MONEY MANAGEMENT
Practical Uses Of Relative Strength
Can Relative Strength Be Used In Portfolio Management?
by John Lewis, CMT; Michael Moody, CMT; Harold Parker, CMT; and Andrew Hyer
The concept of relative strength is part of the foundation of technical
analysis, but can it be used successfully when it comes to portfolio management?
In its simplest form, relative strength
is the measurement of the performance of one item versus another over a
period of time. Dozens of formulations of relative strength have been proposed
by technicians, as well as others, over the years. One of the early mentions
of relative strength is from one of the masters of technical analysis,
Richard Wyckoff:
As your trend charts are made on transparent paper they may be laid
over other charts of groups or individual stocks to show which groups and
which stocks are stronger or weaker than the general market, as represented
by the averages. One of the best indications of the future course of a
group or a stock is its comparative strength when the rest of the market
is weak, or its comparative weakness in a strong market.
THE EARLY YEARS
Numerous other technicians including George Chestnutt and Sedge Coppock
made their own inquiries into relative strength. These technical analysts
were aware of how useful it could be, but their published works on the
topic generally lacked statistical detail. (Chestnutt may have preferred
the pudding to the proof; he was the manager of one of the best-performing
mutual funds of the 1960s.)
One of the first looks at relative strength in the early computer era
came from Robert Levy in his seminal work The Relative Strength Concept
Of Common Stock Forecasting. Levy used a moving average formulation of
relative strength and found that returns were far superior to the returns
of the universe of stocks. Seen as an assault on the efficient market theory
of the era, Levy's work was criticized in academic circles. Perhaps as
a result, few academic papers were published on the topic for years afterward.
More recently, relative strength has gotten coverage for a broader audience,
most notably in James O'Shaughnessy's What Works On Wall Street. O'Shaughnessy
gained access to the Compustat database and tested all sorts of strategies,
both value and relative strength, over a period from 1951 to 1996. Of his
rather conclusive results, O'Shaughnessy noted that, "relative strength
is one of the criteria in all 10 of the top-performing strategies, proving
the maxim that you should never fight the tape." He pointed out that the
worst strategy he tested was the anti-relative strength strategy of bottom
fishing and buying the 50 stocks with the worst one-year price performance.
...Continued in the September issue of Technical Analysis
of STOCKS & COMMODITIES
Excerpted from an article originally published in the September 2005
issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights
reserved. © Copyright 2005, Technical Analysis, Inc.
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