One of our premier sources for technical information is NASDAQ Dorsey Wright. Last December, they published their annual series called The 12 Days of Christmas. In those 12 columns last December they highlighted major concepts from the video on our website (Link: We Are Not Your Old Stock Broker), and expanded on each in depth. I have been blogging about one of those 12 topics monthly all year and will wrap up in November. Again, my purpose is not to make you experts on tactical strategies, but merely to give you a sense of the process and diligence that we perform daily in order to help minimize the damage to you should a large decline hit the market and also to properly construct portfolios that help meet your goals.
Our topic this month revolves around Relative Strength Cycles and a summary of what Relative Strength is and is not. Every investment strategy, whether it is value investing, growth investing, fundamental, or even trend following, goes through periods of underperformance, and Relative Strength (RS) investing is no different. RS laggard periods can be uncomfortable, and looking in the rear view mirror at late 2015 and early 2016, serves an unfriendly reminder of this. It is important to understand that sometimes RS based strategies are not immune to periods of underperformance; however, we have found that the RS has tended to rebound out of these laggard periods, providing, at times, consistent and robust returns.
As is the case with any investment factor, Relative Strength is not a guarantee. It will not provide outperformance every day, week, month, quarter, or year; nor is that what it is designed to do. It is not designed to get you in at the bottom and get you out at the top. Instead, it is designed to allow you to participate in the “meat” of the move. It will force you to remain invested in strong trends and themes, even if your gut may be telling you the ride is over. Just as importantly, it will give you an indication to move to the sidelines when those trends do in fact come to an end.
The graphic above highlighting the "relative strength cycle" is the rolling six month excess return of the Dorsey Wright Technical Leaders Index DWTL versus the S&P 500 Index SPX. The DWTL is an index that is designed to select 100 stocks on a quarterly basis that exhibit high relative strength within a universe of 1,000 stocks. Going back to March 2007, you can see how there are periods where DWTL, or relative strength, underperforms, but it's often followed by a strong rebound. The periods where it underperforms are often around market bottoms as well as choppy market environments where most relative strength and trend following strategies struggle. There is no doubt that underperformance can be uncomfortable, and while not common, it is not unprecedented. But it is important to understand that these bouts of underperformance often present great opportunities. As new leadership trends rise to the top, these strategies tend to rebound up from a trough in the relative strength cycle.
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Until next time, cheers!