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Relative Strength Strategies for Investing

by Mike Abelson   December 6, 2021
Stock market investors aim to maximize the return on their assets. As a result, they utilize different strategies to track fluctuations in the market and identify investment opportunities. Relative strength is a popular approach to investing. Before adopting this method, consider the advantages and disadvantages this investment strategy offers.
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The ultimate goal of any investor is to maximize returns. Therefore, they constantly keep a close eye on the stock market fluctuations, track the value of their stocks, and lookout for new investment opportunities.

Investors use different strategies to buy and sell the right securities at any given moment. One of these strategies is relative strength. John Lewis, Mebane T. Faber, and many other professionals have researched and provided valuable insights on relative strength strategies for investing. If you’re planning to take on the relative price strength approach, you can consider adopting these strategies in your investment behavior.

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But before looking at those strategies, let’s understand what relative strength is in investing. 

What Is Relative Strength?

Investor checking stock market on computer.

Relative strength is a strategy based on momentum investing. As opposed to value investing, when investors opt to buy low and sell high, momentum investing aims to buy high and sell even higher. Thus, relative strength investing aims to purchase stocks with relative volatility to try and make quick gains. By purchasing steadily increasing stocks, investors anticipate them to continue growing and generate higher returns.

Investors usually start by looking at industry benchmarks, such as the Nasdaq Composite Index. This index keeps track of more than 2,500 domestic and international stocks’ movements. They closely observe which companies have outperformed their peers in a given period. Outperformance may signify that the particular stock is thriving in the current economic market. Ultimately, relative strength investors may jump to capitalize on the continued performance of these stocks.

Relative strength strategies are usually risky undertakings. Because of market volatility, they work best when the economy is stable and can be dangerous during a recession. For example, the 2007 to 2008 financial crisis led to abrupt shifts in stock trends, causing many investors losses.

Even though momentum investing is usually associated with individual stocks, investors also apply these strategies to a broader range of securities. They can also be applied in Exchange-Traded Funds (ETFs), index funds, and pairs trading. Some investors also implement relative strength in real estate investment trusts (REITs) and derivatives products.

What Is the Relative Strength Index?

Close up of stock market graph on cellphone

Relative strength index (RSI) is a momentum indicator that shows the fluctuations in stock prices. It is used to measure overvalued and undervalued stocks.

RSI is generally calculated by looking at an asset’s performance during the last 14 periods. It scales a particular asset’s average gain or loss. Then, it plots the data on a graph with thresholds of zero to 100.

Generally, if a security’s RSI is higher than 70, it is overvalued. When an asset is overvalued, the earnings do not justify its current price and are expected to drop shortly. Conversely, an RSI lower than 30 means that a security is undervalued. An undervalued asset’s selling price is presumed to be lower than its intrinsic value and is expected to grow in the future.

RSI is one of the most prominent indicators of a stock’s relative strength. It can give insight to investors on how to deal with their portfolios. An RSI of around 70 can be a signal to sell the stock. Conversely, an RSI of around 30 can hint at purchasing the stock and selling at a higher price to potentially get your money growing.

Things to Consider

When using relative strength tools, you need to be aware of the following four points:

  • When security is outperforming (for example, steady growth for three months in a row). This can be a signal to purchase the stock as it may continue growing in the future.
  • When security is underperforming (for example, decreasing in the price for three months in a row). This can signify that the stock is declining in value, and you may consider selling it as soon as possible.
  • When a security rises faster than others. Most relative strength investors see this as a potential sign to purchase the stock.

Each of these points is easier to understand when you jump in and start investing.

What Makes a Stock Strong?

Investor monitoring stock growth on computer.

The concept of a strong stock can be confusing at times. In relative strength, investors are not usually interested in stocks that have historically maintained a high price. Instead, they care about the stock’s growth level.

For example, Tesla stock exploded even though the company faced revenue losses for consecutive years prior. On the other hand, Amazon, whose stock is worth four times that of Tesla, has remained relatively steady during the same period. Amazon generally reinvests its earnings, making some of its shareholders unhappy.

Does this mean that Tesla’s stock is actually stronger? For relative strength investors — yes, as they may assume the stock to continue outperforming the market.

Pipeline companies typically have massive earnings, yet their stock prices usually demonstrate low or no growth at all. Grocery companies also deliver high cash flows, but their stock price growths are soaring. The concept of relative strength revolves around these price growths. Once investors spot significant growth opportunities, they are quick to add those stocks to their portfolios, establishing the stock’s strength on its own terms.

Relative Strength Strategies for Investing

Investors meeting to discuss investing strategies.

A team of professionals at Nasdaq Dorsey Wright has developed relative strength strategies for investing. These strategies allow investors to invest in companies or industries with the highest potentials. Below is a summary of these strategies.

Aggressive Strategy

This strategy aims to achieve long-term capital appreciation. It looks at a ranking of sectors within the U.S. Mid and Large Cap equities and suggests investing in about 25 securities that have outperformed their peers for a set period. The aggressive strategy means holding these outperforming stocks until they begin to plateau.

The aggressive strategy is not limited to a certain investment style. For example, an investor may decide to invest based on a stock’s growth value within the mid and large-cap range. The strategy also prioritizes asset class diversification, which is crucial for minimizing negative impacts.

Core Strategy

Very similar to the aggressive strategy, the core strategy also aims to increase long-term portfolio appreciation. It requires keeping mid and large-cap equities in the portfolio until their relative strength decreases. However, this strategy has historically proved to be less tax-efficient than the aggressive strategy.

ESG Core Strategy

Similar to the core strategy, the ESG core model picks relatively strong stocks with positive ESG characteristics. Environmental, Social, and Governance (ESG) criteria show how a given company manages its operations. The environmental component looks at a company’s sustainability. Social criteria measure a company’s relationships with its stakeholders, while the governance evaluates its leadership, internal controls, and shareholder rights.

The ESG model is a common way for investors to evaluate a company’s viability. When applied to relative strength, it usually assumes less risk than the core strategy but may imply lower earnings too. 

Growth Strategy

Investors discussing stocks.

The primary goal of this strategy is to achieve high capital appreciation by also mitigating some level of risk. The strategy involves incorporating an equity exposure overlay. Overlay management helps investors rebalance their portfolios and mitigate relevant risks. For instance, overlay management tools can tell you when to sell underperforming security to offset another one with great potential. Through growth strategy, investors can spot red flags on certain stocks and switch to cash to maintain stability. Investors utilizing the growth strategy may hold up to 50% cash.

Global Macro Strategy

The global macro strategy seeks to generate long-term investment returns and risk diversification. It incorporates multiple asset classes, including domestic and international equities, real estate, currencies, commodities, and fixed-income assets.

The strategy suggests holding 10 ETFs with significant relative strength characteristics. ETFs are a basket of securities that can include any of the abovementioned asset classes. They can serve as a solid tool to spread the risk among investments.

Tactical Fixed Income Strategy

The tactical fixed income strategy pursues long-term income growth by spreading out investments across different fixed income sectors. These include but are not limited to U.S. Treasury bonds, convertible bonds, high-yield bonds, investment-grade corporate bonds, international bonds, etc. Implementing the tactical fixed income strategy can be done through ETF investing.

Three main points lie at the core of this strategy:

  • Riskier bond sectors do not always guarantee high returns.
  • Bonds are relatively more stable in different economic cycles.
  • Fixed income markets are usually complex, so it is better to focus on the price and exclude noise as much as possible.

Balanced Strategy

Investor monitoring stock on laptop.

The balanced strategy is a mix of the core model and the fixed income strategy. It seeks to reach long-term appreciation by spreading investments to 60% in equities and 40% in fixed-income assets. The fixed-income component allows the investor to tame some market volatility.

International Strategy

This strategy aims to look outside the U.S. market and achieve long-term capital appreciation by investing in overseas equities. The strategy targets securities in both developed and emerging overseas markets.

The tactic selects approximately 30 to 40 international securities that have demonstrated relative strength characteristics, which includes faster growth than most other companies in the industry. The investments can be made through the American Depositary Receipts (ADRs). ADRs are negotiable securities that represent foreign companies’ securities and introduce them to the U.S. trade sector. 

General Overview

All eight strategies mentioned above vary in risk and return. While it is almost impossible to perfectly evaluate the risks and returns of these relative strength strategies, we can make some conclusions based on historical data and common sense. Higher risk is usually associated with higher returns or losses.

According to Nasdaq Dorsey Wright, below is an estimated ranking of all eight strategies descending from highest expected volatility and return to lowest.

  1. International strategy
  2. Aggressive strategy
  3. Core strategy
  4. ESG core strategy
  5. Growth strategy
  6. Global macro strategy
  7. Balanced strategy
  8. Tactical fixed income strategy

Bottom Line

Relative strength investors try to invest in top-performing stocks that can increase their returns in the future. Buying or selling stocks depends on their recent performance. They opt to purchase stocks that have outperformed the market based on such indicators as the Relative Strength Index.

Some relative price strategies propose investing in specific asset classes, while others suggest diversifying the portfolio. Generally, more diversification implies less risk but also lower possible returns.

 

Disclaimer: Strategies presented in this article may not always guarantee predicted results. We advise consulting with an industry professional before making

Mike Abelson   Editorial Director
Mike is the Editorial Director at Lendza. He enjoys helping entrepreneurs and startups succeed through smart, innovative strategies. He’s partnered with CEOs and executives to grow businesses from the ground up. Before his work at Lendza, Mike was a stock market analyst. When he’s not traveling for work, he enjoys reading adventure and science fiction novels.