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12 Days of Christmas – Day 7

12 Days of Christmas – Day 7

| June 05, 2018
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Thus far in our 12 Days of Christmas series we have discussed how we apply the Point & Figure Methodology to the direction of movement for securities, AKA “Trend Analysis.”  Another equally important component of the evaluation equation is “Relative Strength Analysis.”  Simply put, Relative Strength allows us to compare the price movement of two or more securities to identify which have the greatest magnitude of potential movement. 

Using Relative Strength as a way to measure leadership across multiple securities gives us a greater potential for outperformance than following just the price trend of individual securities.

Consider the following analogy:

Michael Johnson was the reigning world record holder with his time of 43.18 over 400 meters, for seventeen long years.  While none of the members of the Jamaican 4x100 meter relay team could make a reasonable stab at besting Johnson's 400 meter world record on their own, they did collectively demolish his time over the same distance.  Four sprinters, passing a baton among them, covered that 400 meter distance significantly faster than Michael Johnson ever could.  Simply put, four trends can be stronger than one. 

We utilize relative strength because of its demonstrated capacity to generate outperformance as an investment factor.  While we rely mainly on Dorsey Wright to advance the utility of relative strength for our clients, the concept of relative strength investing certainly did not originate with them.  Research conducted by James O'Shaughnessy, among others, has also established credibility for the process and shown that, over time, relative strength has been a driving factor in generating excess returns.  One study conducted by O’Shaughnessy and published in “What Works on Wall Street” found that “A $10,000 investment on December 31, 1926, in the top decile of stocks from all stocks with the best six-month price appreciation is worth $572,831,563 at the end of 2009, a compound return of 14.11% a year.  This return dwarfed an investment in the all stock universe, which turned $10,000 into $38,542,780 over the same period, an average annual compound return of 10.46%.”

It is also important to point out that O'Shaughnessy found that this relative strength portfolio outperformed the benchmark in 68% of single-year returns, 79% of rolling 3-year returns, 87% of rolling 5-year returns, 95% of rolling 7-year returns, and 98% of rolling 10-year returns.  Also, keep in mind that this is just a generic relative strength strategy based on a 6-month return factor with an annual rebalancing.

His book showed that using a 12-month relative strength factor also outperformed the benchmark with a compounded return of 12.34%.

Just in case you were wondering, a strategy based on buying stocks with the worst 6-month returns and then holding for a year had an annualized return of 4.15%!  As stated in his book, "If you're looking for a great way to underperform the market, look no further (than buying relative strength laggards)."

The Relative Strength calculation that we use does not go beyond basic arithmetic and the end result is nothing more than a ranking system.  Think about it like ranking your favorite sports team.  Every sport has a ranking system – from golf to tennis to baseball to football – and they are all based upon the same philosophy.   The better a player or team performs, the higher they go in the rankings.  When they start to lose, they begin to fall in the rankings.  We can affect the same type of ranking system based upon how an investment performs relative to others.  The more it outperforms the alternatives, the stronger it is.  When it begins to lose that strength, it falls in ranking. 

The actual relative strength calculation is very simple.  We take the price of one investment (stock, ETF, Mutual Fund, Index, etc.) and divide by another.  This number is then multiplied by 100, and then plotted on a Point & Figure chart like those we have previously discussed. 

Below is an example of a Relative Strength chart of a stock (Macy’s M) and an index (The S&P 500 Equal Weight Index SPXEWI), which serves as a market benchmark.  This chart is created by taking the closing price of Macy’s (M), dividing it by the closing price of the index, and multiplying by 100.  Each day, the resulting value is plotted on the Point & Figure Chart.  If we think about the mathematics behind that simple equation, an increasing relative strength value would tell us that the stock, Macy’s, is likely to outperform the index.  That could occur because the price of Macy’s is increasing at a faster rate than the price of the index; or, even if both were experiencing lower prices, as long as Macy’s isn’t falling as quickly or drastically as the index, our relative strength value may still increase.

As a result, when this chart is on a buy signal (a column of X’s exceeds the previous column of X’s) it’s telling us Macy’s is “winning” and has the positive relative strength.  In a world where we could invest in only these two options, we would want to own Macy’s.  On the other hand, when the chart falls to a sell signal (a column of O’s falls below the previous column of O’s), the index is the one with positive relative strength, and would be the better investment option.

Notice that over the last decade there have been only three signal changes indicating major shifts in the relative strength relationship.  Each signal has shifted us to the strongest investment option over that time frame as well. This is to say that the index outperforms Macy’s during the period of time the chart is on a sell signal (red highlight), and Macy’s outperforms the index during the life of the buy signal (green highlight).

We can compare any two investment options with daily price data in this manner.  We can use it to identify strength in stocks, funds, sectors, or even asset classes.  We are engaged in this analysis daily in order to provide the best risk-adjusted returns to our advisory clients.  This practice is consistent with our oft-stated objective of avoiding large losses.

Until next time, cheers!

Jim

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