It’s always interesting to talk to different investors. Many will be able to explain what they look for in charts. Individual investors are often looking for large price declines. They are often looking for value and believe that value is easiest to spot after a breakdown.
Professional investors often take a different view of charts. Rather than a variety of indicators, many professionals look for relative strength (RS) on their charts. This is an indicator that compares the stock on the chart to all other charts.
RS highlights whether a stock is outperforming or under-performing when compared with other stocks. This is a critical piece of information to professional investors.
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Professionals Have Well Defined Goals
It might seem that all investors share a common goal which is simply to make money. And, many individual investors do claim that is their primary goal. Professional investment managers will usually have a more refined goal. Their goal is to beat the market.
Now, that is an important difference in perspective. If an investor is trying to make money, it might make sense to buy stocks that are beaten down since sometimes they will turn around and deliver gains. But, it doesn’t necessarily mean that the stock will beat the market.
Professional investment managers will strive to beat the market. This means if the S&P 500 index, for example, is up 10% they will want to deliver returns of 12% or more. In a similar manner, if the S&P 500 index is down 10%, they may be trying to show a loss of 8%.
It might strike an individual investor as absurd to believe that a professional will accept a goal of losing less than the stock market but in a bear market, that is defined as success by professional investors. And, a well defined goal is a first step towards success.
RS Holds a Key to the Goal of Professionals
In order to beat the market, it helps to own stocks that are outperforming the market. This is an obvious sounding statement that summarizes the momentum anomaly to the efficient market hypothesis (EMH).
Research shows that, in general, as a group stocks that have been winners over the past six to twelve months have a tendency to continue leading the market over the next six to twelve months. That anomaly is often captured with RS calculations as the chart below shows.
This is a chart of General Electric (NYSE: GE). As the price fell, the stock became increasingly attractive to many individual investors. The blue line shows the RS. The declining RS tells investors there are better opportunities elsewhere in the market.
Now, the RS rank of GE under this system is 7 indicating that 93% of the stocks in the market are doing better than GE.
As a professional investment manager, holding stock that is performing in the bottom 10% of all stocks makes it difficult to beat the market. This is why RS is an important input to their decision process. They want to hold market leaders since that should contribute to market beating performance.
RS for Individual Investors
Individual investors may not follow RS simply because they don’t know where to find the indicator. It is not widely available on free web sites and many individual investors cannot afford the expensive data services that provide the indicator. Fortunately, there are some free resources that provide RS.
There are a number of ways to calculate RS and proprietary formulas are popular like the one shown above from investors.com.
In academic papers, the momentum anomaly is often measured by comparing performance. All stocks in the group are sorted by performance and the biggest winners are the high RS or high momentum stocks while the worst performers are low momentum group.
The chart below uses FinViz.com, a free screener available on the internet to sort large cap stocks by performance over the past year. GE is near the top of this list with the second worst performance.
This simple procedure provides enough information to make the decision of whether or not the stock is a market leader or a market laggard.
In this example, there are 693 classified as large caps. New buys could be limited to stocks with gains that place them in the top half of performance. It could be desirable to limit new buys to stocks in the top 10% or top 30% of this sort.
Studies generally use time frame of at least three months and up to a year. There are advantages and disadvantages to any calculation method, including the expensive data services.
Another source of RS for free is StockCharts.com. The chart below shows GE again and includes the StockCharts.com SCTR indicator. This line is in a downtrend and shows a value of 5.1. Although different than the investors.com RS value, SCTR shows a similar trend in RS.
The StockCharts Technical Ranks (prounced ‘Scooters’) are a relative strength metric which rates a stock’s technical strength against that of its peers. StockCharts offers several different SCTR-based reports. SCTR can also be added as an indicator to the chart of any stock as shown here.
Using RS does not need to be complex. It can rely on a simple and free quantitative screening tool as we demonstrated here. But, it will require time to find and manage trades.
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