What is Relative Strength?
Relative strength is a strategy utilized in momentum investing and identifying value stocks. This technique emphasizes investing in stocks or other assets that have exhibited strong performance relative to the broader market or a specific benchmark. For example, an investor might select technology companies that are outperforming the Nasdaq Composite Index or stocks exceeding the performance of the S&P 500 Index.
Technical analysts often use an indicator known as the relative strength index (RSI) to gauge overbought or oversold signals.
Key Takeaways:
- Relative strength is a key component of momentum investing used by both technical analysts and value investors.
- The strategy involves selecting investments outperforming their specific market or benchmark.
- Investors rely on the continuation of current trends, and any trend reversals could lead to poor performance.
Understanding Relative Strength
Contrary to value investing, where the goal is to buy low and sell high, relative strength investors aim to buy high and sell even higher. This strategy is dependent on the assumption that existing market trends will persist long enough to generate positive returns. However, sudden trend reversals can result in negative outcomes.
To identify investment opportunities, relative strength investors observe benchmarks like the Nasdaq Composite Index. They analyze which companies within the market have outperformed their peers, either by rising more swiftly or falling less steeply.
This approach is most effective during stable market periods with minimal disruption. During chaotic times, such as the 2007-2008 financial crisis, relative strength investing can be risky due to potential sharp reversals in investment trends, driven by shifts in investor psychology.
Momentum investing can apply not only to individual stocks but also to entire markets or sectors through index funds and exchange-traded funds (ETFs). Investors can also apply this strategy to other asset classes, like real estate via real estate investment trusts (REITs), and even more exotic instruments such as commodity futures, options, or other derivative products.
Strategies Employing Relative Strength:
Relative strength investing can be part of a broader strategy, such as pairs trading.
Real-World Example of Relative Strength
Harry is a relative strength investor focusing on corporate bond prices and the S&P 500. His portfolio includes an S&P 500 index fund and an ETF tracking the corporate bond market. Periodically, Harry increases his allocation towards the asset outshining the other. Recently, he noticed a trend of investors boosting bond allocations at the expense of stocks, driving up bond prices and lowering yields. Expecting this trend to continue, Harry shifted his investment from the S&P 500 to the corporate bond ETF, aiming to benefit from ongoing bond outperformance.
The Relative Strength Index (RSI)
Relative strength is also significant in short-term and technical trading. The RSI is a momentum indicator assessing recent price changes to determine overbought or oversold conditions in an asset. Displayed as an oscillator (a line graph moving between two extremes), RSI readings range from 0 to 100. A value of 70 or above typically indicates an overbought condition, suggesting a potential trend reversal or price pullback. Conversely, an RSI reading of 30 or below points to an oversold or undervalued condition.
Image by Sabrina Jiang
Related Terms: momentum investing, benchmark, technical analysis, relative strength index, value investing.
