One of our favorite ways to evaluate the current environment for relative strength as an investment factor is to look at the relative strength spread. The relative strength spread is calculated by dividing an equal-weighted index of the top quartile of stocks in our relative strength ranks by an equal-weighted index of the bottom quartile of stocks in our relative strength ranks. The investment universe for this is about 900 U.S. mid and large cap stocks. Essentially what this chart shows us is a comparison in performance between the RS leaders and the RS laggards. When the chart is rising, relative strength leaders are performing better than relative strength laggards. As of 5/18/17:
In looking at the RS Spread over the last 3 years we can see that we had a generally rising RS Spread in 2014 and 2015 and generally a declining spread in 2016 as the RS laggards tended to do better than the RS leaders last year. Keep in mind this has nothing to do with absolute returns of the leaders or the laggards---rather, this chart is simply reflecting which is performing better in relative terms. Over the last 6 months or so the RS Spread has flattened out and then in recent weeks we have seen the RS Spread move above its 50 day moving average and show some real signs of moving higher.
For a longer-term evaluation of the RS Spread, see the chart below:
*1990 – 5/18/2017
Some key observations:
- RS leaders have performed much better than RS laggards over time.
- The RS Spread is not smooth. There are good environments for relative strength as an investment factor and poor environments for relative strength.
- The RS Spread tends to rise when leadership is stable and tends to fall when there is changing leadership.
One logical question from this is whether or not you should try to time exposure to relative strength as an investment factor. Each investor will have to make up their own mind on that question, but I will offer it as my opinion that most people are probably better off not trying to time exposure to relative strength (or other investment factors like value or low volatility). Rather, diversifying by investment factor seems like a pretty good option for most investors.
That said, I do find the current RS Spread to offer some encouraging signs for relative strength in the near term. If the RS Spread continues to climb from here, that could bode well for relative strength investing in the coming months.
The relative strength strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value.Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss. Hypothetical Back-test Period: 12/31/1989 – 5/18/2017. Performance information for the RS Spread is the result of a strategy back-test on an index that is not available for direct investment. Back-tested performance is hypothetical and is provided for informational purposes to illustrate the effects of the RS Spread during a specific period. The hypothetical returns have been developed and tested by DWA, but have not been verified by any third party and are unaudited. Back-testing performance differs from actual performance because it is achieved through retroactive application of a model investment methodology designed with the benefit of hindsight. Model performance data (both back-tested and live) does not represent the impact of material economic and market factors might have on an investment advisor’s decision making process if the advisor were actually managing client money. Returns do not include dividends, fees, or transaction costs. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.