Relative Strength
What is it and why should investors care?
When a technician refers to relative strength, it is not to be confused with the popular technical indicator the Relative Strength Index (RSI) created by the late J. Welles Wilder. RSI is a momentum indicator that compares a security’s strength on positive days to its strength on negative days. You can learn more about the indicator here and here.
Relative strength is the study of one index or security’s price change versus another index or security’s price change. For example, we have two stock price indices - The Russell 2000 Index (A) representative of US Smallcaps and the S&P 500 Index (B) representative of US Largecaps. We’re seeking to analyze the data series of A divided by B, gaining insight into their relative price behavior through various points in the economic cycle.
Blue line = (A / B) Russell 2000 Index vs. S&P 500 Index
Red line = Gauge of US economic activity (ISM Purchasing Managers Index)
When the blue line is trending higher (lower), the Russell 2000 Index is outperforming (underperforming) the S&P 500 Index. It’s important for investors and portfolio managers to understand the relationship between the two indices. Are they behaving as expected based on observations of past cycles? Does it pay to be overweight Smallcaps given current condition of the economy? These are some of the questions we’ll ask ourselves.
Even more popular is the comparison of an individual security to that of the market or a sector index. When applied in this way, the analyst will ask him or herself, “Is the price behavior witnessed on an absolute basis confirmed on a relative basis?” Let’s take a look at a nameless US Large-cap Technology stock and its corresponding relative strength chart. The numerator in this case will be the individual equity security (A) and the denominator will be the equal-weight US Large-cap technology sector (B).
Purple line = (A) absolute price of individual equity security
Blue line = (A / B) individual equity vs. sector benchmark
Something very important occurred in 2018. The absolute price chart and the relative strength chart began to diverge. Absolute price (purple line) continued to form new highs, whilst the relative strength chart (blue line) formed new lows. By owning this security, you are underperforming on the sector level i.e. you own one of the weaker stocks that make up the sector. This is important information. Divergences between absolute and relative price charts speak to strength of trend. Since 2018 the stock has gone nowhere and continues to form new relative lows.
If you own an individual equity and it has consistently underperformed its sector, maybe it’s time to consider swapping out the individual equity and just owning the diversified sector index.
Taking on more risk (volatility) and reducing your average return? That doesn’t sound too attractive. Below is a comparison of the individual equity and the sector benchmark’s rolling 1-month realized volatility. Talk about higher risk, lower reward…
Relative strength is a simple, yet powerful tool. It speaks to the value of data visualization in finance and investing. Well, that’s enough out of me. Questions or comments? Let us know!
SM