By: Spencer Israel
Last week we wrote about the Relative Strength Index (RSI) and its usefulness as a technical analysis tool for analyzing individual stocks.
RSI is often confused with a concept called relative strength, though the two are completely different things. If RSI is a tool in your toolbox, then relative strength is an entirely separate drawer.
What Is Relative Strength
Relative strength is simply a way of looking at the market by comparing the performance of one asset to the performance of another.
This comparison can be made for any assets that have any sort of historical relationship or correlation, such as one stock to another, a stock to an index, or a stock to an ETF that holds it.
The idea is that this comparison provides context for how two related assets correlate over time and can help identify when that correlation may change or if one asset is disproportionately outperforming or underperforming the other.
Observing Relative Strength
One way to see this comparison is to quantify it. The easiest way to quantify relative strength is to divide the price or percent return over a given time of one asset by the price or percent return of the other.
So, for example, if shares of Pepsi ($PEP) are up 10% over the course of a month, and shares of Coke ($KO) are up 20%, then we can say Pepsi’s relative strength to Coke is 0.5. In other words, Pepsi has been half as strong has Coke.
More commonly however, relative strength can be observed via the eyeball test. Just looking at two assets side-by-side can often be enough to see it.
For example, if shares of Microsoft ($MSFT), the largest holding in the S&P 500, are down 2% while the index is down 3%, then we can say Microsoft is relatively strong for the day.
The more we use relative strength to compare performances, the more clues we can get about market sentiment. If on that same day, Apple ($AAPL), Google ($GOOGL), and Facebook ($FB) are all down 2% along with Microsoft, then we can safely say that, for whatever reason, technology is in favor relative to the rest of the market for that day.
There are several other ways of observing relative strength. Investor’s Business Daily is known for having its own proprietary Relative Strength Rating that tracks a stock’s price over the previous 52 weeks and compares it to the performance of all other stocks.
Using Relative Strength
The simplest way to use relative strength in your daily trading is to keep an eye on the major market meters—the S&P 500, bond yields, gold—and major foreign markets like China to get a feel for what the general market sentiment is. You can then drill down into the 11 individual sectors to understand what’s in favor and out of favor in the U.S. market, or drill even deeper by looking at specific industries. At a micro level, you can compare the performance or related companies.
As you observe these daily relationships over time, you’ll learn to identify when they change in different market conditions and when their correlations get out of whack, allowing you to trade off those inefficiencies.
The author is long all the stocks mentioned above in his 401(k).
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