Decoding the Market with Relative Strength
By John Jagerson and Wade Hansen, Editors, SlingShot Trader
After an incredibly bullish first six months of the year, everyone wants to know where the market is going to go in the second half of 2013. Of course, predicting where the market is going to be six months from now is an incredibly difficult thing to do.
Here are a few potential scenarios. The S&P 500 could:
- Churn around resistance at 1600 for a little while longer before finally capitulating and dropping back to 1500 or 1400.
- Battle resistance near 1600 before eventually moving on to new 52-week highs.
- Continue to consolidate until Wall Street figures out when the Fed is going to start “tapering” and how quickly that process will take place.
We admit, those are three fairly evident statements to make. The market could go lower, it could go higher or it could remain flat. Thank you, Captain Obvious.
But we make those statements exactly because those statements are always true. Sure, there are some times in the market where there is a greater chance stocks are going to move higher or lower, but there are never any guarantees as to which direction the market in general is going to go.
That being the case, one of the best things we can do is watch and see how individual stocks and industry groups are performing in comparison to the market as a whole. That’s how you sift through all of the information that is out there and determine where the market’s strengths and weaknesses really lie.
So how do you do that? How do you determine which stocks are the strong ones and which stocks are the weak ones? You conduct a relative strength analysis.
Relative strength is a comparison of the price performance of one stock compared to the price performance of another stock, or market index. Typically, investors will compare the performance of an individual stock to the performance of the S&P 500 to see whether the stock has been outperforming or underperforming the index. If the stock has been outperforming the index, it has a positive relative strength. If the stock has been underperforming the index, it has a negative relative strength.
Market technicians have actually come up with many different methods for calculating relative strength, such as the percent-change method, the alpha method, the trend-slope method and the Levy method. Each methodology has its strengths and weaknesses, but for our discussion here, we’re going to focus on the original percent-change method.
The percent-change method compares a stock to the S&P 500 by measuring how much, on a percentage basis, the stock has moved during a set period of time compared to how much the index has moved during that same period of time.
For instance, if you were to look at the performance of the S&P 500 during the past six months, you would find that the index (as of the close Tuesday) has gained 11.3% – based on the closing value of 1,426.66 on Dec. 24, 2012, and the closing value of 1,588.03 on June 25, 2013. Compare that to the performance of Charles Schwab (SCHW), which has gained 46.8% — based on the closing value of $14.33 on Dec. 24, 2012, and the closing value of $21.04 on June 25, 2013 — and it’s obvious that, even though the S&P 500 has done quite well, SCHW has had a better six months.
To determine the relative strength ratio of SCHW compared to the S&P 500, you simply divide the percent gain of the stock by the percent gain of the index. In this case, you would get a ratio of 4.14 (46.8% / 11.3% = 4.14). The higher the ratio, the stronger the stock.
Using Relative Strength Today
So how can we put this to use for us today? Going back to our “Captain Obvious” statements from earlier, we don’t know where the market is going to go during the next six months, but we do know where it has gone during the past six weeks. That’s right — it’s gone down.
But not all stocks have dropped. Some stocks have actually thrived during this period. Those are the stocks you want to identify and focus on moving forward if you want to buy stocks during the next six months. If a stock has had the strength to withstand this recent pullback, it will most likely have the strength in the coming six months to outperform the S&P 500.
Note: We are very careful to say “outperform the S&P 500” rather than “go higher” during the next six months because a strong relative strength doesn’t guarantee bullish movement. It simply puts the odds in your favor that the stock will do better than the S&P 500 in the near term. Here’s how it tends to play out:
- If the S&P 500 moves higher, the strong relative strength stock will most likely move higher at a faster pace.
- If the S&P 500 remains flat, the strong relative strength stock will most likely move higher.
- If the S&P 500 moves lower, the strong relative strength stock will most likely remain flat or move lower at a slower pace.
In any one of these three scenarios, holding the strong relative strength stock is typically preferable, but there are never guarantees of actual price gains.
There are 108 of the 500 stocks that comprise the S&P 500 that are actually higher today than they were one month ago. Of the top 50, 19 stocks are in the Financial sector, 10 are in the Healthcare sector and 7 are in the Technology sector. This gives us a pretty good idea of which stocks might be outperformers (useful as we evaluate potential call options in our portfolio) and which stocks might be underperformers (useful as we evaluate potential put options).