Relative Strength Beats Buying Cheap

When the market falls, the instinct is to go shopping among whatever fell hardest. Down 40%, therefore cheap. The stock that barely moved looks expensive beside it and gets passed over.

That instinct is backwards a good deal of the time, and the reason has less to do with valuation than with the question of who was standing on the other side of those trades while the decline was under way.

What “held up” is telling you

Consider a stock that gave up 5% during a 15% index decline, which is to say it lost money and still did better than almost everything standing around it. Through that period it was bought, persistently, by people under no obligation whatsoever to buy anything that month, which is another way of saying that someone with capital looked at a market where nearly everything was marked down and put money into that name specifically. No valuation ratio contains that.

Now the stock that fell 40%. It was sold by holders who had plenty of other things to sell. They sold this one. That is information too. What it says is that the holders wanted out of this more than they wanted out of anything else they owned, which sits some distance from “bargain.”

The recovery, when it arrives, tends to be led by the first group. Buyers present through the decline are still there, and everyone who has since noticed has joined them. The second group faces a queue. Sellers who never finished selling are still there, and they sell into strength.

Cheapness is a statement about price measured against the past. Relative strength is a statement about demand measured against everything else available right now. In a recovery, the second of the two moves first.

There is a rail at the back of every clothes shop where the reductions live, and plenty of shoppers walk past it without slowing down. The reasoning is that things end up there for a reason. It is not a statement about equities and it travels to them anyway.

What relative strength actually measures

The calculation is a ratio. Take a stock’s return over some window and set it against a benchmark’s return over the same window, normally the index or the sector the stock belongs to. A stock that fell 5% while the index fell 15% scores well on that measure. A stock that rose 3% on a day the index rose 4% scores badly, which surprises people who read only the sign in front of the number.

Two clarifications. The RSI indicator measures something else entirely, namely one stock’s momentum against its own recent history, with no benchmark anywhere in the calculation, and a shared word in two names accounts for a fair amount of the confusion.

The second concerns purpose. This is a screening tool and it belongs at the very start of a search, because leaders do roll over, sometimes abruptly, and a high reading tells you where to point the telescope while saying remarkably little about what happens next. As a starting point it beats the sale rack.

The list worth keeping

Through a falling market, a reasonable habit is a short list rebuilt each week: the names in your universe sitting closest to their highs while the index sits furthest from its own. Nobody should buy from it yet. The tide is still going out, and the broader market check says to wait. It is the list to buy from once the index turns.

Build it and the entries will look expensive and rather dull, while the charts one would be drawn to by instinct are the beaten-down ones with the dramatic shapes. Six months on, the dull list has commonly done the work, while several of the dramatic charts remain dramatic in the wrong direction.

Using it

1. Whenever a decline runs beyond a few weeks, rank your watchlist by distance from the 52-week high, or by performance against the index across the same window. The top of that ranking is your relative strength.
2. Do not buy during the decline. Watch instead. Other people’s buying builds the list. You want to see it hold.
3. Once the index puts in a higher low and reclaims a level, buy from the top, sized and stopped exactly as you would size and stop anything else.
4. Keep the beaten-down names on a separate list. Attach a fundamental question to it: has the reason they fell stopped operating? The value traps guide covers how often the answer comes back no.

Relative strength is one of the few things a chart will tell you that a spreadsheet will not, which is why it sits in the technical analysis section while the fundamental pages leave it alone.