• February 1, 2023

Relative Strength Investing Trends: The Great Rotation

J.ohn Lewis, CMT, shares insights into notable leadership changes in the market, including improvements in many sectors of the market that had previously lagged. He also takes a look at various market width metrics to measure the overall health of this market and shares some key insights into implementing relative strength strategies.

What’s hot … and not

How different the investments have been over the past 12 months, six months, and one month. The global nature of financial markets has never made it easier for investors to invest in the strongest trends wherever they are in the world. Relative strength provides a disciplined framework for mapping to these trends. The markets are global and so should your portfolio. As of 03/11/21:

Past performance is not an indication of future results.

See details in Appendix A., including the ETFs and indices used for this performance table. The performance numbers include dividends, but not all transaction costs. Investors cannot invest directly in an index. Indexes have no fees. Past performance is not an indication of future results. The profit potential goes hand in hand with the possibility of a loss.

Fund flows

Estimated total inflows into long-term mutual funds and net exchange traded funds (ETFs) issuance collected by the Investment Company Institute.

Net-net cash flow

See details in Appendix A..

Sector and capitalization performance

Sector performance |  Capitalization performance

Past performance is not an indication of future results. As of 03/11/21

See details in Appendix A..

High RS diffusion index

As of 03/11/21:

High RS diffusion index

The 10-day moving average of this index is 36% and the one-day value is 41%. This index measures the percentage of high relative strength stocks (top quintile of ranks) trading above their 50-day moving average. Pullbacks in this index have often provided a good entry point for new money into relative strength strategies.

See details in Appendix A..

Relative strength distribution

The following graph shows the spread between the relative strength leaders and the relative strength retarders (universe of mid- and large-cap stocks). When the chart rises, the relative strength leaders outperform the relative strength laggards. As of 03/11/21:

RS spread

The RS spread has been falling over the past few months as we have seen the RS laggards continue to outperform the RS leaders. If this strength continues, many of the RS stragglers will continue to climb the ranks until they become the new RS leaders.

See details in Appendix A..

Q&A with John Lewis, CMT

John Lewis, CMT, is a senior portfolio manager at Nasdaq Dorsey Wright and has been with the company since 2002. In these questions and answers, John provides insights into important market developments.

What are some of the key market breadth metrics that you are following and what indicators are pointing to them today?

We look at a number of market indicators at Dorsey Wright. One of our favorites is the NYSE HILO indicator, which measures the percentage of stocks making new 52-week highs versus new lows. This indicator is currently very optimistic. There are a lot of stocks making new highs. There were 511 new highs on the NYSE on March 11th. That is the highest sum since May 2013. If we filter out clusters, it is only the 9th time since 1980 that we have such a high sum! The average returns after 12 and 24 months were very good when we have such conditions. We also want to look at the percentage of high momentum stocks trading above their own 200 day moving average. This is an indicator that gives some insight into the health of the specific types of stocks our models tend to buy. This indicator is also very optimistic at the moment and is around the 90% mark. We have seen a lot of rotation at the sector and capitalization level, but the overall market picture is positive. We believe that replacing stocks will continue to be very important as they collapse and continue to morph into new leadership. But the extreme numbers that the aspiring leadership should have should be able to carry the broader market higher as the old leadership fades.

If you turn the clock back to when you developed the tactical fixed income strategy, what factors / goals led the strategy to be designed as it is?

Tactical Fixed Income is an interesting strategy because we view the fixed income market so differently from most managers. We use a simple trend that follows the method rather than doing economic forecasting or individual credit analysis. This works very well with the kind of “risk-on-risk-off” method that we adhere to. Three things really drove the construction of this strategy. First, we believe that riskier bond sectors will outperform until they don’t. We try to avoid the “until they don’t” part by jeopardizing the strategy at certain times. We’ll never get every risk-off step right, but we believe there are significant opportunities to be active and over time we’ll be right enough to perform well. The second thing we had to consider was the different economic conditions that existed over time. Interest rates rise and fall. The economy is expanding and shrinking. Different types of bonds do well in different conditions, and we believe we have given ourselves good opportunities to find strength in a number of different environments. The last thing that drove the development of the strategy was the realization that bond markets are extremely complex. So we just had to let the market tell us what to do. By studying price developments and following trends, we can reduce all the noise and focus on what matters most: price movements.

Can you speak to some of the notable leadership changes you see from a sector, style, asset class, and capitalization perspective?

There have been massive changes in leadership in recent months. Investors have been waiting for the “big rotation” and we may be in the early stages. Large-cap growth and technology have been the main leadership for years. That changed quickly. Technology stocks have fallen, and we’ve seen energy and finance move to the top of the rankings. The growth and value of small caps have also moved to the top of the style rankings. This has resulted in a number of changes in our strategies and we have had higher than normal sales so far this year. These types of changes take time as old leadership gradually fades and new strengths emerge.

Can you tell us how your experience of testing relative strength strategies over the years has influenced your decisions about the tradeoffs in using a more sensitive and less sensitive measure of relative strength?

All relative strength strategies need a way to filter out the noise. The whole purpose is to trade the trend and ignore as much noise as possible. It’s much easier said than done. Financial markets are volatile and there are a lot of short term medium reversals. This noise can be filtered out in a number of ways. In terms of the relative strength of the point and figure, the box size becomes the noise filter. When you use a price lookback, the length of that lookback becomes the filter. If you look at last month’s pricing data, you will be trading much of the noise. Sure, you will be able to adjust your stocks quickly as things change, but there is so much short-term mean reversal that you will be making too many changes. The sweet spot for stocks is typically six months on the short end and twelve months on the high end. People tend to think that looking at 12 months of price history, for example, is just too long to make changes. However, all the data we’ve seen shows that you need to be ready to make your winners work for you, going through their ups and downs over time. Let’s face it – big winners don’t grow on trees or this business would be extremely easy. So when you find one, hold onto it for a dear life because all you need is a few to last your entire year. Eventually, you have to part with the named winners, but it’s usually not as quick as you think. If you allow your winners to work for you, there will be times when you should have sold sooner and you will look for reasons why you should have sold. The reality is that you will never be perfect. The data shows that giving your winners the benefit of the doubt pays off in the long run. If you don’t, you will be trading in short-term noise and will be killed by the paper cuts.

The relative strength strategy is NOT a guarantee. There can be times when all investments and strategies are unfavorable and depreciate in value. Relative strength is a measure of price momentum based on historical price activity. Relative strength is unpredictable and there is no guarantee that any forecast based on relative strength will succeed or outperform any index, asset or strategy. There is both a loss and a profit potential in all securities transactions.

Other sources of relative strength

  • Brush, John S. “Eight Relative Strength Models Compared.” Journal of Portfolio Management (1986).
  • Berger, Israel, Moskowitz. “The Case for Momentum Investing.” AQR Capital Management. 2009.
  • Jegadeesh and Titman. “Returns to buying winners and selling losers.” Journal of Finance (1993).
  • O’Shaughnessy, James P. What Works on Wall Street. McGraw Hill, 1997.

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