Part Four: Relative Strength

The 5 Major Forces Affecting Your Investment Performance

by: Ben Crowley

1.Population

2.Supply and Demand

3.Asset Allocation

4.Relative Strength

5.Timing 

Part 4: Relative Strength

December 12, 2000... June 16, 2003.... July, 14 2008... April 9, 2009...

These four dates might not mean anything to any of you, but to me, they are game changing dates.  These dates proved to me (the most skeptical conspiracy theorist I know) that there is a magic bullet when it comes to investing.  Or at least, there is something close to a magic bullet... And I found it at the most unlikely place one would expect to find such information...  while working at a big brokerage firm.  You see most big firms are focused so diligently on the CYA (cover your a**) philosophy that they forget to manage assets. So there I was, in the the mecca of the buy and hold strategy universe, fresh out of school with my shiny new tool kit of financial information and no idea about ACTUALLY managing money.  

Sure, I went to business school, I studied finance and modern portfolio theory and asset allocation and the CAPM and valuation and accounting.  I know how to value companies and analyze data but this is not money management.  That stuff is important to somebody, but not to me and not to my investment strategy.  

I met and became fast friends with a lone wolf financial advisor who was actually MAKING his clients money back in 08 and 09.  Imagine that!  What I learned from this grizzled veteran money manger was that “Fundamental” information is important for helping you to decide WHAT to own, but it does very little to help you decide WHEN or IF you should own it.

I am also, as luck would have it, quite skeptical of "Technical Analysis".  I do not follow charts, or believe in them.  Using candlesticks, head and shoulders, hammers and all of those other charting patterns to guess what a stock price will do next is somewhat ridiculous.  The past does not determine the future and you cannot tell the direction of a stock price based solely on it's past price movements. Charting for charting sake is useless, BUT, in the investing world, you can tell something from performance, relative to something else's performance and the best way to do that is to plot it on a graph.  See: Point and Figure Charting, by Tom Dorsey for some a deep dive into the subject of Relative Strength.

Measuring Relative Strength allows me to know IF I should own something and WHEN I should own it.  Relative Strength compares the price performance of one investment with that of another.  Or another way to look at it is, “how well is this investment performing, in relation to this other potential investment?”  It tells me how an asset class or stock, or bond or ETF or Mutual fund is doing, TODAY, relative so some other metric.  

 The single most important metric in my portfolio decision making process is the relative strength comparison between the S&P 500 and the Money Market.  The Money Market is essentially benchmark for Cash and the S & P is widely accepted as the standard benchmark for the Stock Market.  Generally, the dollar and the stock market are negatively correlated.  That is, when one goes up in price, the other goes down.  So when the relationship between the two point to holding cash, you damn well better get out of stocks and play defense.  The four dates I mentioned at the top of this article are the ONLY four times this relationship has changed in the past eleven years.  When it does, you had better take action.  The chart below is a chart of the S&P since 1999 and I have plotted the four dates and the relationship change.  A buy signal means that the relationship between Cash and Stocks, favors owning Stocks.  A sell signal means that Cash is favored... a very defensive position.

This relationship is always going to be a few weeks or months after the top or bottom of a major market cycle, but I'll take as opposed to inaction or "Buy and Hold" any day. 


Now, let's do some quick hypothetical math.  If you used relative strength as your last line of defense and sold everything out on 12/20/2000 and waited out the down turn by sitting in Cash.  Your $100,000 account would have been blissfully sitting in a bank account missing out on 9/11 and all of the subsequent chaos in the market.  On June 16, 2003 your RS indicators tell you is is safe to jump back in and you are in the Markets until 7/14/08 where your 100,000 has turned into $126,000.  The summer of 08 is a bit rocky but the indicator switches in mid July and you pull out and sit in cash.  The market proceeds to crash nearly 50% but your nest egg is sitting in cash until April of '09.  Well after the bottom of the market back in March.  Today your $100,000 back in 2000 is worth $191,09... up nearly 100% just by reacting to the relationship of Stocks to Cash.


If you bought and held you are just about at 100,000, or the same as where you started... not counting for inflation.  If you sold in a panic twice, you are probably way behind, and god forbid you retired in 2007 and sold in a panic in 2009 with no discernible plan to get back in.


If you used this method to compare other asset classes you would have been a part of the great run up in commodities and emerging markets in the mid 2000's or would have bought gold at about the $550 an ounce mark or owned fixed income in 2002 and 2008.  If you had a plan and stuck to it... you would probably be up over 1000% and would not be reading this blog.  If you want a plan like this....  just 'follow' this blog and watch how I manage my portfolio.


Cash vs. the S&P is just the tip of the iceberg, but it is also the last line of defense.  Choose to ignore it at your own peril.


OTHER USES OF RELATIVE STRENGTH
I use relative strength to compare the performance of the six major asset classes.  I invest ONLY in the top two or three performers at any given time.  The one exception is if cash is performing better than everything... I will be in about 75% cash and will probably be shorting the markets using the short ETF's with about 25% of my portfolio.  


I use relative strength to compare sectors.  The US Stock market is made up of about ten Sectors.  The law of averages say that if the S and P is an average number, half of the sectors will generally perform better than the other half.  So, when it is time to be invested in US stocks, I want to own the 4 or 5 sectors that bring the market up.  I want the leading sectors, not the lagging sectors.  I use relative strength to compare all the sectors and then invest in the best ones.  


I also use relative strength to decide which individual stock to own.  I don't generally like holding individual stocks (another topic all together) but if the markets are really roaring sometimes I'll keep about 5% of the portfolio as "opportunity" money.  So I'll use it to compare  Apple or RIMM, Exxon or Conoco, GLD or SLV.  ....  etc.   In a good strong bull market, like the one we are in now, the question is not whether to own stock, it is which one is performing best. 



WHERE CAN I LEARN MORE?
Dorsey Wright is the best place to go.  For $25 bucks a month you can subscribe to their charting service online and do all the comparisons your heart desires.  (FYI, I am a subscriber to the Dorsey service.) They also have a ton of research and books on the topic.  Point and Figure Charting by Tom Dorsey is the bible on the subject.  I would highly recommend picking up a copy for a deep dive into the subject.  


If you have any specific question or want the formulas for figuring out relative strength, just email me.  Be sure to follow the blog and check the weekly portfolio updates and scorecard for any major portfolio changes.  


Happy Investing!