Relative Strength, which is also known as momentum, provides us with a framework for identifying leadership, positioning your portfolio to invest in those leaders for as long as they remain strong, and adjusting when new leadership emerges.
Just like how any sport has a method of Ranking teams based on their past success, Relative Strength allows us to rank securities based on their history of outperformance.
Think about Relative Strength like filling out a March Madness bracket. The higher seeded teams are those that have performed best over the course of the entire season. Upsets happen, but they are hard to predict and the tournament is generally won by a team seeded near the top. Relative strength investing is built on the idea that we want to focus our investment among the securities that have shown the greatest ability to win up until now.
Calculating Relative Strength
There are many different ways to calculate Relative Strength, but Nasdaq Dorsey Wright uses Point & Figure Relative Strength charts as the foundation of our Relative Strength analysis. To develop a Point & Figure Relative Strength chart, we divide a security’s price by the price of a benchmark, multiply that number by 100, and plot the resulting value as we would any Point & Figure chart.
The Market Relative Strength benchmark used for most securities is the S&P 500 Equal Weighted Index (SPXEWI).
Relative Strength charts move a lot more slowly than standard Point & Figure charts that measure the movement of just one security. As you’ll see at the top of this chart, a Relative Strength chart can stay in the same column for multiple years.
This is by design- we use Relative Strength charts to filter out noise and focus on intermediate and long-term relationship between two securities. This means we’ve done just that and there is no short-term volatility clouding our view of that relationship.
Relative Strength Scales
There is a sweet spot for Relative Strength in the 6-12 month range, but since Point & Figure eliminates time from the charts, we use a chart’s scale to adjust the chart’s volatility and hone in on the intermediate relationship between a security and its benchmark. The goal is to find a box size that is small enough to pick up the intermediate term trend, but large enough to filter out the short term trading gyrations that lead to whipsaws. Much like the time-based methods, the returns suffer when the box size is too small or too large.
The default scale for RS charts on stocks is 6.5% and for RS charts on ETFs and Mutual Funds is 3.25%. Since individual stocks are more volatile than funds, we need a larger scale in order to filter out the short term market noise. This highlights a benefit of using Point & Figure for Relative Strength- being able to easily adjust the box size to match the universe you are looking to evaluate makes it a very powerful tool for constructing Relative Strength rankings.
This percentage means that there needs to be 19.5% relative outperformance between a stock and its benchmark in order to trigger a column reversal on an RS chart. This may sound like far too much, but relative price moves in this range exhibited the best long term performance in the testing we have done on box sizes. The magnitude of these moves indicates how important it is to stick with a strong stock during the dynamic part of its price appreciation cycle. We have noticed over the years that stocks with strong momentum characteristics are often volatile and are prone to sharp pullbacks before continuing to new highs.
Trying to “get out in front” of the trend change by using a smaller box size may seem like a preferable approach and will certainly work favorably in some cases, but the data indicates that periods in which this strategy will work effectively are hard to predict. As a result, a larger box size allows you to reduce the chances of selling a strong stock due to short term underperformance and missing out on additional gains. The disciplined application of the method is what drives the returns over the long haul.