What Is Relative Strength?
Relative strength is a technique used in momentum investing and identifying value stocks. It consists of investing in securities that have performed well, relative to their market or benchmark. For example, a relative strength investor might select technology companies that have outperformed the Nasdaq Composite Index, or large cap stocks that are laggards against the S&P 500 index.
Technical analysts use an indicator known as the relative strength index (RSI) to generate overbought or oversold signals.
- Relative strength is a type of momentum investing used by technical analysts and value investors.
- It consists of selecting investments that have been outperforming their market or benchmark.
- Relative strength investors assume that the trend of outperformance will continue. If the trend reverses, their investment will likely perform poorly.
Understanding Relative Strength
While the goal of value investing is to buy low and sell high, the goal of relative strength investing is to buy high and sell even higher. As such, relative strength investors assume that the trends currently displayed by the market will continue for long enough that they can realize a positive return. Any sudden reversal to that trend is likely to lead to negative results.
To identify investment candidates, relative strength investors will begin by observing a benchmark, such as the Nasdaq Composite Index. They will then look to see which companies within that market have outperformed their peers, either by rising more rapidly than their peers or by falling less rapidly than them.
Because relative strength investing assumes that present trends will continue into the future, it is most effective in stable periods with minimal disruption. By contrast, chaotic periods such as the 2007–2008 financial crisis can be dangerous for relative strength investors because they can lead to sharp reversals of the previous investment trends. In those situations, investor psychology can suddenly reverse itself, with yesterday's investment darlings quickly becoming shunned by investors.
Although momentum investing is often associated with individual stocks, it can also be applied to whole markets or industry sectors using index funds and exchange-traded funds (ETFs). Similarly, investors can make relative strength investments in other asset classes, such as in real estate using real estate investment trusts (REITs). More exotic instruments, such as commodity futures, options, and other derivative products, can also be used.
Relative strength investing can also be used as one component of a larger strategy, such as pairs trading.
Real World Example of Relative Strength
Harry is a relative strength investor who keeps a close eye on corporate bond prices and the S&P 500. His investment portfolio consists of an S&P 500 index fund and an ETF that tracks the corporate bond market. As a relative strength investor, he periodically increases his allocation toward whichever asset is outperforming at that time. In doing so, he hopes to benefit from the continuing trend of that asset's outperformance, effectively buying high and selling higher.
In recent months, he has noticed that investors seem to be increasing their portfolio bond allocations at the expense of stocks. This inflow of money into the bond market has been raising bond prices and lowering yields.
Expecting this trend to continue, Harry responds by decreasing his investment in the S&P 500 and increasing his investment in the corporate bond ETF. He hopes to benefit from any ongoing outperformance of bonds relative to stocks.
Relative Strength Index (RSI)
Short-term and technical traders also look at relative strength. In technical analysis, the relative strength index (RSI) is a momentum indicator that measures the magnitude of recent price changes to evaluate overbought or oversold conditions in the price of a stock or other asset. The RSI is displayed as an oscillator (a line graph that moves between two extremes) and can have a reading from 0 to 100. The indicator was originally developed by J. Welles Wilder Jr. and introduced in his seminal 1978 book, "New Concepts in Technical Trading Systems."
Traditional interpretation and usage of the RSI are that values of 70 or above indicate that a security is becoming overbought or overvalued and may be primed for a trend reversal or corrective pullback in price. An RSI reading of 30 or below indicates an oversold or undervalued condition.
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