Relative Strength Beats Buying Cheap

When the market falls, the instinct is to shop for whatever fell most. It is down 40%, so it must be cheap. The stock that barely moved looks expensive by comparison and is passed over.

The record suggests that instinct is backwards more often than not, and the reason lies in what the two price behaviours reveal about who has been on the other side of the trades.

What “held up” is telling you

A stock that falls 5% during a 15% index decline has been bought, persistently, by people who did not need to buy anything that month. Someone with capital chose to put it there while nearly everything else was on sale. That is information about demand which no valuation ratio contains.

A stock that fell 40% over the same period has been sold by people who had a great many other things they could have sold instead. That too is information, and it does not say “bargain.” It says the holders wanted out of this more than they wanted out of anything else.

When the recovery comes, the first group tends to lead it. The buyers who were present through the decline are still present, and they are joined by everyone who noticed. The second group has to work through the sellers who had not finished.

Put simply, cheap is a statement about price relative to the past. Relative strength is a statement about demand relative to everything else, now. In a recovery it is the second of these that moves first.

What relative strength is not

It is not the RSI indicator, which measures a single stock’s momentum against its own recent history and has nothing to do with comparison. The overlap in names causes endless confusion.

Nor is it simply “the stock went up.” A stock rising 3% on a day the index rose 4% is weak, not strong. Relative strength is always measured against a benchmark, usually the index or the sector.

It is not a guarantee either. Leaders roll over. But as a way of deciding where to look, it has a far better record than the sale rack.

The list worth keeping

A reasonable habit in a falling market is a short list, rebuilt weekly, of the stocks in your universe that sit closest to their highs while the index sits furthest from its own. It is not a buy list during the decline; 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.

Run this exercise and the names on it will look expensive and rather dull, while the stocks one would buy by instinct are the beaten-down ones with dramatic charts. Six months on, it is commonly the dull list that has done the work, and several of the dramatic charts are still dramatic in the wrong direction.

Using it

1. During any market decline lasting more than a few weeks, rank your watchlist by distance from the 52-week high, or by performance against the index over the same window. The top of the list is your relative strength.
2. Do not buy during the decline. Watch. The list is being built by other people’s buying, and you want to see it hold.
3. When the index puts in a higher low and reclaims a level, buy from the top of the list, sized and stopped as usual, rather than from the bottom of the market.
4. Keep the beaten-down names on a separate list with a different question attached: has the reason they fell stopped? That is a fundamental question, and the value traps guide covers how often the answer turns out to be no.

Relative strength is one of the few things a chart can tell you that a spreadsheet cannot, which is why it belongs in the technical analysis section rather than the fundamental one.