One of our biggest indicators in trading and investing in markets is relative strength. In general, we believe you should buy things that go up more and sell things that go down more. We know this is not revolutionary but we often think it is not focused on enough.
Let’s consider a few markets, starting with the S&P 500. As an equity index it will have any number of stocks outperform it and underperform it – it is a sort of average and any average requires some things above it and some things below it. A lot of people just buy the index and accept the [cap-weighted] ‘average’. But many, like us, seek to identify what will outperform and be better than average.
In our analysis we will look at the relative strength of the sectors within the S&P 500 as well as the stocks themselves relative to the sector and S&P 500. This gives you a good, ‘top-down’ group of stocks to analyze further in order to build your portfolio. There are a few sites out there that can help you do this (despite being an ad ravaged site I often point people to stockcharts.com because it is free and has a lot of charting options – try this link for my chart of the tech sector vs the S&P 500).
In charting these relationships not only can we identify the best outperformers and underperformers, we can also flag possible trend changes and market rotations. Consider this chart of the utility secotr versus the S&P 500:
The black line is the relationship between the two and the orange line is a moving average of the relationship. You can see where the black line changed, and this is where we started looking at buying more utility companies.
This kind of analysis is also very helpful for trading markets like futures. One of my weekly routines is comparing the relative strength in currency futures. Often a number of currencies will trade with high correlations, that is they all go up or down at the same time. But they don’t always go up or down the same amount. If you want the best probability of the best move you should buy the market that usually goes up the most – that’s the one with the best relative strength. For instance, if I think the dollar is turning I would look to buy the euro rather than the yen based on their current relative strength charts.
Being on the right side or relative strength will both improve your odds of getting a profitable trade but also in maximizing the most profits from your trade.