Whether you have $1,000 or you manage billions, the relative strength (RS) technique is a popular and useful tool for comparing one investment against the overall market. But few individuals ever manage to use the technique effectively because they fail to incorporate RS into a comprehensive trading strategy.

In this article, we'll define relative strength, explain why it works, and demonstrate how individual investors can employ RS strategies. This versatile tool can be applied to stocks, exchange-traded funds (ETFs), and mutual funds.

Relative Strength

The goal of investing is to sell something at a price that's higher than what the investor paid to buy it. The problem investors face is determining when prices are low enough to indicate a buy and high enough to decide that selling is the best choice.

Relative strength addresses this problem by quantifying how a stock is performing compared to other stocks. The idea is to buy the strongest stocks (as measured against the performance of the overall market), hold these stocks while capital gains accumulate, and sell them when their performance deteriorates to the point where they are among the weakest performers.

Relative strength has long been known as a valuable investment tool. Jesse Livermore, in Edwin Lefebvre's 1923 classic "Reminiscences of a Stock Operator," noted that "[Prices] are never too high to begin buying or too low to begin selling." In other words, stocks showing high relative strength are likely to continue increasing in price, and it is better, from Livermore's perspective, to buy those stocks than to buy stocks with falling prices. Since the time that Lefebvre wrote, there have been many discussions on the best way to calculate precisely when prices are high, on a relative basis, and when they are low.

One of the first quantitative calculations of relative strength appears in H. M. Gartley's "Relative Velocity Statistics: Their Application in Portfolio Analysis," published in the April 1945 issue of the Financial Analysts Journal. To calculate velocity statistics, Gartley wrote:

First, it is necessary to select some average or index to represent the broad market, such as the Standard & Poor's 90-stock Index, the Dow-Jones 65-stock Composite, or a more comprehensive measure...The next step is to compute the comparable percentage advance or decline of the individual stock in the swing...And finally, the percentage rise or decline in the individual stock is divided by the corresponding move in the base index and multiplied by 100, to give the "velocity rating" of the stock.

Velocity ratings are very similar to what we now call beta, the Nobel Memorial Prize-winning idea defined by William Sharpe. These steps also define the basic idea behind relative strength, which is to mathematically compare an individual stock's performance to that of the market. There are a number of ways to calculate relative strength, but all end up measuring a stock's momentum and comparing that value to the overall market.

After Gartley, it would be more than 20 years until another study on relative strength was published. In 1967, Robert Levy published a very detailed paper, which conclusively demonstrated that relative strength works (or at least that it did during his test period of 1960-1965). He examined relative strength over various time frames and then studied the future performance of stocks and found that those that had performed well over the previous 26 weeks tended to also do well in the subsequent 26-week period.

Applying RS

As an example of calculating relative strength, we can take the six-month rate of change in a stock's price and divide that by the six-month rate of change of a stock market index. If IBM has gone up by 12% over the past six months while the market, as measured by the S&P 500, has gone up by 10%, we would get a value of 1.2. An example of this type of chart is shown below.

As shown above, buying and selling based solely on RS trendline breaks would have proven to be a profitable long-term strategy. Buy signals are shown as up-pointing arrows. Sell signals are pointing down.

A monthly chart is shown because RS is best applied over a weekly to monthly time frame to avoid being whipsawed. In this example, buys are made when RS breaks a downward sloping trendline, and sell signals occur when a subsequent upward sloping trendline is broken. This technique would have required only three buys over the 15-year period, all profitable.

A more common application of RS is to rank order all stocks within an investment universe.

The first step in any ranking process is to calculate a value for RS. While the simple rate of change calculation works well, some investors prefer to use an average of the rate of change over multiple time frames, beta or alpha, which is a concept related to beta. The method used is not as important as consistently applying the formula. Rankings need to be done weekly to maximize gains and, just as importantly, to minimize losses.

Profiting From RS

The idea of ranking stocks by RS can help small investors to manage their retirement accounts. Many employers offer their employees a retirement plan as a part of a total compensation package. Many self-employed persons also maintain retirement plans because of the tax benefits and because they are an important part of an individual's overall financial planning. While traditional pension plans paid employees a percentage of their annual earnings after their retirement, rising costs forced employers to shift the burden of funding retirement to employees, resulting in the defined contribution plans currently offered at most companies.

Under a defined-contribution plan, employees contribute a portion of their total pay toward an IRA. The employer may match part of the contribution. The total contributions are invested, often in the stock market, and the returns on the investment, which ultimately may be gains or losses, are credited to the individual's account. Upon retirement, the balance in this account provides retirement income.

Most of these self-directed retirement plans include tax advantages. In exchange for the tax benefits, the government defines strict limits on withdrawals from retirement accounts before you reach retirement age. This makes retirement accounts truly long-term investments and means they should be managed as such. Long-term management makes these accounts the perfect vehicle to apply a relative strength strategy, seeking market-beating gains while being able to accept risk.

If we assume that the employer offers a typical range of investment options, there might be a dozen different mutual funds available. To actively manage this account, the investor can calculate the six-month simple rate of change for each investment option along with a market index each week. The RS trader would invest all of the money in the account in the fund with the highest value.

The decision on when to sell and buy something else can also be based on RS. To avoid whipsaws, you could hold the fund while it is ranked as No. 1, 2, or 3. If it falls to No. 4 or below in a given week, it should be sold, and the currently ranked No. 1 fund purchased with the proceeds. When more than 12 funds are used in the calculation, the cutoff rank can be set at 25% to 50% of the number of investment options.

Summary

Test results from studies such as the one conducted by Robert Levy illustrate the benefits of relative strength and prove that this method is worth exploring. The ability to use a relative strength strategy within a retirement account makes this strategy even more accessible to the average investor and it can be used by anyone looking to take an active role in managing their investments. As always, it's essential for investors to do their due diligence and consider their risk tolerance before implementing any investment strategy.

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