Trader Q&A: How and When to Look at Relative Strength

Trying to determine a stock's next move can be like trying to predict which way the wind will blow; if you're blindly guessing there's a good chance you'll get it wrong, but if you use the right tools and methodology… you still might get it wrong, but the odds are much more in your favor. One tool that can help you spot recent broad-market standouts or weak links is relative strength, which compares a particular stock to a larger market force, like an exchange-traded fund (ETF) or stock index. To further explain the concept and uses of relative strength, I sat down for a Q&A with Schaeffer's Senior Quantitative Analyst Rocky White, who also outlined the 20 best and worst stocks of 2016 so far, relatively speaking. 

How is relative strength calculated?
RW: Relative strength is, basically, how much a stock moves relative to another stock or index. Typically, you'll see a stock's relative strength compared to the S&P 500 Index (SPX) or some other broad stock index. It's also common to see a stock return relative to an ETF, such as comparing Wal-Mart Stores, Inc. (NYSE:WMT) to a retailing ETF, such as the SPDR S&P Retail ETF (XRT). This tells you how a stock performs relative to the benchmark that you choose. 

Say you have a stock XYZ and you want to calculate the 21-day relative strength of XYZ relative to the SPDR S&P 500 ETF (SPY). First, the general calculation is:

(XYZ_today / XYZ_21daysago)  /  (SPY_today / SPY_21daysago)

Where:

• XYZ_today  is the price of XYZ stock today
• XYZ_21daysago is the price of XYZ stock 21 days ago
• SPY_today  is the price of the SPY today
• SPY_21daysago is the price of the SPY 21 days ago

Notice I denoted the XYZ part in blue and SPY part in orange because I think it's helpful to look at these separately to understand the equation. You can see the blue part is the XYZ price today relative to 21 days ago. The orange part is the SPY today relative to 21 days ago. If I call the blue XYZ part the relative price of XYZ and the orange SPY part the relative price of SPY, then the equation is:

(Relative price of XYZ)  /  (Relative price of SPY)

The relative price of a stock, as I defined it above, will be above 1.0 if the stock increases over the 21 days, and it will be below 1.0 if it decreases (it's exactly 1.0 if the stock stays the same). The relative strength of the stock (relative to the SPY) will be above 1.0 if the relative price of the stock is above the relative price of the SPY. In other words, if the stock moves more than the SPY on a percentage basis, then the relative strength will be above 1.0. If it moves less than the SPY, it will be below 1.0. Below are a few examples that might help someone understand it.  

Note in the first table below (upper left), over the past 21 days, XYZ was perfectly flat. An investor would have gained nothing and lost nothing. However, the relative strength of that stock was 0.977. The fact that it's below 1.0 means it underperformed when compared to our benchmark (in this case the SPY). Another way to look at it is if you invested equal amounts in your stock and the SPY, then your investment in stock XYZ would currently be worth 97.7% of your investment in the SPY.

You can see the other examples below to get a sense of what's going on. The upper right table shows if your stock goes up by more than the benchmark, then you'll have a relative strength above 1.0. The lower right table shows what happens if your stock goes up, but it goes up less than the SPY, and therefore the relative value of your stock is less than 1.0.

When is relative strength important?
RW: Relative strength is important when you want to measure a stock's performance compared to a benchmark. For example, say that over the course of a six-month period, you had a stock that rose by 7%. Typically, this would be a respectable return. However, say that over that same period of time, the S&P 500 was very strong, gaining 15%. Calculating a relative strength of the stock would give you a relative strength of 0.93. Simply by seeing that the relative strength is below 1.0, you can tell your stock underperformed the market.

Also, 0.93 is a pretty low relative strength, so you know you could have done a lot better simply by investing in the benchmark rather than the stock. So relative strength is especially important when you want to view the stock in light of the market environment.

Say the S&P 500 crashed and lost 40%, but your stock only decreased by 15%. In that case, you lost money on the stock, but its relative strength would be 1.42, showing you that your stock actually performed better than the market benchmark.

Under what circumstances is relative strength not an important metric?
RW: If market environment is not important, then I'd say relative strength is not important. One instance where it's definitely not important is when measuring dollars in your portfolio. 

For an extreme example, say someone was nearing retirement right before the 2008 crash, and their portfolio manager had them in the stock market when the S&P 500 lost 56%. The investor now doesn't have enough to retire and has to keep working, and when he confronts the portfolio manager the portfolio manager says “but your stock portfolio only fell 40% compared to the S&P 500's fall of 56%. That's a relative strength of 1.36! So that's pretty good.” Obviously, in this case the relative strength does not matter at all. The goal at that point was capital preservation, not to beat the market. 

Also, there are circumstances where you're comparing two stocks in different sectors where relative strength may not be important, if you're judging the merits of two stock pickers. For example, say there's an oil fund manager picking stocks and a tech fund manager. The oil fund manager picks the oil stock OIL, which falls 10%. The tech fund manager picks tech stock TECH, which gains 5%.

Simply comparing the relative strengths of OIL and TECH against the market doesn't really tell you the oil fund manager is a worse stock picker than the tech fund manager. What if oil stocks were down by 25% over that time period, and tech stocks were up by 20%? In that case, you would rather see a relative strength measurement relative to each stock's sector ETF, such as comparing the oil stock relative to the strength of the United States Oil Fund LP (ETF) (USO), or comparing the tech stock to the Technology SPDR (ETF) (XLK).

Which stocks have most out- and underperformed the SPX so far in 2016?
RW: Here are the best and worst year-to-date returns for SPX stocks so far in 2016, through Aug. 15. Newmont Mining Corp (NYSE:NEM) has led the pack, with a relative strength reading of 2.33 -- the only one above 2.0. Meanwhile, drugmaker Endo International plc - Ordinary Shares (NASDAQ:ENDP) has been the worst on a relative-strength basis in 2016.