Redefining Relative Strength

Buy high sell higher.

Macro shocks, such as economic or political events, can cause significant volatility in the stock market. As traders, adapting our strategies during these times is crucial to avoid significant losses. One powerful method is using relative strength analysis to identify stocks holding up well compared to the overall market. In this post, I'll explain the relative strength concept, demonstrate why it works, and share techniques to apply it in your trading.

What is Relative Strength?

Relative strength refers to the performance of one asset compared to another asset or benchmark over a given period. For stocks, we can measure relative strength versus the S&P 500 or versus other stocks in the same industry. Stocks showing high relative strength outperform the market and maintain uptrends even during market selloffs.

Here is an example comparing the relative strength of individual stocks versus the S&P 500:

Image: ELF stock price (blue) versus S&P 500 (pink). ELF vastly outperformed.

Image: LLY stock price (blue) versus PFE stock price (Pink) over 2 years. LLY outperformed significantly.

Does Relative Strength Work?

Numerous academic studies have proven that stocks exhibiting high relative strength produce superior returns over long periods. Here are findings from a few key studies:

• Jegadeesh (1993) - Buying the top-performing stocks over the past six months and holding for six months outperformed the market by 12% annually from 1965-1989.

• Blackstar Funds (2005) - Constructing a portfolio of stocks hitting 52-week highs from 1991-2005 produced nearly double the returns of the S&P 500 with lower drawdowns.

• Meb Faber (2010) - Rotating annually into the top 3 sector ETFs ranked by trailing 12-month performance outperformed buy and hold of the S&P 500 from 1928-2009.

The exact reasons why relative strength works are still debated, but some logical explanations include:

• Tax-loss harvesting - Portfolio managers sell their weaker performers to realize tax losses and offset gains. This supply/demand imbalance pushes relatively strong stocks higher.

• Window dressing - Funds buy the current outperforming stocks before reporting periods to appease investors.

• Price trends - Stocks in uptrends tend to continue trending while downtrends worsen. Relative strength captures this momentum.

Regardless of the reasons, the data clearly shows rotating into the relatively strongest stocks is an effective strategy, especially during macro shocks.

Applying Relative Strength

To apply relative strength in your own trading, follow these steps:

1. Define Strength

Use metrics like 6-month return, 52-week highs, or position within rising channel to identify strength. Avoid absolute price thresholds that disadvantage low-priced stocks.

2. Rank Stocks

Sort stocks by your strength metric from highest to lowest relative strength. Update the rankings frequently to catch trend changes quickly.

3. Trade the Strongest

Use rankings to select stocks poised to outperform the market. Buy breakouts from consolidations, add to existing positions, or sell weak names.

4. Rotate your Portfolio

Alternatively, automate the process by always holding a portfolio of the top 10-20 ranked stocks and rebalancing regularly.

The Bottom Line

As a trader, it is crucial to find an approach to identify stocks that suits your style. In my case, I always look for a reliable metric as a starting point. Then, I apply conventional technical analysis for further refinement and determine the best time to enter and exit the trade. However, your method may differ from mine. The key is to ensure that your approach makes sense to you.

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References

Jegadeesh, Narasimhan, and Sheridan Titman. "Returns to buying winners and selling losers: Implications for stock market efficiency." Journal of finance (1993): 65-91.

Blackstar Funds. "Why Stocks Outperforming Their Benchmarks Continue to Outperform." 2005.

Faber, Mebane. "A quantitative approach to tactical asset allocation." The Journal of Wealth Management 12.4 (2010): 69-79.