Relative strength is not magic, it’s math!
“…the key to good performance is the ability to identify those stocks that are detracting from the performance of the portfolio. Most portfolio managers spend most of their time and effort trying to find the next big winner in the stock market but good portfolio performance depends more on finding and eliminating the bad stocks from the portfolio.”
Invest in markets, asset classes or sectors with positive trends. Avoid or sell markets or sectors with negative trends. This creates the possibility of preserving capital in declining markets or participating in rising markets/sectors.
“Numerous academic and practitioner studies have shown relative strength—also known in academia as “momentum”—to be a robust factor that leads to outperformance…Relative Strength and momentum strategies have been used by market technicians for stock selection for many years…There has been so much research showing that momentum works that academics no longer dispute its value as an investment factor.”
Research by Kenneth French, Ph.D. (of Fama & French fame) confirms that market strength is persistent. If one is willing to weed out weakness from a portfolio and rotate into relatively stronger performing stocks, portfolio performance improves significantly above the long-term average normally derived from Ibbotson data.
Momentum or Relative Strength, is a mathematical calculation allowing an investor to segregate portfolio holdings into tiers. Once identified, it is easier to make an objective decision to eliminate positions that are a drag on the portfolio.
After conducting a simple study, CXO Advisory concludes: “In summary, simple sector ETF momentum strategies have generally outperformed the broad stock market over the past decade for reasonably low trading frictions…Including ETFs representing other asset classes (such as bonds, commodities, equity styles and international stocks) may enhance results.”
As Dr. French (above) has written, the success of momentum strategies is hard to explain away. It has been an area of interest in the academic and finance communities for more than twenty years. At the very least, relative strength systems can provide natural stops for equity traders and additionally inform them as to which classes, sectors, styles and countries are running hot or cold in the current market environment. At their best, they can make for powerful trading systems in their own right.