Our portfolio management strategy at Mullooly Asset Management has two main parts: point and figure charting and relative strength. Relative strength is also referred to by academics as the momentum factor. To put it plainly, relative strength (or momentum) is the phenomenon that securities which have performed well relative to peers on average continue to outperform, and securities that have performed relatively poorly tend to continue to underperform. We focus on two types of relative strength, peer relative strength and market relative strength. Our friends at Dorsey Wright and Associates have taught us a great deal about both. In this podcast, Tom and I explain these two types of relative strength.
It’s often easier to understand topics when they’re explained through analogy. Peer and market relative strength can be easily understood by talking about golf.
Peer Relative Strength
Let’s say you and three friends played a round of golf today. You had an excellent day and shot a 71. Your friends also played well, but couldn’t quite keep up with you; their scores were 74, 82, and 85. In this scenario, you have the best peer relative strength because your score was better than your friends. Having the lowest score in your golf group means you were the best golfer that day. Your peer relative strength was strong.
Market Relative Strength
Using the same example, let’s think of the golf course as the market. Each course has a par score. The course you played with your three friends has a par of 72. Since you scored under a 72, you have positive relative strength against the course. Your friends have negative relative strength against the course because they were unable to score under par.
In the example above, you have positive peer relative strength and positive market relative strength. You not only outperformed your friends, but also outperformed par for the course. When we’re analyzing potential investments we take a similar approach. We want to invest in stocks, ETFs, and mutual funds that are performing better than their peer groups and better than the overall market.
What do we mean by peers?
When discussing peer relative strength, the “peers” can vary depending on what type of investment we’re analyzing. We can measure all of the stocks in the S&P 500 against one another or all semiconductor stocks against one another. We can also compare all the healthcare ETFs to one another or compare all small cap mutual funds to one another.
What do we mean by the overall market?
Just as the “peers” can vary, so can the overall market. Often we will compare stocks against the equal-weighted S&P 500. We can also compare bond funds against AGG (the aggregate bond index) or ETFs to IYY (the Dow Jones US Index). The idea is to compare a stock, mutual fund, or ETF to a similar broad market index.
Just as we can identify the strongest golfer in a group by comparing their scorecards to each other and par for the course, we can identify investments with the best relative strength by comparing them to their peers and the overall market.