Using Relative Strength to Choose Stock Sectors - Part 1

The salient question of most investors and even traders is what and when should I buy or sell? Before the Internet, investor and traders had to either listen to their brokers or pay for professional management via mutual funds. With access to the markets and information made easier by the Web, most Survivors want to forgo the advice and fees of a broker and step up to the task of managing their investments themselves.

But with so much information and so little time, how does one sift through the deluge of information and by what metric(s) does one compare asset classes, sectors, and individual instruments? Should you throw darts, listen to the financial Main Stream Media (MSM), or diversify until your returns are so diluted that your financial goals may never be realized? (It is not that I don’t believe in diversification. What I find unacceptable is diversification based on hope rather than a solid reason). While I offer no definitive answer, I hope to provide information that will arouse your curiosity, dear Survivor.

For market technicians, one of the simplest answers comes in the form of what is called ratio analysis or, more commonly, Relative Strength (RS) analysis. RS is not to be confused with Welles Wilder’s Relative Strength Index (RSI). Whereas RS compares two separate instruments, RSI compares an instrument to itself over n time periods.

Expressed as a rational number a/b, understanding how to read an RS chart is simple: when the line is rising (a), the numerate instrument, is outperforming (b), the denominate instrument. And when the RS line is falling (b) is outperforming (a). RS will not tell you the direction of price of the compared assets or instruments.

RS can be used in many ways. It is most useful in finding outperforming assets one can buy and create a diversified portfolio; here I will use RS to compare a monetary asset against a sector index to determine the gain/loss of purchasing power. I will then use RS to compare an individual instrument from the sector to calculate its performance against its parent index and a broad market index (did it make more sense to own the index instead of the stock?). Finally, RS will be used to compare the individual instrument against a monetary asset to see whether it is losing or gaining or unchanged in purchasing power.

Gold will be used as the monetary asset. I can hear the arguments now that gold has been demonetized. But unless you have been living under a rock, it is clear that gold is acting like money. I could use a commodity index as a hard asset, but then there would be arguments over the weighting of commodities in the index.