It is not surprising that in this new era of rising markets (ushering out the good old mean-reversion days) that there has been a lot of discussion in the blogosphere about rotational “relative strength” models–most prominently by Jeff Pietsch of Market Rewind http://marketrewind.blogspot.com/2009/12/mrkt-rotation-model.html. Other links include BZB’s “Lazy Man’s Trading System (love the name!) http://bzbtrader.blogspot.com/2009/12/lazy-mans-trading-system.html and Bill Luby touches on the subject and provides some good links here http://vixandmore.blogspot.com/2009/12/some-approaches-to-trading-etfs.html. Of course the Livermore Index by yours truly is just another example–although this index makes no special preferences to strong or weak stocks and is a little more complex.
For those new to the term, “Relative Strength” or “Rotational Models” refer mainly to buying the strongest/fastest or best-performing members of a given group of investable assets. This can be measured by looking at “momentum” or the percentage change over a given time frame- generally at least 20 days, and preferably 6 -12 months. The assets with the highest relative strength will have the highest percentage change over a given time frame.
I have done a lot of research in this area and the first conclusion I can make is that it should be a major portion of any trader or investors portfolio strictly because it is so durable and robust. Whether its asset classes, sectors, stocks, commodities, currencies—-you pick a time frame over the last 40-50 years and this simple method of buying strength and selling weakness has outperformed traditional buy and hold strategies. This outperformance or alpha is also robust to most transaction cost assumptions. The implication from many academic studies is that a relative strength strategy will probably put you in the top 1% of all mutual fund managers (and hedge fund managers as well) when given a long enough time frame such as 5 or 10 years. If the effect continues to persist this is the easiest method in the history of investment strategy to beat the market–and logically it should continue to persist unless human beings become a lot more rational like Spock and a lot less (insert adjective here) like Sarah Palin. As we shall see, relative strength can also be driven by rational action too in my four-stage model explanation for relative strength.
How to Think About Relative Strength (101)
CSS Analytics Four-Stage Behavioural Model for Relative Strength
Based on my own observation and theory I feel that a simple four-stage model best depicts how relative strength occurs and why it takes time to develop rather than occuring instantaneously. The relative strength effect is driven by behavioural feeback loops where investors sequentially pour money into the asset du jour for a plethora of reasons including positive perceived fundamentals, psychological beliefs such as fear or greed, or for positive economic or default risk factor sensitivity. Essentially it starts when certain investors create a theory such as: “emerging markets will outperform because of the accelerated pace of development” and begin to accumulate investments in assets tied to this theory (Stage 1: the early adopters). As time goes on the theory itself becomes more widely known and the rationale becomes more widely accepted. Others quickly catch on and start investing in the same idea (Stage 2: recognition and acceptance). The next stage (and longest stage) is where initial investors wait for hard proof that the idea or theory is supported by tangible evidence in a variety of forms whether economic indicators, qualitative or anectdotal accounts to mention a few. (Stage 3: validation). The “Validation Stage” tends to last long as the early investors are looking for ongoing proof that supports or refutes their theory. The nature of economic data and other information sources is that they require multiple readings to establish that a trend is in fact statistically valid. This is why it is impossible for markets to adjust instantaneously even with purely rational investors. There are two paths the validation stage can take—either the evidence to refute the theory is strong , and as a consequence momentum will fail as early investors bail out. Or if the evidence continues to support and even exceed expectations, the early investors will add to their positions alongside the second stage investors. This added money flowcements the trend and the relative strength begins to really accelerate. At this point we reach the final stage where everyone agrees that a given market is and should go up and people are hopping on the bandwagon simply because the market is going up. This is both the fastest stage and the most rewarding per unit of time (Stage 4: mania).
Anchors and Planets: Understanding the Forces that Govern Relative Strength
The first question you need to ask about relative strength is: “relative to what?” Generally when looking at relative strength strategies involving stocks the best thing to do is to compare momentum to an index like the Nasdaq Composite or the S&P500. In this case the index is your “anchor” and all of the other stocks in the index are the “planets” that move back and forth rotating relative to this center of gravity so to speak. In the case of say all Petroleum commodities, the “anchor” would be Oil and the other “planets” would be gasoline, natural gas, and heating oil etc. Think of the anchor as being either conceptually or mathematically (or both) the aggregate index from which the planets are derived and gain their energy from. When the anchor itself is stable and/or rising, gravity is low and consistent in the force that it exerts on the planets. In this “zone”– free of restraints– certain planets can begin to accumulate relative strength in a highly predictable and persistent manner. Relative to the anchor, some planets begin to move faster than others and hence outperform . When the anchor is unstable and/or falling, gravity exerts a force that is so strong that it negates the effect of relative speed, and all of the planets are dragged down with the anchor in a volatile manner.
What can we derive from this discussion—in English or Trader terminology? When the anchor is below its trend–specifically when the anchor is 1 standard deviation or more below its 200 day or 252 day average, relative strength as a strategy should be abandoned in favor of other types of strategies. The same applies when the anchor is more volatile then average–such as when the historical volatility is high relative to previous measures during the year or previous years (note one can also use implied vol). There are of course more complex methods to track, but that is a good start. Conversely, the best time to engage in relative strength strategies is when the anchor is 1 standard deviation above its 200/252 day average, and volatility is below average. Of course another mitigating factor is in the form of intermediate overbought or oversold indicators which at extremes can also mitigate this effect. Thus it is ideal to bet more of an allocation when the market is not overbought and perhaps even a tad oversold. Mangaging the size of your exposure using an intermediate oscillator such as the DVI or RSI14 will help reduce drawdowns and improve returns.