Welcome back all! Today I would like to start discussing a topic that we have looked at in some of our chart analysis but haven't really gotten too deep into. Relative strength analysis is my primary guide through the markets and individual stocks. What is relative strength? Quite simply, it is the performance of one asset vs another over a particular period of time. Why is it important to know how one stock is performing versus another? It is important to know which stocks are performing strongest and which are the weakest. Why would you want to buy the stock whose price is being destroyed, while its competitors are moving higher? I would hope you wouldn't want to buy those, I would hope that you would want to put your hard earned savings into the strongest most stable performers.
While relative strength analysis can be applied to any asset vs another, I prefer to compare all of my stocks' performance against the SP500 index. I feel the SP500 index represents the "Market" best overall and our goal as individual investors is to achieve gains on our investments that beat the Market's returns. That is why you see many of the charts I post with a comparison chart beneath the general price chart. That comparison chart is always showing the relationship of the stock in question vs the SP500 fund, the SPY. For most retail investors, the SPY is the vehicle that can be easily purchased and traded that reflects the performance of the SP500 index; therefore the SPY is the benchmark I am trying to beat on a yearly basis.
There are many in depth studies showing the value of using relative strength analysis for choosing your investments. I will hope you will take my word for it that using relative strength will significantly improve your overall returns. But if you don't believe me, go take a look through James P. O'Shaughnessy's book "What Works on Wall Street" for a ridiculously thorough analysis on relative strength investing. But the basic gist of relative strength investing is that buying the best performing stocks creates a much stronger return than buying stocks with the weakest. There are many investors that preach the buy low, sell high mantra. The only problem with a strategy like that is that by its very nature you are buying stocks that have been getting clobbered and are out of favor with The Street. There is the bent logic that those stocks are simply cheaper now than they were before, and buyers like discounts. However, a stock that has been getting cheaper for several years is not getting cheaper, its getting worse. A stock's performance will give you a pretty good idea of how investors feel about the future prospects of the underlining company; and you want to put your money into the leading companies, not the ones who are dying.
An analogy I like to use to describe relative strength investing is the concept of a horse race. Imagine you are at the race track and are betting on the ponies. You place your bets, take your odds and hope your horse comes out the winner or near to it. That strategy is analogous with "buy and hold" investing strategies. You place your bet and hope those stocks turn out well in the end. What if you chose wrong in the beginning? Your returns will suffer and you may not achieve the investment goals you set out to. Now imagine that while you are watching this horse race, you had the ability to change your bet after the first turn, then again after the second and even as they are coming down the home stretch! You would increase your chances of coming out in the end with the winner huh? Relative strength investing gives you the opportunity to adjust your positions so you are always backing the best performing companies and in turn gaining those more significant returns.
The concept of relative strength investing is too large to cover in one post. I plan on showing different ways to use relative strength within your own investment plans in future posts to come.
We will discuss long term relative out performance trends, standard use of relative strength for asset allocation plans, and breakouts and breakdowns of relative strength trends for trading.
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