3 Oct

Relative Strength: Understanding the Concept

WRITTEN BY Sanmit Amin

Market Realist: Let’s get a little bit into your methodology. What is point and figure charting and what exactly is relative strength? A lot of people who want to use a product like this don’t know when or how to use it because there is a lack of understanding of the actual methodology.

Tom: Point and figure charting is a lost art that I resurrected almost 30 years ago. It was created by Charles Dow, who was editor of The Wall Street Journal, and it was called “figuring” in the late 1800s. It was simply a logical, organized way of recording the imbalance between supply and demand. In the end, if there are more buyers than sellers, price must rise. If there are more sellers than buyers, price must decline. If buying and selling are equal, price must remain the same – there is nothing else. So we built a multi-billion-dollar industry on the basis of the irrefutable law of supply and demand. The point and figure method was developed using Xs and Os (the X represents stocks rising, the O represent stocks declining). It’s the most simple method to understand, but the least used.

Relative strength is a natural extension of this. Relative strength is something that we have used for almost 30 years. It is a methodology of simply dividing one thing by another, so in other words, if I wanted to compare Pepsi Cola (PEP) to Coca Cola (KO), I would divide the price of Coke by the price of Pepsi, and once that division is done, the number is then generated, and you plot it on a point and figure chart of Xs and Os. The number that you drive for that plotting is done by dividing one thing by another.

So, you can see how it takes more work to do this, to create a relative strength chart. And that’s why 30 years ago, we could only do maybe 200 of those in a week. It was a rite of passage for an intern to do those relative strength charts. We knew they were important but we just didn’t have the computer systems  30 years ago to be able to run a large volume of these charts.

As technology began to advance and computers became faster,  we were able to do more of them. Then we came to the realization that relative strength is exactly where the answer is. We just couldn’t do it until technology allowed it. So as tech got better and better, we began to ratchet up the number of relative strength charts we did — first doing it on US equities, then starting to go around the world. Today, we probably chart 7.5 million relative strength charts every night. We compare everything to everything: we compare Indonesia to Spain, Spain to Malaysia, Malaysia to Hong Kong, Hong Kong to N. Korea or S. Korea, China. We compare everything, and the computer lays it out for us, exactly where the strength is and where the weakness is, because just like the point and figure chart, a buy signal is simply a column of Xs that exceeds the previous column of Xs, and a sell signal is simply a column of Os that exceeds a previous column of Os. Often in our ETFs, the reason for our outperformance is what we didn’t own, not what we owned.

Market Realist: In what kind of markets should these products be used? Where in the business cycle, for instance, should they be utilized?

Tom: That question implies that we understand where the business cycle is. That’s up for conjecture.

However, what our system allows us to do is easily set alerts for buy signals based on our model. For example, the building sector, after it had been totally decimated in 2008-2009, in late 2011 reversed up and gave a buy signal. That alerted us that the building sector was now the move, this is the long term picture, once we went into the building sector and started looking at the micro parts of it, we realized that you needed to buy everything that was related to building, whether it was lumber in the futures market, whether it was paint by Sherwin Williams (SHW), whether it was Home Depot (HD) which sold the paint, anything that had to do with housing was the play and we were able to get into this early only because the relative strength charts had turned positive vs. that, and we had the alerts set to be notified otherwise we wouldn’t have known.

Relative Strength: Understanding the Concept

Market Realist’s View:
The concept of relative strength

The above is an example of a point and figure chart comparing the performances of the SPDR S&P Homebuilders ETF (XHB) and the SPDR S&P 500 ETF (SPY) over the last ten years. The collapse of the real estate sector in 2007 caused XHB to nosedive by a jaw-dropping 80% in a matter two years while the dip in SPY was ~40% at its trough.

However, XHB saw increased interest post-2011. Increased buying pressure relative to SPY would have alerted portfolio managers to increase their exposure to homebuilders if they had used relative strength strategies.

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