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By: Bill Spencer — April 27, 2019

Relative Strength Investing From The Ground Up - Part Two

Last week, we began talking about sector rotation investing by looking at how stocks are really traded in the market.

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We saw that the buying and selling by giant institutions is the engine that truly drives stock prices.

And we looked at how the media -- wittingly or unwittingly -- plays a role in this market drama.

Today let's peel the profit onion a bit by looking at one of the core guiding ideas behind sector rotation -- relative strength.

What Do We Mean By Relative Strength (RS)?

"Relative strength" can refer to many areas of trading that are completely different.  So we'll want to make sure we don't get confused here.

For example, Investor’s Business Daily has its RS ratings.  There is an indicator (that we’ll talk about in the future) called the “relative strength index (RSI)”.  Neither of those has anything to do with the relative strength idea we’re about to discuss.

For our purposes, relative strength is a measure of how well one particular index, sector, security or any investment vehicle is doing compared to... any other one.

Let's see some examples:

  • How is (say) NVIDIA’s (NVDA) stock performing relative to the stock market’s performance?
  • How is the Semiconductor sector (which NVIDIA belongs to) performing relative to the stock market’s performance?
  • How is NVIDIA performing relative to the Semiconductor sector’s performance?

You can do a relative strength comparison (the term-of-art is "relative strength study") that compares any one thing against any other.

You could, in theory, do a relative strength study comparing the popularity of The Big Bang Theory versus how happy people in Duluth are with their cable provider.

But I chose that particular set of studies, above, because those are the ones you'll focus on as you chase down lucrative trading ideas.

The Three RS Charts You Should Use To Find Strong Stocks

Relative strength studies can be charted on many brokerage platforms.  If you're using stockcharts.com, all you need to do is enter the ticker of the stock (or sector) you wish to study...

... and then the symbol for the other stock, or sector, or index you're comparing the first symbol to, separated by a colon.

So to compare NVDA to the S&P you'd enter: NVDA:$SPX.

Let's see what those relative strength studies look like once their charted.

Here's a relative strength study (a five-year chart) showing the performance of NVIDIA against the broad market (the S&P).

(Click any image to enlarge)

NVDAVsS&P

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Look at the beginning of the blue arrow.  It starts at around Feb. -- Mar. 2016, when  a new bull market began off of historically washed out levels.

At that point, the measure of NVDA's outperformance against the S&P stood at approximately 0.013.  (Relative strength studies are a study in simplicity.  All you do is divide the change in NVDA's price on a particular day to the change in the S&P on that same day.  Your answer, which math jocks will recognize as the "quotient", gets plotted on the chart.  Repeat forever.)

When the market topped out in October 2018, the measure of NVDA's outperformance against the S&P stood at .1, or a gain of 669% from the February level of .013.

That's quite a change.  And it illustrates a general tendency of relative strength studies.  If a stock... a sector index... and a market index were automobiles, the stock would be the fastest.  It's price can rise and fall dramatically.  A sector's price less so (because it's diversified, and for that reason gains and losses within the sector cancel out to some degree).

The ups and downs of a broader market index are the slowest and least dramatic of all, because the market index is even more diversified than a sector index, and contains even more individual members.

You'll see this tendency on display below, as we look at the relative performance of the Semiconductor sector versus the S&P.  As our proxy for the semiconductor sector, well use the VanEck Vectors Semiconductor ETF (SMH).

SemiconductorsVsS&P

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Between February and October 2018, the Semiconductor sector's measure of outperformance versus the market went from around .024 to around .036 -- a 50% increase.  Not even close to the 669% we saw with NVDA versus the market, above.

What do you expect we'll see when we study the performance of NVDA versus the Semiconductor sector?  If you said we'd see a change somewhere between 50% and 669%... you're right!

NVDAVsSMH

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Between February 2016 and the October top, the change in NVDA's performance versus the Semiconductor sector was +382%, from 0.56 to 2.70.

And here's something interesting.

Notice how, with NVDA versus the market, and with NVDA versus the sector...

... outperformance continued to trend higher until the October top.  Not so with the Semiconductor sector versus the S&P.

SemiconductorsVsS&P_WithDecline.

Semiconductors actually peaked in their outperformance against the market in April, and then declined some 12.5% between then and October.

In other words, we saw softening in the Semiconductor sector (off its high in terms of outperformance versus the market) before we saw NVDA weaken against the Semiconductor sector and against the market.

As I said, this idea of relative strength is one of the core guiding ideas behind the "True Market" method of investing.  So we're going to have a lot more to say about it going forward.

Have a great weekend everybody!

Bill

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