Why Sector Relative Strength is Important

by | Feb 9, 2015 | Asset Management, Chart School

Relative strength is a topic we enjoy discussing at Mullooly Asset Management. Relative strength measures how one security is doing compared to another. Through research provided by our friends at Dorsey Wright and Associates, we can determine the relative strength of different asset classes, sectors, mutual funds, ETFs, stocks, and more.

Relative strength is useful because it allows us to see what’s working and what isn’t in the market. With this knowledge, we attempt to maximize exposure to relatively strong areas of the market, while reducing or eliminating exposure to relatively weak areas of the market. As we’ve noted before, it’s often about what you don’t own in investing, as large negative numbers can kill compounding returns.

A study done by Dorsey Wright and Associates highlights that well. It displays the results of four hypothetical investors from 1993-2014. These investors include:

  • The “buy and hold” investor: This investor simply buys the S&P 500 and makes no changes.
  • The “perfect market timer”: This investor is only invested in the S&P 500 when it has a positive month.
  • The “best sector investor”: This investor puts their entire portfolio into each year’s top performing Dow Jones sector.
  • The “worst sector investor”: This investor puts their entire portfolio into each year’s worst performing Dow Jones sector.

As you can see on the chart below, these hypothetical investors have had very different results over time. The best sector investor leads the results, with the perfect market timer coming in second. The fact of the matter is that only the “buy and hold” strategy is able to be perfectly replicated. Perfect market timing, best sector and worst sector returns are only able to be calculated in hindsight. Nobody knows ahead of time what the best and worst sectors will be for any given year, just as nobody can tell when the S&P 500 is going to have a positive monthly return. We aren’t recommending you attempt perfect market timing or picking the best/worst performing sector each year.

Market Sector Timing Study 1993-2014

All data courtesy Dorsey Wright and Associates

What we are attempting to show you is that remaining invested in the strongest sectors, while avoiding the weakest sectors can have a drastic effect on your portfolio’s returns. To quote Dorsey Wright and Associates on the topic:

“The magnitude of buying the best sectors is even greater than that of being able to perfectly time the overall market.”

We like to describe relative strength investing as stacking the odds in our favor. Does relative strength always work? No, there are periods of time when relative strength (or any investment strategy for that matter) will underperform. But in the long run, we firmly believe that remaining invested in relatively strong investments while avoiding relatively weak ones is a compelling strategy.