Relative Strength: The Profitable Trader’s Edge

Sometimes, the key to
success in the financial markets depends as much on what you unlearn
as what you learn. Understanding trends is one of those keys.

Successful investors and
traders who pursue market-beating returns in sector and other
specialized funds have learned how to exploiting trends. In doing so,
most of them had to shed some very natural but wrong-headed notions
about how stock prices behave and, by extension, how stock fund values
behave.

From childhood, we’re raised
on pat truths such as what goes up must come down. That maxim seems to
fit our experience in the physical world. A ball tossed in midair, of
course, comes back to earth. And we seem to see the same thing outside
the world of gravity. The cost of gasoline spikes higher at times,
then falls back, only to rise again. Hemlines rise and fall with
fashions. Even our moods and personal fortunes seem to sway between
good times and bad.

And when we watch the
day-to-day volatility of the stock market, it’s easy enough to apply
this simple notion to stock prices.

But in fact, while price
movements in one direction don’t continue forever, they can continue
for longer than you suspect. And this leads to a very important
statistical fact.

The more a stock or sector
outperforms the market, the more likely it will continue to do so.
Success usually begets more success.

A number of studies bear
this out. In one, William O’Neil & Co. looked at thousands of the
biggest winning stocks over a 40-year period. The average stock in
this elite group had already appreciated more than 87% of its peers
over the prior year just before beginning its big advance.

Market analysts coined the
term “relative strength” for this concept. Relative strength
is simply a measure of a stock or fund or sector’s share price
performance relative to its peers.

The corollary exists on the
downside as well. The more a stock or sector underperforms, the more
likely it will lag its peers the future.

Fund manager James
O’Shaughnessy demonstrated both sides of the relative strength
equation in his landmark book on indexing strategies, What Works on
Wall Street (McGraw-Hill). Using the CompuStat database,
O’Shaughnessy ran simulations of a variety of indexing strategies
applied across a 45-year time span. One of the most powerful selection
criteria turned out to be relative strength.

One simulation created a
portfolio of the 50 stocks with the highest one-year relative strength
ratings. The portfolio held those stocks until rebalancing the
following year. This approach produced an average annual return of
18.1% vs. 15.1% for O’Shaughnessy’s all-stocks universe.

Another simulation looked at
the approach of investing in the worst-performing stocks over the
prior year, then holding until rebalancing on an annual basis. That
portfolio returned 6.7% a year on average. Let that serve as a warning
to bottom fishers!

There’s nothing really
mysterious about why price trends tend to be self-reinforcing. When
buyers begin to bid up a market, or a sector, or an individual stock,
it catches the attention of other potential buyers. These traders
don’t want to be left behind, so they, too, begin buying, which in
turn attracts even more longs. This buying momentum begets more buying
momentum, as greed pushes an increasing number of traders into the
market. The effect is especially pronounced when a market or a
market, sector or stock is making a series of new highs.

The same self-feeding
phenomenon occurs on the downside as well. The more a stock, sector or
index heads south, the more the affected shareholders fell pain and
fear. As more shareholders sell, the stock, sector or index falls
further under the same selling pressure, turning still more
shareholders into sellers.

Obviously, trends cannot last forever, but they often continue for
much longer than many people expect, making top and bottom picking
difficult, if not impossible. Trending markets repeatedly pause or
pullback, leading traders to think the trend has ended-only to be
trapped when the market continues in its previous direction. As a
result, it’s much more profitable (and easier) to go with the
flow-with the trend-than it is to fight the market.

Dave Landry contributed
to this tutorial.