Duelling Fools - Relative Strength - The Bull Case
By Nigel Roberts (TMFNigel)
Chippenham, Wiltshire -- Relative strength strategies have gained increased attention here at Fool UK, and many of us have marvelled at the work carried out by Paul Marshall (TMFJonnyT) on relative strength strategies on the FTSE 100 Index and been impressed at the returns that he has shown. I have become convinced that using relative strength strategies is a sure way to guarantee long-term market beating performance.
So what is relative strength?
Investing in shares based upon momentum, or "relative strength", is grounded on a simple premise -- winners continue to win, losers continue to lose. It is simple in that it only requires information related to historical stock prices. The premise seems to me to be reasonably intuitive. It is based on the belief that the price of a share is based on the sum of the expectations that all investors have about the future performance of the company.
But is this a reasonable premise?
The use of relative strength as a method of picking shares is quite controversial. Why select a share just because it has increased in price? That fact in itself is no guarantee that the shares will continue to increase in the future. Indeed it is very tempting to think that if a share price has increased significantly, there may be no more room left for it to grow. On the other hand, selecting a share whose price has just bombed may mean that there is a lot of scope for recovery. So why adopt an investment strategy that insists on buying only shares that exhibit positive relative strength?
Let's define relative strength
What we actually mean by "relative strength"? It is the measure of the performance of a company's share price in relation to the performance of the market. Paul's relative strength strategy measures the performance of all the shares in the FTSE 100 Index and ranks them against each other over a specific time period. For example, a company whose share price has risen by 100% in the last half year will be ranked higher than one that has risen by 50%. Paul found that selecting the five shares that had increased the most over a 26-week period gave a fantastic market-beating return, and he continues to refine and develop his ideas further.
So what is the importance of looking at relative strength?
Buying shares that have appreciated the most in the previous year has been shown by James O'Shaughnessy in his book What Works on Wall Street to be a very effective (if also very volatile) strategy. He found that investing each year in the 50 stocks with the highest one-year relative strength produced market-beating returns of 14.31% compound between January 1952 and December 1996, compared to a market average of 13.2%. That might not sound like a huge difference, but over 45 years of the analysis, and because of the miracle of compound interest, $10,000 invested in those 50 stocks and reinvested each year from 1st January 1952 to 31st December 1996 increased to $4,113,706. Compare this to $10,000 invested in the All-Share Index, which would have increased to only $2,677,557.
He also looked at investing in the 50 stocks with the worst relative strength over the previous year and found that $10,000 invested on 31st December 1951 grew to $43,040 at the end of 1996, which is a compound return of only 3.3%. This seems to show that winners continue to win and losers continue to lose.
O'Shaughnessy's conclusion was that "unless financial ruin is your goal, avoid the biggest one year losers and buy stocks with the best one year relative strength, but understand that their volatility will continually test your emotional endurance."
But a note of warning! Unless you have very deep pockets and are able to buy the top 50 shares based on relative strength each year, tuck them away until the end of the year, then sell them and buy another set of 50 top performers -- and continue to do this for the next 40 years -- you will not be able to replicate O'Shaughnessy's results in real life.
So relative strength usurps the funamentalist's efficient market theory?
Relative strength is a number that drives investment fundamentalists and efficient markets theorists crazy. In the efficient markets theory, short-term price changes are seen as completely random, meaning that investors are best served by investing in indices and not trying to pick individual stocks. Fundamentalists believe that the long-term share price driver will be growth in earnings per share. However, if shares with high relative strength over a relatively recent time period have a tendency to outperform the broader market over any period of time, it means that past price changes are somehow predictive, blowing a hole right through the efficient markets theory and ruining fundamentalist beliefs!
But isn't technical analysis all bunk?
Relative strength is usually claimed by chartists to be purely a technical indicator. It is true that technical analysis uses price changes as a very important component of its overall approach, but this is not the same as saying that relative strength is only a technical indicator and not a fundamental one. I have to say that I am a person who thinks that technical analysis is total bunk, so how can I support the use of relative strength strategies?
All fundamental measures have to be related to the share price at one specific point in time. Not only that, but the companies whose shares have outperformed the market more often than not are the companies with the strongest fundamental stories. Relative strength consistently brings to light companies with superior fundamentals, so it can be just as useful to those working from a fundamental viewpoint as it is to those using technical analysis.
If shares with high relative strength tend to represent the companies with the best fundamental stories, it should not be a surprise to anyone that this indicator can help pick stocks that have a tendency to outperform.
Relative strength strategies really do work!
Relative strength strategies are an exciting tool for attempting to identify which shares will perform well in the future. The research by O'Shaughnessy seems to show that relative strength is one of the most important predictors of future price movements. It is certain that in recent times, based on the testing we have carried out so far, the strategies have performed very well indeed. They may well continue to do so in the future, but this is by no means certain. Pure relative strength strategies are high risk and will display tremendous short-term price volatility. It requires tremendous discipline and the ability to resist second-guessing once the model's parameters have been set. It requires a lot of patience and it is a long-term strategy.
To keep emotions in check, you only need to study the awesome power of compounding on a market-beating strategy. If you are able to beat the market averages by a significant margin over the long run, you need not get excited about short-term setbacks and meltdowns along the way. You're only losing a fraction of what you've already made, or stand to make in the future.
Conclusion
We should go back to the simple theory, borne out by backtesting: winners have a tendency to keep on winning; losers have a tendency to keep losing.
Can you rely on relative strength? Yes, you can. Vote Bull!
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