A topic we can’t seem to discuss enough here at Mullooly Asset Management is relative strength. Relative strength refers to the momentum factor. As John Lewis, CMT of Dorsey Wright Money Management described in a recent whitepaper:
“Relative Strength (momentum) strategies focus on purchasing securities that have already demonstrated the ability to outperform a broad market benchmark or the other securities in the investment universe.”
Momentum strategies have always reminded me of Newton’s Laws of Motion. You remember those from school, right? An object in motion continues in motion and an object a rest remains at rest unless either one is acted upon by an unbalanced force. This concept generally applies to investing as well. It’s been proven time and time again that momentum is a robust anomaly.
There are different ways to calculate momentum, but one form of analysis we rely heavily on is point and figure relative strength charts. We’ve learned a lot from our friends at Dorsey Wright and Associates about this method of calculating momentum.
How to Create a Point and Figure Relative Strength Chart
– You must pick both a security and its benchmark
– Divide the price of the security by the price of the benchmark and multiply by 100
– Plot the number onto a point and figure chart
Often we use the equal weighted S&P 500 as a benchmark for US stocks, however the benchmark can be changed to suit the type of investment you’re analyzing. We could measure a small cap stock vs. the Russell 2000 or a bond fund against AGG.
Relative strength charts look just like regular point and figure trend charts: they have columns of X’s and O’s, and they give buy signals and sell signals. When it comes to point and figure relative strength charts, the column (X’s or O’s) tells us about the security’s shorter term performance, while the signal (buy or sell) tells us about the security’s longer term performance. As John Lewis, CMT shared in his whitepaper on point and figure relative strength signals we should focus on securities that are on relative strength buy signals and in X’s on their charts.
The Power of Relative Strength Buy Signals
I read an excellent article this week on Bloomberg View about Danaher. It outlined the company’s transformation and excellent performance since the 1980’s. The author discussed different acquisitions and sales made by the company’s management, and their overall path to success. Danaher’s relative strength chart vs. the equal weighted S&P 500 tells the same story, only in X’s and O’s
As you can see, Danaher has been on a relative strength buy signal vs. the equal weighted S&P 500 index since May of 1993. In that time period, Danaher is up 4362% vs. 618% for the index.*
While this is certainly NOT a recommendation to buy or sell Danaher or any other security, it provides an excellent example of how powerful relative strength can be.
It’s important to keep in mind that no strategy is perfect. Just because a stock has positive relative strength, doesn’t mean the price cannot go down. Relative strength is…well, relative. If the benchmark you measure a security against is down 20%, relative strength could possibly mean dropping by only 19%.
However, if a security continually holds positive relative strength against a benchmark that is rising, you can safely assume that investment is doing alright.
Sources:
http://dorseywrightmm.com/sites/default/files/White%20Paper%20-%20PnF%20RS%20Signals.pdf
http://www.bloombergview.com/articles/2015-05-19/what-makes-danaher-corp-such-a-stock-market-star-
*Results do not include dividends or transaction costs. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss.