Emerging Relative Strength

I have been playing around with some new screens that will perhaps replace what I currently have on our stock screens spreadsheet. I say possibly replace simply because I really do not know if they are being utilized and if so which ones. That however, is for another day.

First however, let’s go over what is relative strength: Relative strength = stock price ÷ a base index value. That base index value is most often but not always the S&P 500. I use a total stock market index. Relative strength over a time period is merely a rate of change of the relative strength calculation.

Studies and books that I’ve previously mentioned like: Bill O’Neal “The How to Make Money in Stocks“, James O’Shaughnessy. “What Works on Wall Street”  and Charles Kirkpatrick, CMT “Beat the Market: Invest by Knowing What Stocks to Buy and What Stocks to Sell” (which is the basis for our Watch List selection), all point to longer term relative strength as being the most effective tool.

One might ask themselves, why not choose a shorter time frame and get in sooner. First, regardless of your methodology, whenever you shorten the time frame you increase your odds of whipsaw.  While a one week or one month relative strength will turn positive a lot sooner than a six or twelve month, they will also quite often reverse quickly. I believe the longer terms work better because accumulation happens over time, not overnight. As the company or sectors prospects brighten more and more come to realize it and begin buying.  The buying by major institutions can and does occur over months, even years, and not hours or days, as many would have you believe.

What I have noticed is that in the case of Sectors and ETFs as a for instance, once the rate of changes become positive and stay’s positive for a reasonable period of time, I define them as “Overweight“.

Screen Shot 2014-03-31 at 10.01.34 AM

The lower black line is zero in this relative strength plot. The drug sector has been above the zero level for since May of 2011.  The definition: Above zero for a minimum of 10 consecutive trading days equals an overweight rating.

Now let’s look at the Underweight category. I’ll use the Metals and Mining  sector as an example:

Screen Shot 2014-03-31 at 10.06.18 AM

Notice the time around the beginning of the year where the rate of change turned positive? It was very short lived and that period would have been defined as a market perform period.

Keep in mind the first word of relative strength, Relative!  The expectations are relative to the overall market, in other words, underweight does not mean sell or that the sector or stock should decline, it means that should the overall market rise the expectation is that this will rise less or stay the same. Likewise overweight would be an outperformance relative to the overall market. Do not loose sight of that one word Relative!

More detail and Part II tomorrow

Talking Points and Proving Others Wrong Is Misguided:

Random Thoughts (Alhambra)

How to Improve Your Decision-Making Skills (HBR)

Should we care about inequality? (Washington Post)

No End in Sight for Secular Bull Market (Jeff Saut)

The Desperation of the Vanishing Middle Class (Baseline Scenario)

Should financial advice really cost $9 million? Some well-off investors are beginning to wonder (WSJ)

Michael Lewis’s flawed new book (Reuters)

Hedge Fund Letters to Tell of Favorite Trades Unraveling (Bloomberg)

America is not broke (Great Debate)

Shifting Policy at the Fed: Good for Long-Term Growth, Bad for Cyclical Bubbles (John Hussman)

How to Invest $25 Million (Penta)

Here Comes $75 Oil (Barron’s)

Parsing Surprise Decline In Rates (WSJ)

Sorry, But There’s No ‘Law Of Capitalism’ That You Have To Pay Employees As Little As Possible (Business Insider)

Is it time to short stocks? (Humble Student)

Invest in Tomorrow’s Workforce, and World (HBR)

Deepak Chopra: Proving Others Wrong Is Misguided

Have a great day!

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