Relative strength study

In early July ’99 I started sending lists to customers of stocks that I categorized as in uptrend or downtrends utilizing the relative strength point and figure charts produced by Market Dynamics. The lists quickly became very large and in the study I will discuss each list included slightly more than 300 stocks.

I was primarily interested in the tendency of relative strength to persist. Did the uptrends list outperform the S&P 500? Did the downtrends list underperform the S&P 500? Did relative strength persist for days or months?

I calculated the percentage price change for each stock on each list from the day after the list was sent out – from July 19, 1999 til the close on May 1, 2000. There were no changes from the original lists – no additions or deletions.

Average % change number of stocks

Uptrends list +43.15% 330

Downtrends list -.71% 305

S&P 500 +4.31%

The 45-degree bullish support lines and the bearish resistance lines were an important factor in the analysis and the selection for each list. The lists were actually e-mailed to my customers on July 18, 1999. The samples were very large and the differences between the means of these samples were also quite large. At least for the time period covered there seemed to be a very strong tendency for relative strength to persist. In my opinion, the persistence is very important.

The ability to determine the direction of the relative strength trend seems to be a very useful tool. I have to admit that it probably won’t work in all markets, for all stocks and at all times. There probably is no tool available that could stand up to a requirement as
rigorous as that.

Other research has suggested the usefulness of relative strength and I think my work confirms the effectiveness when relative strength is used in a point and figure format. It does seem to provide an edge that while not perfect, is, nonetheless, useful.

Positive turnover

Trading tactics must be subservient to longer-term goals -Retain winners as long as performance lasts- sell losers and reinvest in potential winners- Negative turnover is doing the opposite. Most portfolio managers think about turnover in a negative sense. If you could enhance the appreciation potential of the portfolio at a rate more substantial than the cost of transactions and taxes then that would constitute positive turnover.

When I discuss relative strength with potential clients the objection of increased turnover almost always comes up. If the turnover produced by the application of relative strength means that you hold your winners and sell your losers then it has served its purpose. I believe most portfolio managers tend to do the opposite – they sell winners and hold/add to losers – which is negative turnover to me.

Peter Lynch said “its like pulling the flowers and watering the weeds”.

Too cheap to sell!

It is unbelievable how much performance is lost because a portfolio manager makes the judgment that a stock is too cheap to sell! There is a great temptation to hope that a fallen stock will come back and “duds” are often held long after the hope should have materialized.

I think we would all be better off if we didn’t use the word too when evaluating stocks. Too high, too cheap, too far, too fast, too low etc.

By W. Clay Allen CFA