has long been known as a valuable investment tool. Jesse Livermore, in Edwin Lefebvre's 1923 classic "Reminiscences of a Stock Operator", noted that "[Prices] are never too high to begin buying or too low to begin selling." In other words, stocks showing high relative strength are likely to continue increasing in price, and it is better, from
One of the first quantitative calculations of relative strength appears in H. M. Gartley's "Relative Velocity Statistics: Their Application in Portfolio Analysis", published in the April 1945 issue of the Financial Analysts Journal. To calculate velocity statistics, Gartley wrote:
"First it is necessary to select some average or index to represent the broad market, such as the Standard & Poor's 90-stock Index, the Dow-Jones 65-stock Composite, or a more comprehensive measure … The next step is to compute the comparable percentage advance or decline of the individual stock in the swing … And finally, the percentage rise or decline in the individual stock is divided by the corresponding move in the base index and multiplied by 100, to give the "velocity rating" of the stock."
Velocity ratings are very similar to what we now call beta, the Nobel Memorial Prize-winning idea defined by William Sharpe. These steps also define the basic idea behind relative strength, which is to mathematically compare an individual stock's performance to that of the market. There are a number of ways to calculate relative strength, but all end up measuring a stock's momentum and comparing that value to the overall market.
After Gartley, it would be more than 20 years until another study on relative strength was published. In 1967, Robert Levy published a very detailed paper, which conclusively demonstrated that relative strength works (or at least that it did during his test period of 1960-1965). He examined relative strength over various time frames and then studied the future performance of stocks and found that those that had performed well over the previous 26 weeks tended to also do well in the subsequent 26-week period.
As an example of calculating relative strength, we can take the six-month rate of change in a stock's price and divide that by the six-month rate of change of a stock market index. If IBM has gone up by 12% over the past six months while the market, as measured by the S&P 500, has gone up by 10%, we would get a value of 1.2. An example of this type of chart is shown in Figure 1.
Figure 1: A monthly chart of IBM with its six-month relative strength shown in the bottom portion.