ADVANCED RELATIVE STRENGTH CONCEPTS

ADVANCED RELATIVE STRENGTH CONCEPTS

In the previous chapter, we introduced the concept of Relative Strength (RS)—providing its definition, and a basic interpretation of an RS chart as it pertains to a particular stock. The overriding theme was to demonstrate to you the robustness and adaptability of RS and how this simplistic tool enables you to capture the large winning trades, while helping you to avoid the big losers. As you have learned, RS places you in the venues where out perfor- mance exists, while steering you away from areas of underperfor- mance. In this next chapter we will show you how RS can be used in many different applications, not just as it pertains to individ- ual stocks; and that these other applications provide great in- sights into where best to allocate your investment dollars.

The beauty of RS lies in its lack of complexity—it is merely a simple calculation of division, comparing one security or index to another. Because of this simple equation, the concept of RS can be applied across the entire spectrum of financial products. In essence, anything that has a price associated with it can be used in an RS calculation. Although this sounds so basic, it doesn’t di- minish its effectiveness in determining outperformance. In sum, RS can help to answer broad asset class allocation questions re- lated to capitalization, style, fixed income, sector rotation, and even international exposure. Equally, RS permits you to pinpoint in a very refined aspect whether Pepsi (PEP) is a better choice over Coca-Cola (KO), taste buds aside; or whether Crude Oil is

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outperforming Copper. The point is, the power and transferability of RS is endless, and only limited by your imagination.

In the following discussions on the different RS uses, a com- mon thread exists. The calculation, as alluded to earlier, is the same no matter what you are comparing—you just divide one se- curity by the other and multiply by 100. As well, the plotting of the resulting RS reading is done using the same Point and Figure charting principles that were discussed previously, and with a uniform percent scaling method. The end result is the same—you focus your buying on those securities, sectors, indexes, or funds exemplifying the strongest RS, and sell or avoid those vehicles that display the weakest RS.

Sector Relative Strength

We first turn our attention to Sector RS because of its importance in the investment process. As you will learn throughout this text, it is our belief that sector rotation is the key to your overall suc- cess in the financial markets; an oft-referred study by Benjamin F. King (while at the University of Chicago) summarizes our reason for this posture:

“Of a stock’s move, 31 percent can be attributed to the general stock market, 12 percent to the industry influ- ence, 36 percent to the influence of other groupings, and the remaining 20 percent is peculiar to the one stock.”

In sum, 80 percent of the risk in any given stock is attributa- ble to the market and sector risk, while only 20 percent is due to the actual stock itself; and, the majority of the 80 percent risk is due to sector influences. Not surprisingly, this is where Sector RS comes into the mix. It is a given, based on studies such as the one referred to earlier, that determining which sectors are in “sea- son,” or are in demand, is imperative. So what better way to es- tablish this than with RS? Recall its definition: a way to quantify outperformance and underperformance. It stands to reason, then, that one of the very best instruments you can have at your dis- posal to help navigate the equity market is Sector RS. In essence,

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it is a tool that very easily helps you to analyze the greatest con- tributor to price fluctuation in a stock—sector risk.

The Sector RS reading measures how a particular sector is per- forming compared with the market in general. For example, Sec- tor RS would measure how the Retail sector is performing versus the market. As suggested earlier, this allows you to ascertain which sectors are outperforming the market, while seeing which ones are “out of season,” or underperforming the market.

Sector Relative Strength Calculation

The Sector RS calculation is the same as those previously dis- cussed. Daily, using the closing prices, each DWA Sector Index is divided by the S&P 500 Equal-Weighted Index (SPXEWI), then multiplied by 100. The resulting readings are then plotted on each sector’s respective RS chart. Recall that our DWA Sector Indexes were created for each broad industry group we follow. These DWA Sector Indexes are equal-weighted and include a nice mix of stocks with varying capitalization, unlike the exchange sector indexes, which tend to be more narrow and capitalization-weighted. An RS reading can be determined for an exchange sector index, such as the S&P Retail Index (RLX), and this is something we provide on our web site. But you must remember that in most cases, these ex- change sector indexes are capitalization-weighted, and therefore their price is pushed around by only a few names. For example, with the RLX, Wal-Mart, Target, and Home Depot account for ap- proximately 50 percent of the index’s price movement.

Relative Strength of a DWA Sector Index versus the Market

This calculation uses closing prices and is done on a daily basis. For example, we will calculate the Sector RS reading for two indexes, the DWA Retail Index and the DWA Drug Index.

Sector RS Reading= DWA Sector Index × 100 S&P 500 Equal Weighted Index

144 Learn the Point and Figure Methodology DWA Retail Index is at 451 and the SPXEWI is at 1713:

DWA Drug Index is at 380 and the SPXEWI is at 1713:

DWA Retail Index has now risen to 473 and the SPXEWI is now at 1733:

DWA Drug Index has moved up to 383 and the SPXEWI is now at 1733:

In this comparative example, both of these sector indexes moved higher in price along with the market, but only the DWA Retail Index improved on an RS basis. Said another way, the DWA Retail Index outperformed the market, while the DWA Drug Index slightly underperformed the market. Groups that are ex- hibiting positive Sector RS versus the market are the ones to grav- itate to when you’re deciding which sectors to buy.

Sector Relative Strength Interpretation

When interpreting the Sector RS chart, the process is basically the same as outlined previously. In like fashion, we are concerned with the most recent signal on the RS chart, and the most recent column the RS chart is in. Given that Sector RS measures how a

451 × 100 = 26.33 RS Reading 1713

380 × 100 = 22.18 RS Reading 1713

473 × 100 = 27.29 RS Reading 1733

383 × 100 = 22.10 RS Reading 1733

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particular sector is performing compared with the overall market and that sector risk is the greatest contributor to price fluctuation in a stock, it is imperative to evaluate this on an ongoing basis. (We can’t emphasize this point enough.) Those sectors exhibiting positive RS versus the market are the ones to focus on for new buying. Sector RS buy signals are given when a column of X’s ex- ceeds a previous column of X’s. But of equal importance for Sector RS is what the most recent column is on the RS chart. This is the one slight difference in RS evaluation (compared with a stock’s Market RS or Peer RS). When a sector index reverses up into a col- umn of X’s on its RS chart, we consider that to be a buy signal. Utmost attention is paid to column changes for Sector RS, be- cause such a reversal will often be the beginning signs of a signif- icant switch in sponsorship for the particular sector. We still regard the best reading for the Sector RS chart as being on a buy signal and in a column of X’s, yet recommend exposure to a group if its RS chart is in a column of X’s.

Probably the most valuable aspect of Sector RS is that it not only steers you to the sector(s) moving into favor, but keeps you invested in sectors that are market leaders, even if the sector(s) is considered overbought by other measures. To provide you with a little company history, this is one of the main reasons why we first started charting Sector RS. In 1996 to 1997, the best-performing sector was the Bank/Financial group. This sec- tor had performed very well in 1995, after bottoming out in fairly oversold territory. The group raced to an extremely over- bought condition, as measured by the sector Bullish Percent chart (which you will learn about in an upcoming chapter) by October 1995. Member stocks, such as Citigroup and Chase Manhattan recorded phenomenal gains during this time. Citi- group posted a 70 percent gain, while Chase Manhattan gained a remarkable 100 percent. But the upmove didn’t stop there. Both Chase and Citigroup doubled in price during the 1996 to 1997 time frame. This is about the time when Sector RS became an integral part of our technical research.

We became less enthused with the Bank sector in late 1995 because, as stated, the group was overbought. Our cautious ap- proach to new recommendations in the group was, in hindsight, a mistake. But as we always endeavor to do, we learned from

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our mistake and developed our Sector RS charts. In assessing the Sector RS for the Bank sector, we realized that the group had been outperforming the market, hands down! The Bank group sneakily ascended to top dog status despite being in the believed shadow of Technology stocks. The lesson here—sim- ple mathematics, in the form of division, can quantify and pin- point outperformance if you are willing to delve below the market’s surface and evaluate the group’s RS chart. In applica- tion, move to those sectors rotating into favor, stay with those sectors that continue to exhibit positive RS, and avoid those groups that turn negative on their Sector RS charts (reverse to O’s or break a previous bottom). Bottom line, if you hope to out- perform the market, you had better be invested in those sectors with the best RS.

Examples of Sector Relative Strength Changes

To display the sheer power of Sector RS, let’s take a look at a cou- ple of examples. To do so, we will return to two groups men- tioned in the previous chapter—Telecom and Building. You will recall from that stock-specific discussion that AT&T (T) gave an RS sell signal in May 2000, along with the fallen angel, World- Com. In other words, cracks were starting to appear in the ce- ment with respect to Telecom and Technology after what had been an unprecedented, parabolic upmove in these stocks and sectors. But what is so amazing is how the Telecom Sector RS chart quantified all this information, telling you that not only were there cracks in the cement, but that the whole house was starting to crumble and collapse.

As Figure 5.1 reveals, the DWA Telecom Sector Index gave an RS sell signal in April 2000, when it reversed into a column of O’s. But prior to that, this RS chart was in a column of X’s from January 1998 until April 2000. In other words, the RS chart supported a bullish, overweighted posture with respect to the Telecom sector, all while the group was rocketing into the strat- osphere. Yet before returning to earth, the RS chart warned you and told you to “get out”; to underweight or avoid the Telecom sector. Be it an individual stock, or an entire sector, notice how

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Figure 5.1 Sector RS: DWA Telecom Sector versus SPXEWI.

the RS chart positioned you to capture the large winner—indicat- ing that Telecom was an area of outperformance from 1998 to 2000. The returns speak for themselves; the average Telecom stock, as measured by the DWA Telecom Index, posted a gain of 86 percent while in a column of X’s, against a market return of 25.4 percent.

Conversely, when in O’s, suggesting underperformance, the RS chart steered your focus elsewhere allowing you to avoid a loss of 59.6 percent for Telecom. Sector RS, therefore, provides a very important piece of information in the decision-making process. While in X’s, you look to buy the best stocks within that sector— those with the high technical attribute reading that are in an up- trend, for example. But when in O’s, you are avoiding the group, and concentrating on stocks in other sectors. Not only are AT&T and WCOM noteworthy examples of this, but it was evident

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across the group. We had mentioned that T basically doubled while on an RS buy signal in the late 1990s. But what about Nor- tel (NT) and Corning (GLW), two other very popular names during the Technology bubble? GLW was up an astounding 236 percent while on an RS buy signal during the 1998–2000 period, yet fell a mind-boggling 98 percent after giving an RS sell signal in 2000. Same story with Nortel; NT gained a very respectable 137 per- cent in the tech heyday, but then collapsed after its 2000 RS sell signal, dropping 97 percent. In sum, the carnage on a stock- specific basis continued from 2000 until the October 2002 bot- tom, yet the Telecom Sector RS chart forewarned us very early on that there had been a change in season—summer had turned to winter for Telecom.

But as the saying goes, “out with the old and in with the new.” In 2000 to 2001, “new” literally meant the New York Stock Exchange-type stocks. Sectors such as Healthcare, Financials, Food and Beverage, and Building took the lead and assumed the role of outperformance in the market. Once again, the Sector RS charts were able to broadly summarize this change in leadership, guiding those willing to look into “new” sector opportunities. One such glaring, but much overlooked opportunity was in the Building sector.

We spoke of the RS improvement that we witnessed on an individual basis with respect to such stocks as Lennar (LEN), Toll Brothers (TOL) and Ryland Homes (RYL)—all members of the once-boring Building sector. Once again, though, the Sector RS chart provided a telltale sign that a positive change was afoot. The DWA Building Sector RS chart reversed up into a col- umn of X’s on January 10, 2001, revealing to us that this group had become an area of outperformance, and therefore was one to have long exposure. The Sector RS once again, in dispassionate fashion, told us and you the investor, when it was time to tacti- cally maneuver into a “new” sweet spot in the market. The Building Sector RS chart remains in X’s, and since giving the buy signal in January 2001, has registered a substantial gain of +155.5 percent compared to the SPXEWI gaining 39 percent, and a worst performance of −14 percent by the Nasdaq Composite (see Figure 5.2).

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Figure 5.2 Sector RS: DWA Building Sector versus SPXEWI. Sector Relative Strength Applied

to Exchange Traded Funds

In short, Sector RS enables you to pinpoint those groups that de- serve your investment dollars. One obvious course of action is to buy the stock(s) in a strong RS sector, which themselves possess positive RS versus the market and their peers. But due to the vast expansion in sector products via the Exchange Traded Funds (ETFs) there are now many ways to garner sector exposure, with- out having to buy index options to do so. Instead, Sector RS can be applied to a tradeable vehicle that represents an underlying sector index—you get a basket of stocks in a given sector with a single ETF purchase. This allows you to avoid single-stock risk, while also providing instant diversification in one simple transaction. A caveat to this strategy is the “weighting” issue. As mentioned

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early on, our DWA sector indexes are equal weighted, whereas the majority of ETFs are capitalization-weighted. Therefore, a couple of stocks can be responsible for the bulk of the move in an index, so it pays to be aware of the make-up of each ETF before buying one. We will cover ETFs in more detail in a later chapter.

One way to use Sector RS in conjunction with ETFs would be to merely buy an ETF based on the reading of a particular DWA Sector RS chart. In other words, if the DWA Healthcare Sector Index was in a column of X’s on its RS chart, rather than buy a couple of individual stocks, you could buy a corresponding sector ETF, such as iShares Healthcare (IYH) or any of the other related ETFs now available.

Or why not just cut to the chase and analyze the actual RS of the ETF itself. If you think about it, this would provide a more “apples to apples” comparison—you would be measuring the exact RS of the vehicle that you are considering for purchase. And that is exactly what we do.

Sector ETF Relative Strength Calculation and Interpretation

On a daily basis, we calculate and plot RS readings for every ETF that trades. The calculation mirrors that of Sector RS on the DWA Sector Indexes, with one minor exception. Instead of having the S&P 500 Equal Weighted Index (SPXEWI) as the divisor, we use the Dow Jones Total Market Index that trades as an ETF itself under the symbol IYY. This benchmark is used as the divisor be- cause it is capitalization-weighted and its approximately 1,600 members cut across large, mid and small-cap in asset class. In other words, it tends to reflect how the majority of ETFs are com- prised. As a sidebar, there are new equal-weighted sector ETFs just being rolled out by State Street Global Advisors as I write this book. So when analyzing their relative strength, you may find it more useful to use the equal-weighted SPXEWI as the yard- stick for the market.

In interpreting a Sector ETF RS chart, it is exactly the same as what we laid out with DWA Sector RS—you pay most attention to the current column the RS chart is in. As with a stock’s RS

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reading, or a DWA Sector RS reading, the ETF’s suggestion/pos- ture of outperformance or underperformance can last for years on end. For example, the iShares Dow Jones Real Estate Sector Fund (IYR) has been in a column of X’s, implying you should have long exposure to the sector, since May 2000—for over six years. In fact, the average stay in a column for an ETF RS chart is 500 days. In essence, it is an indicator that similarly allows you to verify, in a succinct manner, the long-term trend of a sector ETF. In sum, when the sector ETF RS chart is in X’s, it represents demand for the sector relative to the market, or it is an area of outperfor- mance. On the contrary, when the sector ETF RS chart is in a col- umn of O’s, it represents supply is in control of that sector relative to the broad market, or that it is underperforming and therefore one to avoid or underweight.

Examples of Sector ETF Relative Strength

There have been a couple of notable themes encompassing the fi- nancial markets over the past few years, namely Real Estate and Energy. Everyone has tried to call a top in the Real Estate market for years, yet as mentioned earlier, the RS chart for the IYR has been in X’s for over six years, and has suggested exposure to that area of the market, and will so for as long as it stays in X’s. When it changes to O’s that is when you would want to back off with re- spect to investment in Real Estate, at least in using the IYR as the measurement. In essence, when in a column of O’s, as it was from October 1995 to May 2000, it suggested there were better oppor- tunities elsewhere. Let’s recap the IYR’s performance, using RS column changes as the inflection point:

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Another popular sector that has caught the public’s eye has been Energy, or anything related to it such as Crude Oil, Oil Ser- vice, and Coal. But really it has only been in the past couple of years that mainstream media (and most investors) jumped on the energy train with respect to touting this sector as a potential in- vestment gusher. But you guessed it, the RS chart allowed you to “strike oil” much sooner. As Figure 5.3 depicts, the iShares Dow

Figure 5.3 ETF Relative Strength: iShares Energy (IYE) versus IYY.

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Jones Energy Sector Fund (IYE) reversed up into a column of X’s on May 3, 2002, suggesting this sector would outperform the mar- ket for some time to come, and that it was a group that investors should commit to on the long side. Those that heeded this signal have been justly rewarded. The IYE, from May 2002 through June 2006, had posted a return of +95.3 percent, dwarfing the IYY’s re- turn of +24 percent.

What is all the more interesting, pertaining to Energy, is how mass media tried to sway the average investor out of Energy only a year and half into this positive RS condition. More specifically, The Economist magazine came out with a negative cover story on October 25, 2003, entitled “The end of the Oil Age,” and depicted a desert condition with two dilapidated gas pumps. Mr. Jones would have seen this bearish cover story, and would have screamed “Get me out of anything related to Crude Oil!” Two and a half years later, the IYE RS chart is still impartially telling you to maintain exposure in the Energy sector (allowing you to cap- ture a big winner), while Mr. Jones is still scratching his head about that magazine article.

Just as a sector ETF’s RS chart will point us toward opportu- nity, as it did with Energy, it can serve to warn us of an impend- ing problem. Such was the case with Technology in 2000. Our RS work identified, on many different levels that the “tech bub- ble” was bursting. Recall our discussions on AT&T and WCOM, and the DWA Telecom sector. In those instances, the RS charts revealed worrisome technical developments. This same phenomenon was witnessed in the ETF arena, too. In a broader respect, the RS chart of the iShares Dow Jones Technol- ogy Sector Fund (IYW) experienced a reversal into a column of O’s on April 14, 2000. After having been in X’s since September 1998, and what amounted to a monstrous rally, this RS chart was advising us that it was time to depart the broad Technology sector. All told, this was another example of how RS got us out of harms way. Surely, you can now guess what the magazine cover stories were like in April-May 2000. Yep, John Chambers’ (CEO of Cisco Systems) picture was plastered all over Fortune and Worth, counseling you to “buy his stock.” Thereafter, Cisco Systems stock price fell precipitously from 75 to 8.50, or roughly 88 percent!

154 Learn the Point and Figure Methodology Drilling Down: Subsector Relative Strength

Before leaving the topic of Sector RS, we want to briefly touch on one more aspect of it. In particular, we want to demonstrate to you how you can “drill down” below the surface of a broad sector, such as Energy, to pinpoint specific sub-sector strength. This can be extremely helpful when trying to determine where best to al- locate your dollars within a given sector. As we have demon- strated, one way to do this is to merely buy a representative proxy (ETF) for a sector when the RS chart is in X’s. Clearly, you would have provided considerable “alpha” to the portfolio had you lis- tened to the Energy RS chart and bought the IYE. But underneath the broad surface of Energy there was a more compelling story.

There are subsectors that comprise each broad industry group, and in the case of Energy there is a subsector known as “Oil Com- panies—Secondary.” Basically, this subgroup is made up of sec- ondary oil companies—those that tend to be relegated to the backseat when compared to their ultra-large-cap siblings such as Exxon Mobil (XOM), Chevron Texaco (CVX) and British Petro- leum (BP). All you have to do to see this submissive role is to check out the weightings of any of the broad Energy ETFs. For ex- ample, the IYE plays favorites with XOM, CVX; approximately 38 percent of the movement in the IYE is attributable to XOM and CVX. Yet it has been these secondary brothers and sisters that truly deserve the “gold star on the forehead.”

Figure 5.4 brings this to light in a way as obvious as the little kid with her hand raised in class saying, “oh, oh pick me, pick me, please”! On February 24, 2003, the DWA DJ Secondary Oil Index reversed up into a column of X’s on its RS chart (versus the S&P 500 Equal Weighted Index), advising you that it was best to pick Secondary Oil names such as Valero (VLO), Burlington Re- sources (BR), Occidental Petroleum (OXY), or Tesoro (TSO) for your Energy exposure. In other words, if you wanted alpha even within a particular group, they were going to give it to you. The returns have been staggering since the RS buy signal pinpointed outperformance in February 2003. For instance, VLO has vaulted 589 percent while TSO has gained a whopping 1295 percent. What makes this story compelling is that during this time the IYE put in a very respectable performance, gaining 145 percent,

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Figure 5.4 Subsector RS: DWA Secondary Oil Companies Index versus SPXEWI.

yet XOM, CVX, and BP’s returns were in line with the market, as measured by the S&P 500 Equal Weighted Index. The ultra-large- cap sector siblings provided very little with respect to outperfor- mance. Now, you cannot argue that the Energy sector was the place to be, and to that end the IYE provided a fantastic venue for that one-stop shopping exposure. But without a doubt, for those willing to buy individual names, this Secondary Oil Companies subsector RS chart is a prime example of the benefit of “drilling down” in order to itemize specific areas of outperformance.

This particular use of RS can be applied to any subsector or mini-sector, with the calculation and interpretation of the chart being the same as that outlined with Sector Relative Strength. It allows you to find specific niches of strength, and therefore en- ables you to position yourself in that defined area. It is particularly useful when analyzing the very large broad industry groups such as Consumer Cyclical, Healthcare, Industrial, and Financial. In the case of Consumer Cyclical, for example, the RS has for years

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suggested that you should invest in the subgroup of Retail—Ap- parel, while telling you to shun Retail—Broadline. In sum, it would have pushed you toward names such as American Eagle Outfitters (AEOS) and steered you away from the likes of Wal- Mart (WMT). This is just one more arrow to put in your quiver when determining which sectors are in season, and which are not.

Relative Strength Applied to Asset Classes

Sports fans know that the three worst words a batter in baseball can recite to himself upon approaching the plate are “don’t strike out.” So it should be no surprise that “investing to avoid losing money” will be as hopeless an activity as “batting to avoid striking out.” Put in investment terms, people crave safety—yet they desire high returns, so they invest in the stock market anyway. But how? By buying (and often holding) “safe stocks,” or at least ones they perceive to be safe, such as General Electric (GE), Coca-Cola (KO), Wal-Mart (WMT), Merck (MRK), Intel (INTC), General Motors (GM), and Microsoft (MSFT). The problem is these stocks, on average, are down 38 percent in the past six years (since the Dow Jones Industrial Average peaked in 2000). The point of all this is, as an investor, you must take whatever returns the market is offering. Over the past six years, it hasn’t been with the blue-chip, “safe” large-cap stocks. In- stead, it has been elsewhere; and not surprisingly, RS has proven to be a viable tool with respect to asset class allocation, too. Re- member, to the extent that you try to seek return where there is none, you create risk. In our opinion, it’s actually less risky to go with the flow and follow the returns wherever they may be in the market; over the past six years it has been in the Small Cap segment of the market.

Relative Strength has yet another application—determining which asset class to overweight or emphasize. As alluded to ear- lier, RS has placed us in the right asset class for many years on end, and in particular has told us to steer our clients toward Small Cap for the past six years. In Figure 5.5 you can see this type of RS at work. In this example, we compare the S&P 600 Small Cap Index (SML) to the S&P 500 (SPX)—or David (small cap) pitted

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Figure 5.5 Asset Class RS: S&P 600 Small Cap versus S&P 500 Large Cap.

against Goliath (large cap). The calculation here is the same as in- structed before, easy division:

The interpretation of the chart is similar to that of Sector RS, in that we place most importance on the current column. The investor should overweight Small Cap stocks at the expense of Large Cap stocks when in a column of X’s (indicating outperfor- mance), and should underweight Small Cap stocks when the chart is in O’s (suggesting underperformance). As you can see, this partic- ular RS chart has been in a column of X’s since February 17, 2000—

SML Price × 100 = RS Reading SPX Price

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for over six years. Simply stated, it has unmistakably told you to emphasize Small Cap stocks and to throw stones at Goliath (Large Cap stocks). The returns speak for themselves with the SML gain- ing 73.8 percent during the past six years while the SPX was in the red by 7.9 percent. Literally, one major switch in your portfolio six years ago would have made a monumental difference in the returns seen since then. Unfortunately, many investors stayed married to their Large Cap, blue-chip stocks, failing to live by the aforemen- tioned phrase of “until RS do us part.”

This type of RS can be used for more than just asset class de- termination. It is also helpful for discovering where to be with re- spect to style allocation—such as Value versus Growth, and whether or not to equal weight or capitalization weight your port- folio. With the explosion in the number of market ETFs now available, determining these types of RS can be useful and easily implemented. For example, you could put asset class and style to- gether and compare the iShares Small Cap 600 Value (IJS) versus S&P 500 Growth (IVW). An RS chart comparing these two ETFs has instructed you (since November 2000) to favor the IJS. The re- turns are astounding:

By using RS to “tactically maneuver” within the confines of a traditional strategic asset allocation pie, you put yourself in a posi- tion to become a consistent hitter, and even hit an occasional home run, rather than going to the plate hoping you don’t strike out!

Before moving on, I want you to take a minute to reflect on what we have discussed so far with respect to RS, and in particu- lar I want you to recall the examples we have used throughout this chapter and the previous one. We talked about how the Technology stocks and related sectors gave RS sell signals in mid 2000, while at the same time the lesser-known Building stocks asserted themselves on an RS basis. We stated that Wal-Mart has been a low technical attribute stock for years, therefore suggest-

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ing poor relative strength, while American Eagle Outfitters has been soaring. Secondary Oil Companies have been a force to be reckoned with, while its ultra-large-cap brethren such as Exxon Mobil and Chevron Texaco have pulled up the rear in the Energy sector. The question is, “Do you see a pattern?” Remember the quote we referred to by Yogi Berra: “You can observe a lot just by watching.” If you put all the pieces together, it should come as no surprise that Large Cap Growth has been the laggard on an RS basis. Surely the RS charts of the SML compared to the SPX and the IJS versus the IVW summarize this conclusion for you in a vi- sual format, but when you have stocks such as Wal-Mart, Coca- Cola, AT&T, and Intel faltering, it should tell you something. I implore you to step back and “observe” what is going on. By ob- serving, you will know. Therefore, knowing is believing, and be- lieving gives you confidence.

Using Relative Strength to Determine International Exposure

We have all heard the phrase, or have read (to our kids) the book known as Where’s Waldo? The book appeals to the reader, asking “Have you found Waldo yet?” The reader basically goes on a quest, wondering where in the world is Waldo, trying to deter- mine what new place he has traveled to now. Well, I ask you in in- vestment terms, “Do you know where in the world there is outperformance”? The answer once again lies with RS. Relative Strength can determine what new place should garner your atten- tion with respect to your Global or International exposure.

In keeping with our earlier discussion regarding the standard strategic asset allocation pie, there is typically a slice or portion of the overall portfolio allotted to International. But often, this slice takes a back seat, as many investors just don’t know how to go about making decisions dealing with the international mar- kets. The good news is you have an investment map in the form of RS right at your disposal; this will not only tell you “where in the world” to be, but will also let you know if you should be cut- ting a bigger piece of the International pie (overweighting or un- derweighting your exposure to the Global markets).

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To chart our International course, we use RS in a couple of different ways. First, we can compare the broad overseas mar- kets to the domestic, U.S. market. This will tell us whether or not the overseas markets are exhibiting positive RS compared to the United States; and therefore prompt us to allocate more or less money to the global markets. Once we know whether or not to gain International exposure, we then can use RS to deter- mine which regions or countries actually deserve our invest- ment dollars. In this exercise, we would literally compare one region to another or one country to another—such as Europe versus Latin America or Japan versus China. The calculations, therefore, are the same as those previously learned—you are merely dividing one security by the other, then multiplying by 100.

Got Global? Measuring Overseas versus United States

It has only been recently that investors have gotten an appetite for foreign investment. But if you look at the RS chart of the EAFE Index versus the S&P 500, it would have petitioned you to travel abroad much sooner. The EAFE Index from Morgan Stanley Capital International is designed to measure the over- all condition of the overseas markets—Europe, Australia, and Far East. There is an ETF benchmarked to this index, offered by iShares, that trades under the ticker EFA. Figure 5.6 reveals how the EFA has been flying first class for several years now, while the S&P 500 (SPX) has been in the coach seats. This RS chart reversed up into a column of X’s on October 3, 2003, stat- ing the EFA was outperforming the domestic market, and therefore deserved your attention, and your dollars. As long as the RS chart remains in X’s, it implies you overweight your In- ternational equity exposure. Of course, you can merely buy the EFA to accomplish this; and in doing so you would have seized gains more than twice that of the SPX. Since the RS buy signal for the EFA, it has jumped 59.9 percent while the SPX has jet- lagged behind with gains of 23.7 percent. Moreover, just a year after this RS reversal to X’s for the EFA, The Economist maga-

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Figure 5.6 Got Global? Measuring Overseas versus United States: EFA versus SPX RS.

zine boldly stated on its cover of October 2, 2004, “Scares Ahead for the World Economy.” This provided us with all the more conviction that pulling the passport out and going Global was the right trip to take.

Where in the World to Be?

To delve a little deeper, RS can be very helpful in zeroing in on those areas or countries that are fueling the international econ- omy. In other words, RS can tell us our precise travel itinerary. Granted, the EFA is an excellent and easy way to broadly allocate your global slice of money, but as the table below shows, there is alpha to be grabbed if you are able to pinpoint region or country outperformance:

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When determining where you should travel to with respect to specific region or country, we use RS, but in a slightly different application. Of course one way to expose specific outperformance would be to compare each region or country to the EAFE Index, similar to evaluating a sector versus the S&P 500 Equal Weighted Index. But another way to establish this type of outperformance is by pitting a region or country against another—Europe versus Latin America, for example. We discuss this topic and its portfo- lio applications in greater detail in Chapter 10.

As you become skilled at plying the investment waters, you can additionally see how RS can help you to effectively reach distant shores; portfolio management need not be relegated just to U.S. soil. And when asked, “Where’s Waldo?” you’ll know the answer.

Mutual Funds: The Same Relative Strength Tools Apply

By definition, a mutual fund is an open-ended fund operated by an investment company that invests in a group of assets in accor- dance with a stated set of objectives. Two of the main benefits of a mutual fund are that it provides diversification and professional money management. The choice of funds available to the investor is staggering, including such types as sector, income, growth, fixed income, blend, tax-free funds, and so on. In many respects, a mutual fund is similar to an ETF, in that both are buying a basket of securities and provide diversification by doing so. But there are a few notable differences: ETFs are unmanaged while mutual

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funds are managed, yet ETFs are transparent while mutual funds do not readily expose their holdings; and ETFs typically have a lower expense ratio compared to the fees of a mutual fund. Each have their plusses and minuses, but differences aside, the mutual fund industry is still the behemoth in the “fund” marketplace with respect to assets under management, despite the progress seen in the ETF world.

Given this mammoth presence, it is worth spending a few minutes discussing how RS can be used with mutual funds. In a nutshell, the same RS tools you have already learned about can be applied to a mutual fund. The calculation is the same, too, in that you divide one security by the other and multiply by 100. For ex- ample, we calculate how a mutual fund is performing versus the market, as measured by the S&P 500 Equal Weighted Index (SPX- EWI). This basically provides you a measurement of outperfor- mance or underperformance along the same lines as Sector RS. We use the SPXEWI instead of the IYY because most mutual funds are closer to being run on an equal-weighted basis, com- pared to most ETFs, which are skewed by their cap-weighted con- struction. The interpretation of a mutual fund RS chart is similar in that RS is said to be “positive” if the chart is on a PnF buy sig- nal. But the best RS reading is when the chart is on a buy signal and in a column of X’s. One difference in interpretation lies in ad- dressing the volatility of the given fund. Sector funds are typically evaluated using the RS signal, whereas lower volatility broad asset class mutual funds are, as a rule, judged by the most recent RS column.

Mutual Fund Relative Strength Examples

In Figure 5.7, an RS chart of the Fidelity Select Energy Services (FSESX) mutual fund is shown. The applicability of RS is apparent here as well, as evidenced by the performance of FSESX versus the SPXEWI since its RS buy signal in March 2002. This particu- lar fund has vaulted 125.8 percent compared to the S&P 500 Equal Weighted Index (SPXEWI) gaining 35.3 percent, and this return trounces the 9.3 percent gain of the cap-weighted SPX. (Note: The return of the FSESX does include dividends.) Relative Strength

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Figure 5.7 Mutual Fund Relative Strength Applied to Fidelity Select Funds.

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works equally well in denoting suspected underperformance with mutual funds. In March 2000, the Fidelity Select Technology (FSPTX) fund reversed down into a column of O’s on its RS chart versus the SPXEWI, providing the first warning sign that perfor- mance was starting to wane on the technology front. Then by No- vember 2000, the RS chart recorded a Double Bottom sell signal. This was yet one more confirmation that the technology bubble had burst. To this day, the Fidelity Select Technology mutual fund remains on an RS sell signal, telling you that there have been better places to put your money. The performance numbers speak for themselves: FSPTX is down 45.6 percent since it gave the RS sell signal in late 2000; conversely, the SPXEWI is up 43.8 per- cent. For those that focus on a family of funds for sector rotation, you clearly see the need to incorporate RS into your evaluation process.

Mutual fund RS can be used in other ways previously dis- cussed. For example, not only could you evaluate how the Ameri- can Funds Growth (AGTHX) fund is doing relative to the market, but you could also assess how one fund is performing versus an- other, such as AGTHX compared to Dodge & Cox Stock (DODGX) fund. This would provide you with an RS comparison along the lines of Asset Class RS discussed earlier. In the case of AGTHX versus DODGX, the RS chart would tell you whether the large-cap growth fund has the upper hand, or whether the large- cap value fund deserves your investment dollars. Not surpris- ingly, this RS chart has indicated for years that the better play was buying DODGX, zeroing in on the outperformance of “value.”

The Fund Score

With respect to mutual funds, we have devised a Technical Rank- ing Method, or Fund Score. This score is similar to the Positive Technical Attribute reading for stocks that was discussed in the previous chapter. Just as the Positive Technical Attribute reading provides a concise summary of a stock’s technical picture, so does the Fund Score for mutual funds. In both cases, these ranking

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methods provide the investor a speedy way to work through and evaluate a large inventory of stocks or mutual funds.

The Fund Score, as a rating system, ranges from a reading of 0 to 6. The score includes the five basic Positive Technical Attri- butes, similar to how we rate stocks; yet the Fund Score also in- cludes more parameters, which take into account chart patterns, moving averages, momentum, and percentile ranking for the fund versus several market and peer groups over several time periods. The Score uses proprietary weightings, but adds up to reflect one- third trend chart attributes and two-thirds RS attributes. Our Fund Score rating system is geared more toward evaluating the current market conditions, which differs from other mutual fund ranking systems that focus on a longer time period; and this longer period may not have pertinence, or can be inflexible for making beneficial investment decisions. In general, you want to focus your buying on those funds that have a Fund Score of 3 or higher. Of course, those funds that possess a Score of 5 or above are exhibiting phenomenal trend and RS characteristics, and should pique your interest most when working through and eval- uating a large inventory of funds to purchase.

Stock versus Stock Relative Strength

Throughout this chapter, I have displayed for you a multitude of ways that RS can be used to help make investment decisions. Most of what we have covered so far has dealt with broader ques- tions pertaining to asset class, style, sector, ETFs, and mutual funds. But now I want to show you how RS permits you to pin- point in a very refined aspect whether one stock is a better choice over another, on a relative basis.

This type of comparison can be very helpful in a couple of ways. For example, you may have a fundamental list of stocks that you like to use as an inventory of ideas. Let’s assume that you want to gain exposure to the Healthcare sector, and your fundamental list has two Healthcare stocks to choose from, but you only want to buy one. How do you choose which one to purchase? One simple answer would be to create an RS chart comparing the two stocks. By doing so, it would tell you, very matter-of-factly, which stock was performing better, giving you fodder to make your decision.

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Also, stock versus stock RS is extremely beneficial when you are trying to narrow a list of strong technically sound stocks down to only a couple of names. For example, let’s say that you wanted to purchase a Steel and Iron stock to take a Metals posi- tion. You have narrowed the list down to two stocks that both possess a 5 (for 5) Positive Technical Attribute reading. In other words, both have exemplary RS and trend characteristics. Which one do you buy? If you pit one against the other in an RS wrestling match, there will be a clear winner. The RS chart will quantify which one is outperforming the other, giving you the correct answer (of which to buy).

The Pepsi Challenge, Taste Buds Aside

The Pepsi Challenge in a formal sense has been an ongoing mar- keting promotion run by PepsiCo (PEP) since its introduction in 1975.* The challenge takes the form of a taste test. At malls, shopping centers, and other public locations, a Pepsi representa- tive sets up a table with two blank cups, one containing Pepsi and one with Coke. Shoppers are encouraged to taste both colas, and then select which drink they prefer. Then the representative re- veals the two bottles so the taster can see whether he preferred Coke or Pepsi. A taste test such as this will help you discern which cola pleases your palate, but it surely doesn’t help you de- cide which cola company’s stock deserves your money. Yet an RS chart is one way to see how investors are voting their wallet, re- gardless of taste buds. In Figure 5.8 you can see that since October 1999, Pepsi has had the upper hand compared to Coca-Cola (KO). PEP has “beat the Real Thing,” handily outperforming KO, gain- ing 75.9 percent since 1999, while KO has fallen 14.4 percent. So while KO may possess the more dominant market share of cola drinkers, or may be your preferred soft drink based on taste, PEP has been more dominant in the stock market on a relative basis. PEP has been the “Joy of Cola” for investors.

A stock versus stock RS assessment can be helpful with spe- cific purchase decisions, yet it can be very beneficial for those

* http://en.wikipedia.org/wiki/Pepsi_Challenge, www.pepsi.com.

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Figure 5.8 Pepsi Challenge: PEP versus KO Relative Strength chart.

traders or investors that like to construct “pairs trades.” An ad- vanced trading strategy such as this consists of buying one stock and shorting the other, and typically is done within one specific sector. So in using the RS information with respect to Pepsi and Coca-Cola, it would suggest that you buy PEP shares and short KO shares. The idea here is that you purchase the stock with the stronger RS, with the idea that it should rise faster than the stock with the negative RS. The best case scenario in this situation then is that the stock you buy goes up in price while the stock you shorted falls in price—such was the case with the Pepsi-Coke pairs trade. As a sidebar, in addition to a stock versus stock RS chart, other technical criteria can be brought into the equation when developing a pairs trade. For example, you can consult the Positive Technical Attribute reading for each stock, with the long

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side of the trade focused on a stock in an uptrend with a 3, 4, or 5 for 5 reading; and the short side geared toward a stock in a down- trend with a 0, 1, or 2 for 5 ranking.

Relative Strength Matrix Concept

In our previous discussions, we have suggested that RS is really nothing more than an arm wrestling match—pitting one oppo- nent against the other such as Hulk Hogan versus Jesse “The Body” Ventura. The RS match determines which security gets its arm raised, declaring it the winner; ultimately, such a match shows where outperformance resides, and gives you important in- formation to make your investment decisions.

DWA Relative Strength Chart Matrix

In an effort to constantly make our research better for our clients, we have taken this arm wrestling match concept and put it in the form of a big round-robin tournament. More specifically, we de- veloped the RS Chart Matrix. In doing so, we created an RS chart for every sector against every other sector using our DWA Equal Dollar-Weighted Sector Indices. This allows us to identify the strongest sectors relative to all others. For example, the Aero- space sector would have 39 RS charts, one against Autos, Banks, Biotech, Buildings, and so on. In addition to the sectors, we also include an RS chart versus the S&P 500 Equal Weighted Index (SPXEWI). This means that each DWA Sector Index has a total of 40 RS charts. Realize it is still the same type of calculation: divid- ing the closing price of one DWA Sector Index by another DWA Sector Index. As well, the RS reading is still plotted on a uniform percent scale, but for these RS charts we use a smaller box size, or scale, than the standard. We wanted to “speed up” the charts in order to key off of signals rather than columns, but still not pro- duce whipsaws.

But how do we possibly display and make sense of all of these RS charts? To do this we created the “DWA RS Chart Matrix.” In

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this table, we placed the sector symbols horizontally across the top and vertically down the left side. The sector on the left side of the table is the numerator in the RS calculation and the de- nominator is defined along the top. As you move to the right of the symbol (numerator) the cells of the table are populated with the status of the RS chart versus the sector in the top row. “B” indicates the RS chart is on a buy signal and “X” indicates the RS is in a column of X’s. An “S” indicates an RS sell signal and “O” indicates the RS chart is in a column of O’s. Remember, an RS chart that is on a buy signal and in X’s suggests that the sec- tor on the left side of the table (numerator) is very strong and is outperforming the denominator on both a long-term and short- term basis.

All told, there are over 1,600 cells in this table or matrix. So how on earth can you “get your arms around” this huge wrestling tournament? To help quantify all this information, we imple- mented a simple ranking of the sectors. It is based on the total number of RS charts that are on a buy signal for a given sector. We tally the total buys for each sector and the one that has the most is ranked as #1. For the sector with the lowest number of buy signals, it is ranked as #41. If two or more sectors have the same number of buy signals, the tie is broken based on the one that has the most RS charts in a column of X’s.

When applying this to your portfolio management, you obvi- ously want to concentrate your buying on those sectors that are at the top of the matrix as they are the ones that are outperform- ing the most sectors. It is these sectors that have been able to win the most RS arm wrestling matches against their sector oppo- nents. All told, the DWA RS Chart Matrix provides you another way to evaluate sector relative strength, and allows you to know which sectors to overweight, while also letting you know which sectors don’t deserve your attention. A sample of the DWA RS Chart Matrix is shown in Figure 5.9; this matrix would suggest that you focus your buying on those sectors toward the top, such as Steel and Iron (STEE), Metals Nonferrous (META), Oil Service (OILS), and Transports Nonair (TRAN). Conversely, those sectors with the worst overall RS compared to other sectors would be Auto and Auto Parts (AUTO), Household Goods (HOUS), Media (MEDI), and Forest Products and Paper (FORE).

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Figure 5.9 DWA RS Chart Matrix.

Stock to Stock Matrix

The DWA Matrix product, as outlined earlier, evaluates RS be- tween multiple securities (sectors), rather than just against the market or one other index. We now want to take it a step further and enlighten you to how this same concept can be applied to a group of stocks. The goal here is the same—to identify from a group of stocks those that are the RS leaders.

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For this style of matrix, the basis or starting point comes from creating an RS chart along the lines of the Pepsi (PEP) versus Coca-Cola (KO) RS chart, comparing the performance of one stock to another. Once again, the underlying calculation is the same in that we divide the closing price of one stock by another stock. The matrix in this case is sector specific, and is comprised of 20 to 25 representative stocks from a given sector. The member stocks are optionable and tend to be the larger cap or more well- known names from the group. For example, the Food, Beverage, and Soap sector matrix would include such stocks as PEP, KO, Archer Daniels Midland (ADM), Colgate-Palmolive (CL), Her- shey’s (HSY), Sara Lee (SLE), and so forth. To create the matrix, we literally create an RS chart of every stock in the list against every other stock. This allows us to identify the strongest stocks relative to the other 20 to 25 names. For example, Archer Daniels (ADM) would have approximately 20 RS charts, one against PEP, KO, SLE, CL, and so on. In addition to the stocks, we also include an RS chart versus the DWA Food Sector Index (DWAFOOD). All told, we have a Stock Matrix for every one of our 40 DWA sectors. This allows us to know at any given point, on a relative basis, what are the best-performing stocks in the Semiconductor group or the Biotech sector, for example.

The layout of each matrix is the same as that outlined with the DWA RS Chart Matrix; the RS signal of each chart is repre- sented by a “B” for buy signal, an “S” for sell signal, with the “X” and “O” representing the recent column reading of each RS chart. Likewise, a similar ranking system is used to tally all of this RS data. Again, it is based on the total number of RS charts that are on a buy signal for a given stock, and the one that has the most is ranked as #1. For the stock with the lowest number of buy sig- nals, it is ranked last, and appears at the bottom of the matrix. In the event of a tie, it is again broken based on the ones that have the most RS charts in a column of X’s.

When using such a matrix for individual stock purchases, you undoubtedly want to focus your buying on those stocks that are at the top of the matrix as they are the ones that are outperform- ing the other member stocks. In Figure 5.10 the Food, Beverage, and Soap stock matrix is shown. Clearly, ADM should catch your attention because it resides in the top spot, followed by British

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Figure 5.10 Food, Beverage, and Soap Stock to Stock Relative Strength Matrix.

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American Tobacco (BTI) and Campbell’s (CPB). Those to avoid or consider as shorts would be names such as Wrigley’s (WWY) and Sara Lee (SLE). Taking it a step further, by using this type of ma- trix in conjunction with the Positive Technical Attributes read- ing, you can easily stack the odds in your favor with respect to your individual equity positions.

This matrix concept can be applied to any number of uni- verses. For instance, a matrix can be built to compare all sector ETFs to each other, or one that conducts an arm wrestling match between all the different commodities. The results will be the same—the matrix will identify those securities that are outper- forming; it will tell you who has won the round-robin arm wrestling tournament.

Summary of Advanced Relative Strength Concepts

Throughout this chapter, we have tried to demonstrate to you the robustness, and more notably, the adaptability of RS; and how this simplistic tool enables you to capture the large winning trades, while helping you to avoid the big losers. You have hope- fully learned that RS is not only useful for individual stock evalu- ation, but that it can be applied across a broad range of financial products. Moreover, the calculation is consistent across the board, as is the interpretation of the RS chart, with the overall goal being the same regardless of what you are measuring—to de- termine outperformance or underperformance.

The adaptability of RS is amazing in that it allows you to ana- lyze so many different pieces of the investment puzzle. As dis- cussed, RS is a must with respect to sector rotation, as this is where the majority of risk resides in any given stock. Not only that, a broad appreciation of where to tactically maneuver with respect to your strategic asset allocation pie can be accomplished with just a few RS charts. Basic, but important questions on Asset Class and Style can be easily answered with a glance at an RS chart. And new horizons can be traveled to, with greater confi- dence, by consulting RS charts on different regions and countries. Without a doubt, the possibilities are limitless.

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In the end, these different RS applications provide great in- sights into where best to allocate your investment dollars. Put to- gether, they create a dramatic and discernible picture; and from that, an understanding of what IS happening in the financial world. All told, the final result is the same—you focus your buy- ing on those securities, sectors, indexes, or funds exemplifying the strongest RS, and sell or avoid those vehicles that display the weakest RS. Remember, as Yogi Berra used to say, “You can ob- serve a lot just by watching.”