Liverpool -- I can remember his words clearly, my old mate Chris. "You certainly know how to pick a share that's already gone up," he said. It was a couple of years ago and I'd just bought some shares in Northern Leisure(LSE: NLS). The company was on a bit of a roll and had seen its share price accelerate impressively. Forecasts for the next year were pretty good, and the company would have looked just about perfect to a PEG or Relative Strength investor. At least, that's what I thought.
The shares were trading for around £2.50 at the time, but that turned out to be the best they ever achieved, either previously or since. In fact, just a few short months after I bought my shares, they could be picked up for the bargain price of 90p or so. Sure, I made the most of a bad situation and bought some more near the bottom, eventually selling the two lots for an average that was just above break-even. That didn't change the fact that my original purchase was a disaster, though, and since then I've been very careful of buying companies exhibiting very high relative strength.
The Crowd is Right?
The essence of investing using relative strength lies in buying the shares that have already gone up the most; betting that the crowd is right. Don't think, just follow them blindly. They can't go wrong. Crowds never get emotionally obsessed with crazes and wouldn't ever, through a combination of blind greed and ignorance, throw loads of money at bad companies just because they're the latest hot things, would they? No, of course they wouldn't. So if the crowd wants to buy tulips, ostrich farms, Internet incubators, or whatever, they must be right. Bag O'Shite.com(LSE: POO)? If the crowd is buying it, it must be good, so fill yer boots.
Phew, the lack of oxygen on whatever planet I just visited was making me go giddy there for a minute. But I'm back on planet Earth now, so let's cool down a bit, open a tinny, and think back through history. Let's get a grip on reality.
Yeah, Right!
So the crowds are right and should always be followed, eh? What is it that most people, who when first exposed to the idea of investing in the stock market, are conditioned to think of? Yes, it's 1929. Or the South Sea Bubble. Or any other craze that eventually went wrong. "The Stock Market?" they'll cry, incredulously, "What about all those fortunes that were lost in the crashes of the 20th century?". And they're right to worry about such potential catastrophe.
At the Fool, we are constantly engaged in a crusade against the idea that the stock market is only for gamblers prepared to bet all on the hope of getting rich quick. And it is those very gamblers, the ones that Relative Strength investors hold so dear, that have been the cause of all of the major crashes in the history of stock markets. They caused the busts by causing the preceding booms. And they caused those booms by severing their connections with reality.
How many of these companies have lost most of their value recently? More than I'd feel happy owning, that's for sure. But those are the companies that Relative Strength pundits would have us buy. If you'd bought any of these companies after they'd gone up a lot, simply because they'd gone up a lot, you'd be forgiven for crying in your beer today.
It's Doing OK Now
"But look", they'll tell you, "our backtesting over the last 10 years shows that Relative Strength strategies really do bring home the bacon. Just look at the return we would have had." We might ask them what kind of companies they would have bought and request their evaluations of their long-term chances of success. But we'd most likely get an answer along the lines of "Who cares? You don't have to understand what you're buying -- all you need to know is that it's going up."
Investors in early 1929 might have said "Look at the returns you would have got if, like me, you'd put all your money over the last few years into these new-fangled, highly-geared investment trusts. I've no idea how they work, but I'm buying them simply because they keep going up in price."
Can you see any similarity between the two arguments? Hmm.
When the Levee Breaks
As we approach the end of the year 2000, we can look back on the longest uninterrupted bull market in history. We've seen the relentlessly rising tide of share prices, a lot of which are becoming more and more detached from the underlying fundamental performances of the actual companies themselves. How much higher can they go before reality sets in and the flood defences are overwhelmed? (Ooh, there's that word again, "reality".)
Excessive exuberance on the part of investors, both causing and simultaneously being fed by the discontinuity between reality and hope, is finite. Like all things, it will end. It is only sustained in the short term by the "greater fool" theory (small "f", note). "Buy it now because there will always be someone greedy enough to buy it from you later at a higher price," goes the doctrine.
While the music is playing and there aren't enough chairs to go round, each chair will be in ever increasing demand and will change hands for a spiralling price. But one day someone will realise that these chairs aren't all they're cracked up to be and will head for the door. And before long, others will follow. But it's a big herd and a small door, and they won't all fit through. They'll be left with an excess of chairs that nobody wants any more, kicking themselves for being part of an "oh so obvious" bubble.
The Slippery Slope
Ultimately, there's far more to lose by following the Relative Strength gurus than mere money. Carry it too far and you'll lose your independence, your self-identity. You'll stop being an individual and slowly become a willing victim of the dark art that is Technical Analysis. You'll start out looking with innocent-sounding statements like "Its 50-day moving average is showing relative strength of 92.27% compared with a sector average of 83.15%", and soon you'll be talking about support levels and all the rest; and you'll be lost.
Just Say No
So stick to what works best -- long-term fundamental analysis -- and vote Bear in the great Relative Strength poll.
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