DO YOU WANT TO BET ON THE FASTEST HORSE OR THE SLOWER ONES?

DO YOU WANT TO BET ON THE FASTEST HORSE OR THE SLOWER ONES?

Not much of a question, is it? The Author has never been given this option at the betting window and neither has anyone else. We are usually left to the old gambler’s saw, “You never know until you bet.”

But investing is not gambling, at least not if done with competence and consistency.[i] With knowledge, experience and good tools, one can select investments that will outperform their respective markets. One of these measures is relative strength. Relative strength is a method of picking out the faster ponies. And knowing when to jump off of them before they run out of steam.

The Author’s investment methodology uses relative strength of an individual stock relative to its sector and a sector’s relative strength compared to the overall stock market. Stocks and sectors with greater relative strength will be those that the Author screens for his investments.

An article in the September 2005 edition of “Technical Analysis of Stocks and Commodities” looks at using relative strength of stocks to direct portfolio management. The title of the article is “Can Relative Strength be Used in Portfolio Management?” [ii]

The authors of the article conducted a study using relative strength to construct portfolios and then compared them to the underlying benchmark. The universe of stocks they used was the S & P 900 index. Their underlying benchmark was an equal-weighted return index of the S & P 900, not a capitalization weighted index that would skew the results toward the larger stocks in the index.

The methodology of the study is detailed and will not be addressed in this post due to brevity and boredom-inducing reasons. But basically, the authors tracked stocks with the highest relative strength using two different measures. The first were stocks with relative strength in the 90th percentile. The other used stocks whose then-current price where furthest above from their six-month moving average price. When the stocks fell from their high relative strength positions, they were sold and different stocks were added.[iii]

Both formulations were developed to pick out the strongest stocks, and both tests produced returns that often doubled the return of the underlying benchmark. All tests produced returns that were over 80% better than the underlying benchmark.

Using only relative strength as a stock selector might screen out other good investments. But the study does demonstrate that the model works and indicates that anyone wishing better investment results should consider relative strength approaches in their investing decisions.

WE ONLY WANT WINNERS IN THE DESERT OF THE REAL!

IMPORANT DISCLAIMER: This newsletter is offered for informational purposes only. Sources of information provided are believed to be reliable, but are not guaranteed to be complete or without error. Opinions and suggestions are provided with the understanding that readers acting on information contained herein assume all risks involved. The Author may or may not buy or sell securities discussed in this newsletter

[i] The Author is troubled when he hears ostensibly educated or sophisticated pundits analogize stock market investing with gambling. The most recent spate of this disinformation occurred in the debate surrounding the ill-fated Bush Social Security “reform” proposal that included provisions for “private accounts”. There are strong policy and financial arguments against the plan, but stock investing and gambling analogies were hyperbolic.
[ii] Technical Analysis of Stocks & Commodities”, September 2005, p. 25. DISCLOSURE: The authors of the study are affiliated with Dorsey, Wright & Associates. The Author uses the Dorsey Wright methodology in his investing. However, he has no financial relationship with Dorsey Wright & Associates and pays for these services just like any other poor shlub.
[iii] Turnover in the test portfolios was extremely high, however. About 100%, on average, in the 90th percentile test, and from 200-400% in the six-month moving average model.