Mullooly Asset Management

Fiduciary Fee-Only Financial Planner | Investment Advisor in Wall, NJ

relative strength

Relative Strength Chart Configurations: Sell Signal in O’s

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We’ve previously discussed the following configurations for point and figure relative strength charts:

Buy Signal in X’s
Buy Signal in O’s
Sell Signal in X’s

Today we conclude our discussion on the four types of point and figure relative strength chart configurations by discussing what it means when we see a chart on a sell signal and in a column of O’s.

To put it plainly, this security is likely to be a laggard. When a relative strength chart is on a sell signal that identifies its longer term underperformance versus the specified benchmark. Near term underperformance is characterized by the chart being in a column of O’s.

Longer term underperformance, without any signs of near term improvement, makes this the weakest point and figure relative strength chart configuration. This is one to be avoided if your investment strategy focuses on high relative strength securities.

Source:

http://dorseywrightmm.com/sites/default/files/White%20Paper%20-%20PnF%20RS%20Signals.pdf

Relative Strength Chart Configurations: Sell Signal in X’s

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There’s a big difference between a point and figure relative strength chart on a buy signal and one on a sell signal. According to a recent white paper written by John Lewis, CMT of Dorsey Wright Money Management:

“Stocks on relative strength sell signals underperformed the market by a wide margin. Whether they were in a column of X’s or O’s, they performed worse with more volatility than either of the two benchmarks.”

Being on a relative strength sell signal is a big deal. It indicates long term underperformance by the security. Being in a column of X’s shows that the security has been outperforming its benchmark in the near term. However, until that security has reversed its point and figure relative strength chart to a buy signal, the long term trend is still one of underperformance.

Source:

http://dorseywrightmm.com/sites/default/files/White%20Paper%20-%20PnF%20RS%20Signals.pdf

http://systematicrelativestrength.com/2014/09/02/point-figure-rs-signal-implementation/

Relative and Absolute Asset Class Trends Matter

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We’ve gained an outstanding education on relative strength investing from our friends at Dorsey Wright and Associates. Between their Point and Figure Institutes and daily research, they’ve taught us an incredible amount about the markets. One of the biggest tools they provide us with is called DALI, or Dynamic Asset Level Investing. DALI evaluates the supply and demand forces of asset classes, and ranks them from strongest to weakest based on their relative strength. It also takes their absolute trend characteristics into account. We strongly believe that relative and absolute asset class trends should be considered in the tactical asset allocation process.

Measuring Asset Class Relative Strength

When it comes to point and figure relative strength charts, buy signals indicate longer term outperformance. Therefore, these signals serve as our central unit of asset class measurement. Each asset class is given a ranking based on the number of relative strength buy signals it’s able to accumulate. DALI displays this score not only as a numerical ranking, but as a percentage of the total possible signals as well. The asset class with the highest number (or percentage) of buy signals has the best relative strength.

Why Not Stop There?

An issue with only considering relative strength is that sometimes relative outperformance means being down 20% when everybody else is down 25%. This is why DALI pairs relative performance with absolute performance.

Measuring the Absolute Performance of Asset Classes

An additional DALI component looks at each asset class’s cash percentile rank. This is done by creating an inventory of the asset class’s underlying components and including a proxy for cash. Cash’s relative rank among the asset class’s inventory is considered. When cash ranks highly in comparison to the majority of an asset class, that’s a clear red flag. Anything that ranks beneath cash on a relative strength basis has been losing money. This is our absolute benchmark.

DALI also looks at something Dorsey Wright and Associates have deemed the “cash bogey check”. This involves a point and figure relative strength chart of each asset class that measures it against a cash proxy. When the relative strength chart is in X’s, the asset class passes its cash bogey check. That means it has been outperforming cash in the near term. When the relative strength chart is in O’s, the asset class fails its cash bogey check. On these charts, column changes tell us about near term activity, so that asset class has been underperforming cash in the shorter term. In order to generate a column change on these relative strength charts, an asset class must reverse by 10%. Failing a cash bogey check means an asset class has reached correction territory. It may not always mean an end to the trend, but it definitely warrants attention.

How Do We Consider the Relative and Absolute Together?

If an asset class has accumulated a strong percentage of the available relative strength buy signals, and cash ranks poorly against its components, that is a trend we would strongly consider participating in. However, if an asset class has strong relative strength characteristics, but cash is outperforming many of its components, we may want to think twice about our level of participation in that trend.

All of DALI’s pieces work together to provide us with guidance in the tactical asset allocation process. By considering total relative strength buy signals, as well as cash percentile rank and the cash bogey check, we are given a more accurate depiction of where each asset class stands on both a relative and absolute basis.

Further Reading on Asset Allocation Using Relative Strength:

http://dorseywrightmm.com/downloads/hrs_research/White%20Paper%20-%20TAA%20Using%20Relative%20Strength.pdf

http://dorseywrightmm.com/downloads/hrs_research/SSRN-id1585517.pdf

Relative Strength Chart Configurations: Buy Signal in O’s

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As we discussed on a previous video, the optimal configuration for point and figure relative strength charts is to be on a buy signal and in a column of X’s. In this video, Casey continues the discussion on point and figure relative strength chart configurations.

What does it mean when a relative strength chart is on a buy signal and in a column of O’s?

When a point and figure relative strength chart is on a buy signal, it indicates outperformance over the longer term. When a point and figure relative strength chart is in a column of O’s, it indicates underperformance in the more recent past. So while the longer term performance trend may still be intact, the tides could be changing.

We believe it’s very important to stay abreast of column changes on relative strength charts. The shorter term often spills over into the longer term. Column changes are what lead to signal changes.

P90x and Factor Diversification

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There’s a stigma surrounding home exercise DVD programs, I get it. Maybe it’s driven by the infomercials or the way they seem to gather cult-like followings. Either way, I’m willing to admit that I’ve become a Tony Horton disciple over the last few years. Every morning I pop in a P90x DVD and get my daily workout in. I’m confident that Horton’s program has improved my health.

Muscle confusion is P90x’s foundation. It helps fight the plateau effect by continually mixing up workouts. On any given day you could be in for cardio, resistance training, mixed martial arts, yoga, Pilates, or intervals. There’s no way for your body to get used to it, and that’s the beauty of the program. You’ll eventually adapt to any one of those exercises on their own, but when they’re constantly rotated within a program, your body is left guessing. It also helps you avoid boredom from too much of one exercise type. Boredom often leads to slacking off or quitting entirely.

This isn’t all too different from the idea of factor diversification. Different investment factors are cyclical in nature, and diversifying them can help smooth the ride.

A classic example of factor diversification is combining value and price momentum (or relative strength). Value investing works, but it has the tendency to be early. Momentum investing works, but it’s sometimes volatile. Both factors have outperformed the market over time, but neither of them works all the time.

Jack Vogel of Alpha Architect did an excellent two part series of combining value and momentum strategies. The premise is that pure versions of these strategies held in conjunction can generate higher returns, higher Sharpe Ratios, and lower standard deviations than either can on their own.

Back in January, Patrick O’Shaughnessy was interviewed by Barry Ritholtz on his Masters in Business series. The two spoke about several topics, but one that applies to factor diversification is Patrick’s checklist for active investors. In order to identify stocks worthy of investment, Patrick urges investors to look for stocks with high shareholder yield, high return on invested capital, operating cash flows greater than reported profits, enterprise value to free cash flow less than 10x, and 6 month price momentum in the top three quarters of the market. This is another excellent example of factor diversification. Rather than rely on any one of the five factors alone, the combination of many is what provides optimal results.

Patrick’s father, Jim O’Shaughnessy, is also an advocate of multifactor strategies. In his classic book, What Works on Wall Street, Jim discusses many investment factors including value and relative strength, as well as various accounting principles. One of the main themes I took away from reading What Works on Wall Street is that factors are better together. The best performing strategies from the book were all combinations of several factors. Jim also makes an excellent case for combining value and momentum investing.

Finding an investment strategy that works is easy, it’s sticking with it that’s hard. Tadas Viskanta of Abnormal Returns recently blogged about this, writing:

“Strategies are easy to adopt. Almost too easy. The challenge is in following through with the strategy through thick and thin.”

I believe this is similar to finding a workout regimen that produces results. It’s easy to get hooked on running, lifting weights, yoga, or martial arts. However, you’ll almost inevitably reach a period of time when it becomes boring or your results lag, causing you to contemplate quitting. A diversified exercise program like P90x strives to avoid the moment when you want to quit by mixing up the routine.

The same can be said for a portfolio that diversifies across investment factors. No investment strategy works all the time. That’s a fact of life. By diversifying across factors, you can smooth the ride and also help fight the urge to abandon ship when a strategy goes through an inevitable period of underperformance.

Relative Strength Chart Configurations: Buy Signal In X’s

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As Tim shared on a previous video, point and figure relative strength charts can be configured in one of four ways. One of these configurations involves being on a buy signal and in a column of X’s.

What Does This Point and Figure Relative Strength Configuration Tell Us?

When a point and figure relative strength chart is in a column of X’s, it signifies near term outperformance versus its benchmark. When a point and figure relative strength chart is in on a buy signal, it indicates longer term outperformance versus its benchmark.

When a point and figure relative strength chart is on a buy signal and in a column of X’s, it is performing better than its benchmark on both a near term and longer term basis. This is the optimal relative strength chart configuration to seek for potential investments.

To quote a whitepaper on this subject written by our friends at Dorsey Wright Money Management:

“No matter how you look at the data, over long periods of time the stocks on point and figure relative strength buy signals and in a column of X’s are really where you need to focus.”

Source:

http://dorseywrightmm.com/sites/default/files/White%20Paper%20-%20PnF%20RS%20Signals.pdf