What Is Relative Strength?

What Is Relative Strength?

Let me explain relative strength to you directly: it's a strategy in momentum investing and for spotting value stocks. You focus on investing in stocks or other assets that have done better than the overall market or a specific benchmark. For instance, you might pick tech companies that have beaten the Nasdaq Composite Index, or stocks outperforming the S&P 500.

Technical analysts like me use an indicator called the relative strength index (RSI) to spot overbought or oversold signals.

Key Takeaways

Relative strength is a form of momentum investing that technical analysts and value investors use. It means choosing investments that have outperformed their market or benchmark. As a relative strength investor, you assume that this outperformance trend will keep going; if it reverses, your investment could suffer.

Understanding Relative Strength

While value investing aims to buy low and sell high, relative strength investing is about buying high and selling even higher. You, as an investor, assume that current market trends will last long enough for you to profit. Any quick trend reversal will lead to losses.

To find good investments, you start by watching a benchmark like the Nasdaq Composite Index. Then, you identify companies in that market that have outperformed others—either by rising faster or falling slower than peers.

This approach works best in stable times with little disruption. But in chaotic periods, like the 2007–2008 financial crisis, it can be dangerous for you because trends can reverse sharply. Investor sentiment can flip suddenly, turning yesterday's favorites into rejects.

Momentum investing isn't just for individual stocks; you can apply it to entire markets or sectors using index funds and ETFs. You can also use relative strength for other assets, like real estate through REITs, or even exotic ones such as commodity futures, options, and derivatives.

Important Note

You can incorporate relative strength investing as part of a broader strategy, such as pairs trading.

Real-World Example of Relative Strength

Consider Harry, a relative strength investor who monitors corporate bond prices and the S&P 500. His portfolio includes an S&P 500 index fund and a corporate bond ETF. As a relative strength investor, he adjusts his allocations periodically to favor whichever asset is outperforming.

In recent months, he's seen investors shifting more into bonds, away from stocks. This has pushed bond prices up and yields down.

Anticipating this trend to continue, Harry reduces his S&P 500 holdings and boosts his corporate bond ETF investment. He's aiming to capitalize on bonds outperforming stocks going forward.

Relative Strength Index (RSI)

Short-term and technical traders also examine relative strength. In technical analysis, the RSI is a momentum indicator that assesses recent price changes to detect overbought or oversold conditions in a stock or asset. It's shown as an oscillator—a line graph moving between 0 and 100. J. Welles Wilder Jr. developed it and introduced it in his 1978 book, 'New Concepts in Technical Trading Systems.'

The standard way to interpret RSI is that readings of 70 or above suggest the security is overbought or overvalued, possibly signaling a trend reversal or price pullback. A reading of 30 or below indicates oversold or undervalued conditions.