AAII Journal6

Just as a rising tide lifts all boats, a rising market tends tolift all stocks. Well, almost all stocks. Strong individual stockperformance during a strong market represents only averageperformance, while a minor stock price decline during amajor bear market represents strong relative performance.Relative strength compares the performance of a security,industry, or portfolio relative to some benchmark, usually anindustry or market index.

Relative strength has grown in popularity as a stock selec-tion tool as a number of research studies and successfulinvestors have highlighted the benefit of seeking out stockswith high relative strength, especially when combined withother fundamental selection variables. The usefulness ofrelative strength is premised on the belief that relativestrength persists. If a stock has displayed significant positiverelative strength against the market, it would be expected tocontinue to display positive relative strength.

Relative strength is calculated using a range of methods.This article will examine some of the more popular sourcesand calculation techniques.

Calculating Relative Strength

Relative strength can be calculated over whatever timeperiod is desired. In practice, it is usually calculated over aweek-to-week, month-to-month, and year-to-year basis. Thebasic calculation of relative strength is accomplished simplyby dividing the value of the investment you are measuring—the price of a stock, for example—by the value of an index forthe market or appropriate industry:

Relative strength = stock price ÷ index value

When the ratio is increasing over time, the stock price is

rising at a faster rate than the index or even falling at a slowerrate than that of the market decline. A declining ratio indi-cates that the stock price is performing more weakly than thatof the index value.

There are variations on the basic calculation and althoughmathematically different on the surface, they are intrinsicallyidentical. For example, a simple adjustment to make analy-sis easier is to divide the relative value of the stock price bythe relative value of the index. Some relative strength mea-sures are calculated by subtracting one from the calculation,setting the base period at zero. Figures above the base figurereflect performance above the index, while below-marketperformance is portrayed by figures below the base level.Another popular adjustment to more easily handle factorssuch as stock splits is to divide performance of the stock byperformance of the index value:

Ending stock price ÷ Beginning stock priceRelative strength = ––—————————––––––––––––——

Ending index value ÷ Beginning index value

Table 1 gives monthly closing prices for the S&P 500 andAdvest along with the relative strength for Advest. The cumu-lative relative strength is calculated with a base of 1.00 anda starting date of December 31, 1996. Thus, a value above1.00 shows relative strength based on price movementssince December 31, while ratios below one would highlightrelative weakness since December 31. The key, however, isnot the actual number, but the trend—whether the actualvalues are increasing or decreasing monthly. The calcula-tions for the first two dates are as follows:

1/31/97 11.75 ÷ 10.75Relative strength = —————–—— = 1.03

786.16 ÷ 740.74

2/28/97 13.625 ÷ 10.75Relative strength = –————–—––– = 1.19

790.82 ÷ 740.74

Seeking Stocks With Momentum:A Look at Relative Strength MeasuresBy John Bajkowski

WORKSHOP

STOCK

ANALYSIS

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John Bajkowski is AAII’s senior financial analyst and editor of Com-puterized Investing.

August 1997 7

Dividing the ending price by the beginning stock pricecreates a return relative that is basically one plus the per-centage change. By dividing the stock price return relative bythe index value return relative, the base is set at 1.00 and thismakes the relative strength number more understandable. Arelative strength ratio of 1.05 could indicate performance 5%better than the index, while a ratio of 0.95 would indicateperformance 5% below the market.

Value Line is a good source for fundamental investorsseeking relative strength charts of medium and large-sizedcompanies. Advest was selected from Value Line’s weeklylisting of best- and worst-performing stocks over the last 13weeks. Figure 1 highlights Advest’s relative strength chart.The dotted line is a plot of Advest’s monthly relative strengthagainst the Value Line composite index. With this longer-term perspective you can see that, while Advest has been astrong performer lately, it has also had periods ofunderperformance.

The trick to interpreting relative strength charts correctly is

to keep in mind that even a stock that is rising in price mayhave weak relative strength if the market is rising morerapidly. This was the case for Advest in late 1992. Conversely,stocks with a declining stock price may be falling slower thana declining market and therefore show strong relative strength.Defensive securities such as utilities had strong relativestrength even when declining during the bear markets of1987 and 1990. Market movement can easily mask true stockmovement or industry performance. Relative strength chartscan help to factor out the market.

Relative Strength Rank

Investor’s Business Daily is another good source of relativestrength data. However, unlike the relative strength index,which tracks performance relative to a base index, Investor’sBusiness Daily uses a company’s price change ranking againstall other firms. This percentile rank against all other firmsranges from a low of 1 to a high of 99. A company with arelative strength rank of 25% outperformed one quarter ofthe firms tracked by Investor’s Business Daily, but was out-performed by three-quarters of the firms. The higher thepercentage rank, the better the relative strength.

Investor’s Business Daily reports the percentile rank, rank-ing the performance over the last 12 months. It also providesa weekly ranking of stock industry groups broken down intofifths, with industries in the top 20% by performance over thelast six months getting a letter grade of A, while groups in thebottom 20% receive a letter grade of E. Figure 2 highlights aportion of the New York Stock Exchange listing table, whichincludes statistics for Advest. Advest’s relative strength rank(Rel St) is 97% indicating that its 12-month performance wasin the top 3% of all stocks. The group strength rank (Grp. Str.)of A indicates that Advest’s industry performance is in thetop 20% over the last six months compared against the 196industries tracked by Investor’ Business Daily.

Table 1.Relative Strength: Advest Group

S&P 500 AdvestClosing Closing Relative

Month Value Value StrengthEnding ($) ($) (X)12/31/96 740.74 10.75 1.00

1/31/97 786.16 11.75 1.03

2/28/97 790.82 13.625 1.19

3/31/97 757.12 11.875 1.08

4/30/97 801.34 12.625 1.09

5/31/97 848.28 16.25 1.32

6/30/97 885.14 23.75 1.85

Target Price Range2000 2001 2002

Shaded areaindicatesrecession

40

30252016

1210

8

654

3

2Percent 9.0shares 6.0traded 3.0

ADVEST GROUP NYSE-ADV 13 9.3 9.816.0 0.58 0.9%

TIMELINESSRelative Price Perform-ance Next 12 Mos.( )

SAFETY(Scale: 1 Highest to 5 Lowest)BETA (1.00 = Market)

3 Average

3 Average

1.202000-02 PROJECTIONS

Ann'l TotalPrice Gain Return

High 25 (+90%) 18%Low 18 (+40%) 10%Insider Decisions

J J A S O N D J Fto Buy 0 0 0 0 0 0 1 0 0Options 0 0 1 0 0 0 0 0 0to Sell 0 0 0 0 0 0 0 0 0Institutional Decisions

2Q'96 3Q'96 4Q'96to Buy 7 4 9to Sell 5 2 7Hld's(000) 1553 1540 1655

High: 16.7 15.0 9.8 10.1 7.6 5.1 9.1 8.1 6.9 9.8 11.1 15.0Low: 10.1 6.1 5.9 6.6 1.6 2.3 4.9 5.5 5.0 5.0 8.5 10.4

Options: NoneThe Advest Group, Inc. began operations 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 VALUE LINE PUB., INC. 00-02

RECENTPRICE

P/ERATIO

RELATIVEP/E RATIO

DIV'DYLD( )Trailing:

Median:VALUELINE

Figure 1.Value Line Chart of Advest Group

Source: Value Line Investment Survey, May 9, 1997.

AAII Journal8

EP Rel. Acc. 52-wk. Closing Vol% Vol. Grp. Day’s PriceS St Dis. High Low Stock Symbol Price Chg. Change 100s Str. High Low

70 97 A 271/2 9 Advest Group ADV 221/8 + 1/4 -69 248 A 221/4 215/8k63 85 A NH 91/8 Advo Inc. AD 167/8 + 3/8 -32 215 B 167/8 165/8k95 78 A 115/8 57/8 Advocat AVC 111/4 - 1/8 -14 138 A 115/16 111/8

67 77 A 765/8 421/4 AegonNV AEG 763/8 + 115/16 -10 3243 B 761/2 7653 47 A 6 31/8 Aeroflex ARX 47/16 … -63 204 B 41/2 43/892 90 A NH 277/8 AeroquipVick ANV 4913/16 + 7/16 -38 660 B 501/2 491/8

William O’Neil, publisher of the Investor’s Business Dailyand originator of the C-A-N-S-L-I-M investment approach,advocates seeking out smaller companies with strong short-term and long-term earnings growth, leadership positions,and strong relative price strength. (See “C-A-N-S-L-I-M: AGrowth Approach Using Technical and Fundamental Data”by Maria Crawford Scott in the July 1996 AAII Journal; avail-able on-line in the AAII Journal archives at www.aaii.com.)One criterion for his initial consideration dictates that acompany have a relative strength rank of 70%. However, justas with the relative strength index, momentum, or accelera-tion, of the relative strength is important. A stock withincreasing relative strength rank is more desirable than onewith a steady or declining rank. In a article by Marc Reinganumtitled, “Investment Characteristics of Stock Market Win-ners,” published in the September 1989 AAII Journal, ninecommon characteristics were identified of stocks that wenton to become top price performers, including a weightedone-year relative strength rank of 70% or higher coupledwith an increase in the relative strength rank from the priorquarter. [Editor’s Note: A screen using the criteria identifiedin the Reinganum article was developed in a October 1994AAII Journal article titled, “Stock Market Winners: Applyingthe Rules in Today’s Environment.” AAII members can viewthis article at our Web site, listed above.]

Relative Strength Considerations

An investor using a trend-following indicator such as therelative strength index will typically miss the very start ofthe trend and give up some of the gains at the top as thestock leadership shifts before it becomes apparent. Thegoal with trend indicators such as relative strength is to staywith the trend until there is a clear signal that the trend hasreversed. However, identifying this signal can be difficult,furthering the notion that stock analysis is an art as well asa science. The relative strength period will determine howsensitive the index is to changes in leadership. A shorterperiod of analysis will be more sensitive than a longerperiod, but will also tend to lead to more frequent tradingand provide more false signals.

Relative strength can be very erratic over short-term timeframes and at critical market junctures. Strong stocks that

have led the market advance often experience the largestdeclines, as investors rotate from one sector into anothersector such as defensive stocks. The catalyst may be aneconomic event such as a sharp shift in interest rates, infla-tion, or even the relative value of the dollar. Financial secu-rities may quickly become more or less attractive to indus-trial export-driven securities.

Relative Strength Combinations

While relative strength is a worthwhile analytical tech-nique on its own, its value increases when combined withother stock selection criteria. Notably, combining contrarianvalue measures such as low price-to-sales ratios, price-to-book-value ratios, or price-earnings ratios with a require-ment of high and increasing relative price strength tends tolead to better stock price performance than when the factorsare used independently.

Relative strength screens point to stocks exhibiting strongprice momentum, with the premise that this strength willcontinue in the future. Many of these stocks may be richlypriced when compared to factors such as earnings.

On the other hand, contrarian investing is based on thepremise that the market is prone to overreacting to news,good and bad, thereby providing the opportunity to pur-chase mispriced securities at attractive prices. Patience isrequired when selecting stocks using purely contrarian rulessuch as a low price-to-book-value ratio. It often takes time forthe market to come around and recognize the value in thefirm. Price momentum measures such as strong and increas-ing relative strength seem to help highlight well-priced stockslikely to advance further.

Conclusion

An understanding of relative strength is useful not only inhighlighting promising investments, but also in enabling youto judge your own performance. While a variety of relativestrength measures are available to investors, all attempt tocapture stocks showing stronger price movement than thatshown by the overall market. Like all investment techniques,proper use requires a careful study and understanding of thefactors driving the stock price movement.

Figure 2.Price Listing from Investor’s Business Daily

Source: Investor’s Business Daily, July 14, 1997.