We are going to be using Relative Strength to separate the winners from the losers in the market. What is so great about this kind of analysis is that it can be done in seconds. After a brief tutorial you will be able to look at any stock or fund or commodity, compare it to the SP500 or whatever asset you choose to match, and you will know it your stock is beating the benchmark or not. Very simple, cut and dried, and massively effective for your investment returns.
Lets take a look at a quick example of how we would compare two competing stocks:
1. Open a chart of one of the stocks in freestockcharts.com
2. From the "price history" tab select comparisons
3. Enter the symbol for the stock or index you wish to compare the stock to.
4 Click ok
Here I have done this with the price chart of Best Buy and compared it to Amazon
What this chart shows is the relative price performance of Best Buy vs Amazon (in white). This shows that over the last 8 years Best Buy's shares have gained 24%, while Amazon has grown by nearly 600%!
If anyone out there thinks Best Buy is a better choice for your portfolio, then you should just stop reading now and give all your money to someone else to manage for you. Yes there will be those who want to buy the beaten down Best Buy because its "cheap". Let me tell you that long term returns do not support that thesis as a successful investing strategy. The stocks that perform the worst tend to continue to perform the worst. Sure there are those that come back, but its much fewer than is acceptable for out sized returns. A stock that has been under performing its peers for more than 5 years is not getting cheaper, its getting worse and it will most likely end badly for the laggard.
Here is another example of this type of comparison
This is a look at Black Berry (formerly RIMM) vs Apple. Even after Apple's "crash" this year, it has managed to outperform by more than 2500%! Please don't try to be a hero and buy BBRY down at these levels. Just buy some Apple after this very generous sell off and sleep better at night.
The other way to compare stocks to each other is to use the Relative Strength chart from the freestockcharts.com indicator menu.
1. Choose your stock of choice
2. Select "Add Indicator"
3. Scroll down to "Relative Strength" and click
You will see the Relative Strength sub-chart below your normal price chart. The default is your stock compared to the SPY fund (fund that mirrors the SP500 index). When the line is moving up, your stock is outperforming the SP500, when its moving down its under performing. Very effective and yet the most simple indicator to choosing consistently winning stocks. If your goal is to beat the market (which mine is) this is the only indicator you will need to follow.
Just in case anyone thought I was giving Black Berry a raw deal by comparing it to one of the best growth stocks in our generation, here it is compared to the SP500 with our new indicator. Clearly the the relative performance in BBRY has been terrible since the 2008 peak; you would have been much better off just buying the SPY.
So here is where you want to apply this tactic into your investment ideas. Choose a stock you have interest in and after having looked at their company's financial standing, you are more or less confident they are not headed for bankruptcy. Then compare its long term performance vs the SP500. If its outperforming the SP500 over that period of time, then it passes the test and you can consider purchasing the stock for your portfolio.
Note: There will be times where you have an idea that is just so good you can't let it slip by regardless of its rampant under performance and you have no choice but to buy this dog of an asset. Just please make sure you don't allocate too heavy a position toward it. Blind speculation is ok as long as its kept to a reasonable level, no more than 10% of your total portfolio)
Here are a few of the winners I like for my portfolio:
Enbridge (ENB)
This thing is just a pure beast of a stock. I guess someone has to transport all that oil.
3D Systems (DDD)
DDD has been a monster over the past 3 years and I see 3D printing technology as a game changer.
Apparently I'm not the only one!
Cummins Engines (CMI)
While CMI hasn't been super over the past 2 years, the overall performance has been stellar.
Now, just because these stocks have done well in the past does not guarantee that they will continue in the future. But using the concept of Relative Strength in this simple way will generally keep you on the right side of the trade.
One last important aspect of using this method is understanding that things can change; when things change we have to change with them. Luckily (and I will expand on this further in the next post), the "Relative Strength" indicator will give you a definite signal that a shift is underway.
Lets revisit our Black Berry chart for a minute to explain. Things weren't always so bad for this tasty little phone company.
After trading between $17 and $35 per share from 2004 to 2007, the stock went parabolic increasing to over $150 per share. That rally created a spectacular gain for anyone invested in the stock and everything seemed peachy. Then in 2008 the stock crashed along with the broader markets and gave back nearly all of its gains from the previous 2 years. Now, if you were a Relative Strength investor, and were on the conservative side you would likely be inclined to hold onto those shares through the bad times that came. In late 2008 when the stock bottomed out, you could have drawn in your relative strength trend line (shown in white) connecting the lows from 2006 and 2008; you would still have an uptrend in out performance and now would know exactly when that trend breaks. Sure enough that trend did break about 18 months later and signaled under performance at a price of about $70 per share. If you had held onto the stock from the original purchase, you would have made a cool 350% on your investment.
However if you had chosen not to follow the "out performance" sell signal in the middle of 2010 (the trend support being violated) you would currently be losing roughly half of your money. That's a 350% gain vs a 50% loss...And that is with a very conservative trend line being drawn. If you were a little more trigger happy, like I tend to be, when the stock went straight up for a year I would likely have adjusted my trend line to lock in some of those outrageous gains. Following another simple trend line, the out performance ended in the 3rd quarter of 2008 and the trend line was broken at roughly $115 per share. That would have been an excellent signal to trim some position and take profits.
Sure it's easy to go back and look at charts in hindsight and see what we should have done. But I tried here to use an objective view of how this strategy can be implemented in actual practice. Would we know to exit right at that point? maybe not. Likely our emotions would have been running wild and we may have done something different. The point is that after using history as a guide and implementing this in real-time, I have found that it is a remarkably strong signal generator, both on the buy side and the sell side.
The purpose of using relative strength is to try to identify where the strong parts of the market are and moving your money away from the weakening areas and toward the stronger areas. Keeping yourself aligned with the strongest groups will surely help you on your way to investing successfully. Many individual investors don't invest wisely, whether its because of their mindset about the markets or the hot tips from that spamming penny stock ad that keep popping up in their email boxes. But those lost souls would improve their returns significantly, right off the bat, if they stuck to buying the strongest stocks in the market.
In the next post I will continue deeper into performance trend reversals and trading setups that I use everyday in my own portfolio management strategy.
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