FOUNDATIONS OF RELATIVE STRENGTH

FOUNDATIONS OF RELATIVE STRENGTH

“Ever hear the one about the two guys camping in the woods and a bear appears? As one guy starts running, the other stops to put on his sneakers. ‘What are you doing?’ the first guy yells out. ‘You’ll never outrun the bear.’ His partner replies: ‘I don’t have to. I just have to outrun you’ ” (BusinessWeek, May 5, 2003).

The 80/20 Rule, or Pareto’s Principle (named after the Italian economist Vilfredo Pareto), is something we have all heard about. It basically means that in anything—management, wealth distri- bution, time spent on client relationships, and so on, a “few are vital” and “many are trivial.” This same principle holds true with investment results; more specifically, that 20 percent of your trades are responsible for 80 percent of your profits. Said another way, it is not the number of winning trades versus the number of losing trades that is most attributable to your investment suc- cess, but rather it is the size of your winners versus the size of your losers. The saying is true—size does matter!

Given this proven, time-tested principle, it is imperative that you position yourself to capture the large winning trades. This is where Relative Strength comes into play. It is our contention that Relative Strength (RS) allows you to “catch the positive outliers” or big winners while helping you to avoid large losers. Others tend to agree. In What Works on Wall Street, Jim O’Shaughnessy found that RS was a factor in all 10 of the top per- forming strategies (that he tested). He also found that the worst

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strategy in his testing was buying stocks with the worst RS (see Figure 4.1).

At Dorsey, Wright & Associates (DWA), Relative Strength is a very important component or cornerstone of our research. Since the company’s inception in 1987, RS has been part of our daily re- search; and yet over the past 20 years, the emphasis we place on RS has grown dramatically, as have the number of RS tools we have created to assist us in helping in the stock selection process. We have found RS to be one of the most robust and adaptable methods of security analysis. Despite it truly being a very sim- plistic concept, RS has been proven time and time again to be a viable methodology for outperforming the market over time. This is the essence of RS—a way to measure outperformance.

Relative Strength, as the name implies measures how one se- curity is doing compared to another. For example, how Microsoft is performing versus the S&P 500, or how Ford is acting compared to General Motors. In essence, such a comparison allows you to determine which security is outperforming the other. The impli- cation is that you invest in the vehicle that is outperforming the other, be it the market, or another stock. (This speaks to the transferability of the RS concept—basically you can do an RS cal- culation on anything! It can be applied on a stock-specific basis, with sector analysis, asset class evaluation, mutual funds, ETFs, commodities, fixed incomes, and even foreign countries.)

Figure 4.1 Relative Strength 80/20 Rule.

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One of the visual adoptions to the RS concept is a picture of two arms, locked in an arm wrestling contest. You have all seen two people arm wrestle before. In fact, you have probably seen na- tional arm wrestling contests on TV. It is this type of battle be- tween investment vehicles that we pay much attention to. Let’s say you brought 10 contestants to an arm-wrestling tournament. You will take the top five to the grand championships. You can’t decide who to bring until the match is over. We, in essence, put stocks, indexes, bonds, and the like in an arm wrestling tourna- ment to determine who has the strongest arm. Our tournament consists of mathematical computations to determine the winner but the computations are nothing more than a seventh grader can perform by hand. Computers simply allow us to do these compu- tations thousands of times over in a very short time. Technology is amazing. In the end, RS steers you toward the outperformer and away from the underperformer; and helps you to invest in, and stay with, that winner for as long as the RS chart suggests outper- formance. You focus your buying on those securities exemplify- ing the strongest RS, and sell (or sell short) those vehicles that exhibit the weakest RS.

Different Types of Relative Strength

We use two main types of RS charts when evaluating a specific stock. In both cases, the calculation is very simple, yet the results provide us with a ranking system. This is not unlike other areas of life, such as in the sports world, and in particular, college foot- ball. Each week during the college football season, we hear about the BCS rankings, which tells us what team is considered to be the best in the nation. These rankings are based on strength of schedule (opponents) and how the team has performed each week—did they win or lose, and by how much. It’s interesting how this RS concept permeates our daily lives. Even when you shop at the supermarket you are employing the concept of RS. I know that the RS of summer squash is low in the winter, and the RS of winter squash is low in the summer. Consumer Reports is a magazine that focuses on evaluating RS of various products. We consult this magazine to determine how a certain stereo system

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functions versus another, or how a particular model of car ranks versus another. Although we use this concept of comparing one to another in our daily lives, few even think of it when evaluating investments. Let’s now take a detailed look at each of these meth- ods of “ranking” a particular stock.

1. RS versus S&P 500 Equal Weighted Index. This is the more common and most widely used of our RS calculations. It mea- sures how a stock is performing compared with the market in general. For this comparison, we use the S&P 500 Equal Weighted Index (SPXEWI). We often refer to this as the stock’s Market RS. The RS calculation is simply done by dividing the price of the stock by the price of the S&P 500 Equal Weighted Index, then multiplying by 100. (We move the decimal point merely to have an easier number to work with.) This number is then plotted on a Point and Figure chart, using the same charting principles discussed in earlier chapters. Okay, stop for a second. Let me backtrack for a moment. Just like plot- ting a Point and Figure chart for the trend of a stock we use a number. This number is simply the price of the underlying stock. The RS chart is plotted the exact same way but the number we use is derived by dividing something by some- thing else. In this discussion we are dividing the price of the underlying stock by the Equal Weighted Standard & Poors 500, resulting in a NUMBER. This number is then plotted on a Point and Figure Chart just like we did when plotting the trend chart. We just get this number by dividing one thing by another instead of using the price of the underlying stock. It really is this simple. You know what? We even calculated a RS chart for Phil Mickelson versus Tiger Woods using their publicly available statistics and plotted the results on a Point and Figure Chart. We looked at Tiger as “the market” and Phil as the stock. It worked fine. It gave us some very interesting insight between the two players. We’ll reserve more discus- sion on this for our Professional Golf Point and Figure Charts we will do in the future. Hey just kidding on the Pro Golf Charts but let your mind wander a little. What if? Okay back to the real RS charts. We use the S&P 500 Equal Weighted

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Index as the divisor for a stock’s Market RS, but you can choose to use another market index, such as the Nasdaq Com- posite or Value Line; just be consistent and always use the same index when you update your RS chart. Using the SPX- EWI makes sense to us, though, since as the name implies, it is an equal weighted index. This helps to eliminate the capi- talization or price bias found in most other market indices. Previously, we used the Dow Jones Industrial Average as our benchmark to measure RS, but changed over to the SPXEWI in February 2003 after Standard & Poors announced the cre- ation of an equal weighted version of their S&P 500 Index. Be- sides having the appeal of being equally weighted, the SPXEWI is a much broader based index than the Dow Jones. One point we want to make before moving on concerns the scale used for an RS chart. It differs from the basic trend chart scale in that it is not a fixed box size scale, but rather a uni- form percent scaling methodology that treats all stocks equally, regardless of price. This was another change that we incorporated in February 2003 after extensive, collaborative research by the home office in Richmond and our Money Management division in Pasadena, California. The efforts to make our RS tools even more robust and adaptable is an ex- ample of our commitment of constantly striving to make Dorsey, Wright’s technical analysis and research better for our clients.

2. RS versus DWA Sector Index. This is also known as Peer Rel- ative Strength. It measures how a stock is performing com- pared with its sector peers, as measured by the Dorsey, Wright Sector Indexes. For example, the Peer RS reading would mea- sure how Intel (INTC) is doing relative to other Semiconduc- tor stocks. This RS chart allows you to determine the strongest stocks within a particular sector, or what we like to call “the best in class.” The Peer RS calculation is equally simple, and is done by dividing the price of the stock by the appropriate DWA Sector Index chart, then multiplying by 100 to come up with a plottable number. The DWA Sector Indexes were created for each broad industry group we follow. These DWA Sector Indexes are equal weighted and include a nice

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mix of stocks with varying capitalization, unlike the ex- change sector indexes, which tend to be more narrow and cap- italization weighted. The uniform percent scaling method is used with this type of RS chart, too, as well as all other RS charts.

How to Calculate Relative Strength

Now that you understand the two basic RS charts we use for an individual stock, let’s look at an actual example of each type of RS calculation.

Relative Strength of a Stock versus the Market

(This calculation uses closing prices and is done on a daily basis.) For example: XYZ Corp is at 81 and the SPXEWI is at 1252:

For example: XYZ Corp is now at 74 and the SPXEWI is at 931:

In this case, the stock dropped in price and the S&P 500 Equal Weighted Index also fell lower, but the RS reading for XYZ went up. This tells us that the stock is performing better than the SPX- EWI, and it is possible that the only reason it has fallen in price is that the overall market has dragged it down. These positive RS stocks will likely be the first ones to snap back once the overall market does. As a general rule, stocks with positive RS versus the

RS Reading= Stock Price × 100 SPXEWI

81 × 100 = 6.47 RS Reading 1252

74 ×100=7.95RSReading 931

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market will typically outperform the market during a bullish market condition, and will be more likely to hold up and weather the storm in a bearish market condition over the longer term. When the market transitions from Offense to Defense, these high RS stocks that have done so well verses others will likely experi- ence profit taking as many other stocks have no profits to be taken. Take, for example, the market beginning in early May 2006. The positive RS stocks carried the ball for most of the year. Stocks like Coca-Cola (KO) had burned out years before, and had done virtually nothing in 2006. It is natural that when optimism turns to pessimism in the market, investors rush to nail down profits but hold those stocks that have done nothing. In the two months from May 2006 to July 2006 the high RS stocks came down faster than the negative or low RS stocks because of this profit taking. Once the profits were taken they reasserted their RS and were the first to begin the run up once the offensive team came back on the field. There are a lot of little nuances in invest- ing that make up the market.

Relative Strength of a Stock versus DWA Sector Index (Peer RS)

(This calculation uses closing prices and is done on a daily basis.) For example: Intel (INTC) is at 22.50 and the DWA Semicon-

ductor Index is at 236:

For example: Intel (INTC) rises to 22.90 and the DWA Semi- conductor Index is at 244:

Peer RS Reading = Stock Price × 100 DWA Sector Index

22.50 × 100 = 9.53 Peer RS Reading 236

22.90 × 100 = 9.38 Peer RS Reading 244

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In this case, INTC rose in price, the DWA Semiconductor Sec- tor Index moved higher, but the Peer RS reading for INTC went down. Now, let’s substitute Advanced Micro Devices (AMD) for Intel in the previous example.

For example: AMD is at 30 and the DWA Semiconductor Index is at 236:

For example: AMD rises to 34.50 and the DWA Semiconduc- tor Index is at 244:

In this case, AMD rose in price, the DWA Semiconductor Sector Index moved higher, and the Peer RS reading for AMD moved up.

This comparative example demonstrates how AMD is outper- forming its Semiconductor sector peers, while INTC is underper- forming its peers. AMD’s Peer RS reading moved up from 12.71 to 14.14, while INTC’s Peer RS reading fell from 9.53 to 9.38. This particular type of RS reading allows you to identify the stocks that are the strongest of the group—the best in class—and these are the stocks that will likely perform the best within that sector. You have all heard of “Market Neutral” Hedge Funds right? Wouldn’t it make sense in the above example to buy AMD and si- multaneously sell short INTC? Think about it.

How to Interpret the Relative Strength Chart

In evaluating an RS chart, buy signals are given when a column of X’s exceeds a previous column of X’s (also referred to as posi- tive RS). Conversely, sell signals are given when a column of O’s exceeds a previous column of O’s (also referred to as negative RS). The pattern doesn’t matter with the RS chart (e.g., whether

30 ×100=12.71PeerRSReading 236

34.50 × 100 = 14.14 Peer RS Reading 244

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it is a Double Top or Triple Top buy signal), just whether the most recent signal is a buy signal or a sell signal—a top being broken or a bottom being broken. As well, unlike other RS meth- ods, the RS “reading” or number itself doesn’t matter; the results of these RS readings really don’t come to life until plotted on a PnF basis. Once the chart is plotted, the RS picture unfolds and provides guidance. Questions are easily answered, such as “Is the RS chart in X’s or O’s?” “Is it on a buy signal or a sell signal?” If you read my first edition book on Point and Figure Charting you will remember in the RS chapter I mentioned that I had found that the column was more important on the RS chart than the actual signal that developed, as it often indicated a change in trend was occurring. Since then we have done extensive work on the RS concept, and made improvements to these charts, as dis- cussed earlier.

Positive Relative Strength, or an RS buy signal, suggests the stock will outperform the market (or whatever you are compar- ing it to), while negative Relative Strength, or an RS sell signal, suggests the stock will underperform the market. But it is im- portant to note that just because a stock has positive RS doesn’t mean that it can’t fall in price; it merely means that it should not fall as much as the market averages. It’s as the name sug- gests—it is a relative measurement, not an absolute one. It is also important to watch for RS reversals, or changes in columns, as this provides shorter term guidance. While the RS signal indicates longer term relative strength, the most recent column provides an indication as to the shorter term relative strength. If the most recent column on the RS chart is X’s, it suggests the stock is outperforming in the near term; con- versely, when the most recent column on the RS chart is O’s, it demonstrates underperformance by the stock in the near term. As well, if you continue to see an RS chart put in another X after another X, it suggests the RS is only getting stronger, or is rising. This is a good sign for a stock, showing that it persists in outperforming the market. Conversely, if a stock is in a column of O’s and continues to put in more O’s, it is telling you that this stock’s RS is falling, and therefore should be avoided. In sum, the best combination for the RS chart is to be on a buy sig- nal and in a column of X’s; while the worst is for it to be on an

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RS sell signal and in O’s. Oh, one more thing. I find it very help- ful to look at the last calculation on that RS chart so you can gauge if the RS is beginning to move in another direction. Say the last box in the RS chart is in X’s at 20. A three box reversal will happen at 18.56. If the last reading on the calculation was 20.4 then you know the RS chart is not losing any strength. Conversely, in this same example, if the RS chart was at 20 and the last calculation on that RS chart was 18.72, you are close to a reversal to O’s and had better prepare for it.

The beauty of RS is that it can keep you invested in strong stocks for a long time, allowing you to participate in the gains— enabling you to catch the positive “outlier.” Think about it for a second. If a stock continues to have positive RS for years on end, all while the market averages continue to record notable gains, what does that say for the particular stock? Well, the only way a stock can continue to have positive RS versus a market that is moving higher, is for it to move higher in price, and at a faster pace than the market. In essence, RS allows you to let your prof- its run, with the (positive) RS chart providing a clear-cut reason to do so. This statement fits with the fact that a stock’s (market) RS signal will typically last about two years on average; and gen- erally speaking, it tells us the overall expected trend of the stock. Yet there are plenty of examples of how RS can stay posi- tive or negative for years on end. For example, IBM had positive RS from November 1996 to October 2000; its RS chart has been on a sell signal since October 2000. More staggering is the fact that Dell Computers (DELL) was on an RS buy signal from No- vember 1993 to April 1999—during this time the stock was up 100 fold! If that’s not impressive enough, Danaher (DHR) has been on a RS buy signal for 16 years, since May 1993. The out- performance during this expansive time frame is incredible— with DHR up 1545 percent compared to the SPXEWI which posted a not-so-shabby return of 256 percent. But just as RS works well to pinpoint outperformance, there are dramatic in- stances of how it warns of long term underperformance. Take Eastman Kodak (EK)—this stock was on an RS sell signal for 121⁄2 years, from March 1992 to September 2004; and the numbers shouted underperformance with EK losing 22 percent in a little over a decade while the market gained 242 percent. Another ex-

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ample of this is WorldCom. On page 100 of the second edition of this book, I recommended avoiding or selling short WorldCom before any of the negative news came out. Who could have tipped me off to this? The RS chart did. I said the following: “Overall weak RS stocks that reverse back to O’s are dangerous, and in most cases should be avoided, or potentially shorted. A case in point is WorldCom (WCOM).”

Another beneficial aspect of RS is it allows you (or tells you) to get off a horse not running the race and to move to one that is. This is where it’s imperative to keep up with changes in Relative Strength. Each day, changes in RS will occur—some stocks will move from an RS buy signal to an RS sell signal and vice versa, and some will show changes in column on their RS chart. The point is, you must constantly monitor the RS chart for changes. Our system at www.dorseywright.com will do this for you and alert you by e-mail of any changes in stocks that warrant your at- tention. If you own a stock that has just given an RS sell signal, it is time to evaluate whether that stock should be sold. Also, by knowing when a stock has given a new RS buy signal, or reversed up into a column of X’s, it will alert you to a potential turnaround situation or viable investment opportunity. Some graphical expla- nations will make this concept easier to grasp.

Examples of Relative Strength Changes for Stocks versus the Market

It never is too hard to find classic examples of relative strength, merely because the concept is so dynamic and robust. But, I must say some of the more dramatic illustrations of RS at work come from the year 2000. We all remember this time period; some fondly, while others are still licking their wounds from losses in- curred following the tech meltdown. Those that used technical analysis, and in particular Relative Strength, came through the 2000–2002 time period relatively unscathed. The evidence of a major top in technology and telecom stocks was right before your eyes, if you were willing to look.

One of my favorite examples of this on a stock specific basis is AT&T (T). As we all know, the Telecom sector had recorded

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blistering gains in the late 1990s, with stocks like Corning (GLW), Nortel (NT), Qualcomm (QCOM) and Lucent (LU) lead- ing the way. Even the venerable AT&T participated in the Tele- com sector ascension, as it more than doubled from 1997 to its peak in 1999 to 2000. But by early 2000 the jig was up—the RS charts started shouting that it was time to get out. AT&T, and another high-profile company that you surely remember—World- com (WCOM) (discussed earlier), were two of the first to scream uncle. In early May 2000, T gave an RS sell signal when it broke a Double Bottom on its RS chart, as indicated in Figure 4.2. This

Figure 4.2 AT&T Relative Strength chart.

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RS sell signal suggested the stock would underperform the mar- ket for some time to come. AT&T did exactly that! From May 2000 to August 2005, with the RS sell signal persisting, T was down 70 percent while the SPXEWI was up 38.5 percent. Simi- larly, WCOM gave an RS sell signal in May 2000, and we all know what happened here—RIP.

There is a saying, “as one door closes, another one opens.” This couldn’t have been more true in 2000. What we witnessed on an RS basis was a veritable “changing of the guard”; Technol- ogy and Telecom exited center stage while other, previously ne- glected sectors took the baton. This passing of the baton took the form of NYSE-type stocks giving RS buy signals. Stocks from such sectors as Building, Healthcare, Food and Beverage, and Utilities got the leading roles; and oh, what a performance they delivered. In fact, many of the RS buy signals given by these type of stocks in 2000 continue to be in place today. For example, United Healthcare (UNH) gave an RS buy signal in May 1999; its positive RS remains in force today. Throughout this time period we have seen UNH post an astronomical return of +483 percent; that is what I would call a “positive outlier” re- ferring back to the 80/20 Rule! A similar phenomenon happened with many of the Building stocks. These stocks have proven to be a textbook example of the power of (positive) Relative Strength, and how signals can last for years on end, allowing you to capture large winners.

In all my years on Wall Street, the Building stocks were never ones that attracted much attention. The action in them, for the most part, was like watching paint dry—boring, if you will. For example, it was not unusual for Toll Brothers (TOL) to trade in a range between 16 and 22 for a couple of years on end. But that all changed in 2000 to 2001. Once again, the RS chart steered you in the right direction, unemotionally able to remove any predisposi- tions one might have had about the “boring” Builders. The role reversal started with TOL and Lennar (LEN) in late July 2000; both gave RS buy signals, suggesting these stocks would outper- form the market for some time to come. LEN stayed on an RS buy signal from July 2000 to May 2006 and during this time gained 376 percent! Not bad for a boring Building stock. But this action

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Figure 4.3 Ryland Homes Relative Strength chart.

was not relegated to just a few—others followed suit. Pulte Homes (PHM), Beazer Homes (BZH), Ryland Homes (RYL), and KB Home (KBH) all gave RS buy signals in the months to follow. Not surprisingly, the Building sector has been one of the best per- forming sectors since July 2000. So while the OTC/Technology arena was giving RS sell signals, other opportunities emerged in the least likely places. In Figure 4.3, we show you the Ryland Homes (RYL) RS chart. It is a great example of how RS unemo- tionally measures outperformance; so when doors like this open, be ready to walk through them.

Where’s the Relative Strength Been, or Not Been?

We have, so far, directed our conversation about RS signals to the 2000–2001 period. But we now want to turn our attention toward more recent RS changes. Over the past couple of years, the one

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area that has attracted investor’s attention has been the broad group of Basic Resources—Nonferrous Metals, Precious Metals, Steel and Iron, Oil and Oil Service; for good reason. Not only have the underlying commodities, such as gold and crude oil risen spectacularly, stocks in these sectors have produced unbelievable gains. Once again, RS did the job of guiding you toward these areas of outperformance. In the table that follows, we show you a sample list of some key RS buy signals that occurred in the Basic Resources group. Notice how these signals started cropping up in 2002 to 2003, and how they remain in force several years later. The returns for these stocks speak for themselves:

Where’s the Beef Been Lately?

While the raw materials stocks have been the “sweet spot” of the market for the past few years, it has been the large cap, and specif- ically Consumer Noncyclical and Cyclical stocks, that have been kicked to the curb. Old stalwarts such as Coca-Cola (KO) and Ford Motor (F), not to mention Wal-Mart (WMT), have been “taken to the wood shed.” Their RS charts depict this whipping clearly—having given sell signals over the past few years. Unfor- tunately, many investors still own these blue-chip names, not willing to part with them. But the underperformance cannot be denied; all you have to do is look at your statement each month to see the performance lag brought about by owning weak RS names. So I ask, “Do you need to weed out some poor RS stocks from your portfolio?”

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Spotting Positive Divergences

This leads us to a discussion on market divergence. It is also im- portant to use RS to determine market divergence during times of weakness in the overall market. As discussed in later chapters, our market indicators will help dictate whether you should be playing offense or defense against the market. When defense is recommended, it becomes necessary to evaluate your portfolio positions all the more closely. This is a great time to get rid of your underperforming stocks. If those stocks haven’t kept up while the market has headed higher, they are not likely to hold up well if the market moves lower. RS becomes a valuable tool to help determine which stocks get sold and which stocks are kept. Given that the market, on average, goes up two-thirds of the time, and down one-third of the time, going to 100 percent cash by sell- ing all your positions is a huge bet. A more sensible approach is to weed out the poor RS performers and sell those stocks to raise the cash level in your portfolio. Keep the strong, positive RS stocks since they will be more resistant to decline, and will likely snap back once the market gets back on solid footing.

There is another aspect, or way to visualize market diver- gence and RS. During market corrections, it is important to ob- serve whether a stock (or group of stocks in the same sector) is showing higher bottoms on its trend chart while the market aver- ages are making lower bottoms. Often there is a change in leader- ship after a market correction; in many cases, subtle signs will occur even before the market as a whole has bottomed out.

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We witnessed this phenomenon over the past few years, for example, with the Building stocks and Oil stocks. The market av- erages, for all intents and purposes, topped out in 2000. From there it was a slippery slope to drastically lower prices. This trek south persisted for a couple of years, with new lows being regis- tered in 2001, then 2002; a test of the 2002 market lows then oc- curred in March 2003. Yet while all this was going on in the mainstream, underneath the surface subtle, positive changes were occurring. Certain stocks were bucking the trend, and in- stead were showing a series of higher tops and higher bottoms— in short, they were experiencing a positive divergence from the market. KB Homes (KBH) is one such stock. Each time the market sold off further to make a new bottom or test its old lows, KBH was showing higher bottoms. It was showing a positive diver- gence from the market. The trend chart itself was speaking vol- umes about the future prospects of KB Homes. It was displaying improvement in RS. This phenomenon was not relegated just to KBH, other Building stocks showed a similar pattern; a change in sector sponsorship was underway. KBH, as a proxy for the group, rose 139 percent from May 2000 to March 2003, and its sector brethren joined in the parade, all while the market averages were posting substantial losses (see Figure 4.4).

The KBH example displays how, as Yogi Berra used to say, “You can observe a lot just by watching.” Changes in sector spon- sorship often present themselves in the form of an RS change, no- ticeable right on the trend chart as was the case with KBH; or you may see a cluster of stocks in the same group give RS buy signals all around the same time, as we previously discussed with the Builders and Basic Materials and Natural Resources stocks. But this type of occurrence is nothing new. I remember back in Octo- ber 1990, how we noticed the RS charts of Dominion Resources, Houston Industries, Scana Corporation, and Texas Utilities turned positive for the first time in four or more years. This posi- tive RS change was an early warning system not only for the Util- ity sector, but boded well for the economy and market as a whole. One month later, our market indicators gave major buy signals. A similar case happened in November 1991. In one week, we saw Hercules, Briggs & Stratton, and Cummins Engine turn positive on their RS charts after being negative for years. The message was

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Figure 4.4 KB Homes showing Positive Divergence.

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clear—the cyclical stocks were ready to take the lead. This work is why we have been called “Wall Street’s Air Traffic Controller.” It is equally important to watch for negative divergences. Just as the trend chart of a stock can depict a positive divergence, it can also alert you to a negative divergence. This is easily seen on the chart in the form of lower tops and bottoms, all while the market averages are showing higher tops and bottoms. This situa- tion has occurred more so over the past couple of years given that the majority of market averages have consistently made higher bottoms (since the July–October 2002 lows). When a stock shows a negative divergence from the market, it is a warning sign that something is wrong, and that the stock is losing relative strength. In most cases, it suggests you sell the stock or take some type of defensive action. A case in point is Apollo Group (APOL). The distance-learning stocks, such as APOL, had seen strong moves up, similar to the takeoff of an F4B Phantom Jet from the deck of an Aircraft Carrier. This took place for the better part of four years and in the process these stocks recorded massive gains. But that stopped in mid-2004. APOL peaked at 98 in June of that year, and has not been back to those highs since. Instead, while the S&P 500 Equal Weighted Index (SPXEWI) has made higher correc- tion bottoms, APOL has moved to new lows on each correction and has made lower tops when the market has posted new highs during this same time period. Figure 4.5 is an example of negative divergence—APOL has fallen 48 percent since June 2004 while the SPXEWI has gained 19 percent. All told, the trend chart itself can speak to you about RS, if you are willing to listen (or should I

say “look”).

Changes in Relative Strength Column from Long Tails Up or Down

In a secondary fashion, it is important to pay attention to RS changes in columns. When a stock reverses back up into a col- umn of X’s on its RS chart, it is displaying positive near-term outperformance. An RS change in column (to X’s) can also be helpful in identifying a turnaround situation. This can be

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Figure 4.5 Apollo Group showing Negative Divergence.

especially true if the RS chart had previously been in a long col- umn of O’s down, either because the stock itself had been shunned or because the sector as a whole had been out of favor. Such instances can result in a long tail of O’s on the RS chart. As

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a result, to technically get a buy signal on the RS chart, the col- umn of X’s back up would have to travel a long way to break the previous column of X’s. For this to occur, the stock will have likely already experienced a huge move to the upside. Therefore, after a Long Tail Down, it is acceptable to consider an RS rever- sal to X’s as a buy signal of sorts, or at least a sign that the stock could be in the midst of a turnaround, and is worth you taking a closer look at the technical developments of that stock. I saw this situation many, many times years ago, which is why in the first edition of Point and Figure charting I discussed how the col- umn was more important than the signal. Since then we have changed the charts to represent percent changes and the signals come more frequently now. So what I do is look at the RS chart to see if a signal is close at hand. If so I might wait for it to de- velop before I pile in. If the signal is not near then the change in column is enough for me to go ahead and buy given all other pieces of the puzzle fall into place.

A good illustration of this type of situation can be seen with Lockheed Martin (LMT). As you can see in Figure 4.6, LMT re- versed up on its RS chart in April 2000 after a Long Tail Down. This was the first sign that changes were afoot for this defense contractor. Not too long after the RS reversal, LMT changed its overall trend to positive (in August 2000), and from then on it was “no looking back.” But it wasn’t until August 2002 that LMT gave a formal RS buy signal on its RS chart after having re- traced the entire Long Tail Down of O’s. The performance of LMT from April 2000 to August 2002 was staggering—the stock posted a gain of 185 percent while the market was down 20 per- cent. There were other such occurrences of this type of action in 2000. Stocks such as FMC Corporation (FMC), Emerson Electric (EMR), and Duke Energy (DUK) all reversed up (into X’s) on their RS charts in late 1999 or early 2000, hinting that the NYSE type names were ready to move after having been overshadowed by technology stocks. These three stocks were up 40 to 50 percent each at the end of 2000. Not bad, considering what a tough year 2000 was.

With respect to RS changes in column to O’s, you want to look at it exactly opposite as laid out in the preceding two paragraphs.

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Figure 4.6 Lockheed Martin: RS reversal after Long Tail Down.

As mentioned before, overall weak RS stocks that reverse back to O’s are dangerous, and in most cases should be avoided, or poten- tially shorted.

Strong RS stocks that reverse to O’s suggest lower prices or possibly a period of consolidation for the stock, a breather if you will. At such time, positions in that stock could be lightened up, or possibly hedged by selling calls against the stock. This is espe- cially something to note if the reversal to O’s occurs after a long column of X’s up, Apple Computer (AAPL) is a recent instance of this, which can be seen in Figure 4.7. AAPL’s RS chart had shown dramatic outperformance for a couple of years, spiking up 29 straight boxes. But then in February 2006, the RS chart reversed

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Figure 4.7 Apple Computer: RS reversal after Long Column Up.

to O’s, suggesting the stock was starting to underperform the market; and that AAPL was going to take a breather after having been one of the best performing stocks in the S&P 500. While trying to catch its breath, AAPL so far has fallen 12.6 percent since the RS reversal to O’s, while the SPXEWI has only dropped 2 percent.

Coming Full Circle with Relative Strength

In finishing our discussion on RS of a stock versus the market, we want to leave you with one last example, one that we believe is a textbook example of using RS with overall trend analysis. In other words, XM Satellite (XMSR) provides a great visual for how

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you can use both “absolute” and “relative” technical measure- ments together to position yourself to capture those large win- ning trades.

XMSR displays the importance of monitoring changes in trend, along with changes in relative strength—not only for entry in to a position, but also with respect to your exit. XMSR was a stock we featured in our “Daily Equity Report” on Febru- ary 21, 2003. In that report, we brought to our clients’ attention that XMSR had just recently violated its long-term Bearish Re- sistance Line; that its overall trend had changed back to posi- tive after years of being in a downtrend. To boot, we wrote that XMSR had just given an RS buy signal in January, a month prior. Putting these two important factors together, we recom- mended to our clients that they buy XMSR. Over the next three years, XMSR gained 543 percent, dwarfing the SPXEWI’s attrac- tive gains of 69 percent. But things change, and you must watch for the evidence of change. As much as XMSR screamed that a positive turnaround was in the offing in early 2003, it shouted that things were likely to unravel in early 2006. After three years of being a positively trending, strong RS name, XMSR vio- lated its Bullish Support Line in January 2006, thereby changing its overall trend to negative. The RS chart followed suit, giving an RS sell signal in the same month. XMSR was “tuning out” and was likely to underperform the market given these negative technical developments. XMSR promptly fell 49 percent com- pared to the market slipping a mere 3 percent. As with life, and the stock market, what goes around, comes around. Therefore, it is imperative to adapt to changes in such things as trend and RS (see Figure 4.8).

Examples of Peer Relative Strength Changes for Stocks

The evaluation and interpretation of the Peer RS chart is the same as the stock’s RS chart versus the market. Similarly, we are inter- ested in the most recent signal on the Peer RS chart, and current column the chart is in, be it X’s or O’s. Here, as well, the best com- bination for a Peer RS chart is to be on a buy signal and in a col- umn of X’s. Since Peer RS measures how a stock is doing relative

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Figure 4.8 XM Satellite: Coming Full Circle with Relative Strength.

128 Learn the Point and Figure Methodology

to its sector siblings, a positive Peer RS (buy signal) reading im- plies the stock is outperforming an index of its related peers. The purpose of Peer RS is to steer you to the stock(s) that will likely perform the best within any given sector.

A good illustration of the power of Peer RS involves Hallibur- ton (HAL) and the Oil Service sector. As Figure 4.9 exhibits, HAL was on a Peer RS sell signal versus the DWA Oil Service Index (DWAOILS) from March 2000 until October 2002. This implied that HAL would underperform its sector peers during this time. That is exactly what we saw. HAL was down 59 percent over this two-and-half year stretch while the DWAOILS Index was only down 8.2 percent. As these numbers would suggest, Peer RS does not speak to the performance of the underlying group, but only to the performance of the underlying stocks compared to the group. By October 2002, Halliburton did an about-face and started to outperform its Oil Service peers, as evidenced by the Peer RS buy signal on October 21, 2002. After a period of underperformance,

Figure 4.9 Halliburton Peer Relative Strength chart.

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this change in signal now implied that HAL was ready to be one of the leaders of the group. The numbers confirm this—as of June 2006, HAL is up 355.4 percent while the DWA Oil Service Index is up a very respectable 187 percent. In sum, HAL is up almost twice that of the average Oil Service stock!

To take it a step further, let’s look at the impact of not paying attention to Peer RS with respect to your stock selection. For this we will once again use the Oil Service sector. Toward the end of 2002, the Energy related sectors were showing clear signs of tak- ing a leadership role. It was an area of the market that we recom- mend to our clients, suggesting they gain exposure. One such stock that presented itself as a viable candidate for purchase was Halliburton (HAL) for reasons mentioned earlier. But some may have said, “it doesn’t matter what stock I buy in Oil Service.” Well, it does matter as Figure 4.10 concludes. Let’s hypothetically say that on a fundamental basis you had narrowed your OILS se- lection down to two names—Halliburton (HAL) and Tidewater (TDW). From there you may have said, “flip a coin” to decide which one to buy. That would have been a very bad decision. In- stead, a glance at the Peer RS charts would have provided all the information you would have needed to make the final decision as to what stock to buy. In October 2002, HAL had given a Peer RS buy signal while TDW remained on a Peer RS sell signal (and in O’s). This alone suggested TDW was and would continue to un- derperform its fellow OILS members, and that HAL was likely to continue to outperform. Through June 2006, these same Peer RS signals remained in force with HAL up 355 percent compared to TDW posting a gain of 63.3 percent. During this same period of October 2002 to June 2006, the DWA Oil Service Index was up 187 percent and the S&P 500 Equal Weighted Index was up 78 percent. So you see, it did matter which OILS stock you selected. HAL was up more than five times that of TDW. This is a simple example of how you can potentially choose the right sector to play, but not necessarily the right stock. Peer RS endeavors to guide you to the best in class, in this case to HAL rather than TDW. A good general rule, then, is to focus your buying on those stocks that have positive RS versus both the market and their peers. This will greatly help in narrowing the list of potential buy candidates down to a reasonable number. This points to the fact

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Figure 4.10 Peer Relative Strength: Halliburton versus Tidewater.

of what we are trying to do, in general, in this book. We’re taking the fire hose of information investors are barraged with each day and rendering it down to the trickle of a garden hose. That’s really the whole ballgame.

Peer RS becomes extremely beneficial when a sector rotates back into favor, as the example demonstrated. We all know that sectors rotate in and out of season just as vegetables and fruits do in the grocery store. Therefore, to achieve consistent returns over time, it is crucial to maneuver in and out of sectors as the indicators dictate. Can you imagine how well a clothing store would do all year if they didn’t change their inventory to reflect the current or upcoming season? (We have numerous sector evaluation tools at our disposal to help guide us to the right sec- tor(s) at the right time; we discuss these in more detail later.)

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The Peer RS chart is quite valuable in this maneuvering process, specifically when it comes down to actually selecting the stock(s) you want to play within that sector. By identifying the stocks within the sector that are outperforming their peers, you are able to find the strongest of the group—and they are the ones most likely to perform the best as the sector strengthens. The Search/Sort function on our online database is extremely effec- tive in handling this task. We have a favorite search that we con- duct when trying to find the best stocks in a sector that has rotated back into favor. Let’s assume that the Metals Nonferrous sector has just moved back into favor, and therefore is a sector that we want to gain exposure to; the search criteria would go as follows:

• All stocks that are on an RS buy signal versus the market, but allow for the most recent column to be either X’s or O’s.
• All stocks whose Peer RS chart is on a buy signal and in a col- umn of X’s.
• All stocks that are members of the Metals Nonferrous sector that are in a positive trend, trading above their Bullish Sup- port Line.

  The results of the query would give us a list of Metals Non- ferrous stocks that have been outperforming the market over the longer term (denoted by the RS buy signal versus the mar- ket). With respect to the sector, we chose to have the stocks dis- played to be on RS buy signals and in X’s suggesting outperformance within their peer group on both a short-term and long-term basis (denoted by Peer RS buy signal and in X’s reading). Last, only those stocks in a positive trend, showing ab- solute price appreciation over time would have made the cut, in addition to having met the strict RS requirements. This list of candidates could be narrowed down further by requiring the stocks to be fundamentally sound. With a couple of clicks of the mouse, this query would allow us to reduce the number of po- tential buy candidates down to a very reasonable number. A fur- ther technical review could then be administered to decide which stock(s) should be bought from this list. This process

132 Learn the Point and Figure Methodology

would pinpoint those stocks within the sector with the best RS, and as you have learned, it is these stocks that will likely lead the sector up as it strengthens.

Had you administered such a Search/Sort back in early 2003 when Metals Nonferrous was moving back into favor, Phelps Dodge (PD) would have made your final cut as a buy candidate. Yet, the venerable Alcoa (AA) would not have made the list. Al- though most investors may have felt better emotionally going with the well-known AA, it would have been a very bad decision. To this day, AA remains on a Peer RS sell signal, while PD con- tinues to be on a Peer RS buy signal (given in late February 2003). Since that time, PD is up 374 percent while AA is only up 47 per- cent; and the DWA Metals Non-Ferrous Index (DWAMETA) is up 172 percent while the SPXEWI is up 82 percent. Phelps Dodge has been the leader and Alcoa has been the laggard, just as the RS implied.

Another application of Peer RS involves sector divergence. If you have representation in a particular sector, there may be times you should swap out of one name and into another be- cause of a Peer RS change. Using the previous example, let’s say you owned Alcoa (AA) in the Metals Nonferrous sector, and this sector continues to be an area where you want exposure. AA then gives a sell signal on its Peer RS chart, and the techni- cal picture in general has deteriorated. One strategy would be to swap out of the Alcoa into a stock with positive Peer RS, such as Phelps Dodge (PD). This allows you to have sector representation in Metals Nonferrous, but realigns the token position to one with better Peer RS, which by definition has a better likelihood of outperforming the discarded Alcoa (see Figure 4.11).

As the Alcoa-Phelps Dodge example would suggest, emotional attachment to a stock because of its name or any other reason, can be detrimental to the overall portfolio’s health, and ultimately can be a big drag on performance. This is why technical analysis, and in particular relative strength, is so powerful and unbiased—it concisely quantifies outperformance or underperformance. When a security moves into a laggard, underperforming position, you need to unemotionally detach yourself from it; sell it to make room for the leaders, such as PD in this example.

Foundations of Relative Strength 133

Figure 4.11 Peer Relative Strength: Phelps Dodge versus Alcoa.

Putting It All Together with Technical Attributes

Over the course of this chapter we have tried to impress upon you the importance of RS. As presented so far, we use two basic RS calculations for stocks. To that end, you have learned the defini- tion and how to calculate and interpret these RS charts. Of course, the significance of each RS measurement by itself is no- table, as you have seen from the previous examples; but the real power lies in bringing this information together in a succinct manner. Therefore, to facilitate a more concise representation of a stock’s technical aspects, which includes RS, we developed what we call our “Positive Technical Attributes” reading. This, in essence, provides a summary of what you have learned so far, and provides a way to easily rank stocks on a technical basis.

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DWA’s Positive Technical Attributes reading (for a specific stock) is comprised of five criteria, yet there is a heavy emphasis on Relative Strength. They are as follows:

Positive Technical Attributes

1. A stock’s RS signal versus the market (on buy signal)
2. A stock’s RS column versus the market (in X’s)
3. A stock’s RS signal versus the peer group (on buy signal)
4. A stock’s RS column versus the peer group (in X’s)
5. Overall trend of a stock (Is it trading above the Bullish Support

Line?)

There are five possible positive technical attributes a stock can have, as listed above. Strong stocks have at least three out of five of the criteria positive, and this is where your buying should be focused. Conversely, weak stocks, and typically ones to avoid, are those that have a Positive Technical Attribute reading of 0, 1, or 2 out of 5 (positive). In other words, strong stocks are those that are trending higher with superior RS; while weak stocks are typi- cally those in a negative trend with poor RS. There are three charts to consult when determining what the Technical Attribute reading is for a stock—the Trend chart of the stock, the RS chart of the stock versus the market (SPXEWI), and the RS chart of the stock versus its peers (DWA Sector Index). As the list lays out, four of the five possible technical attributes are RS based—two are longer term in nature, dealing with the RS signals, and two are shorter-term based, dealing with the RS columns. In sum, the Pos- itive Technical Attribute reading merely provides a quick, easy way to summarize the strength of a stock versus the market and the sector, in both an absolute and relative manner.

Although our DWA charting database provides the Positive Technical Attribute reading of each stock for you, an example of how the reading is arrived at may be helpful. For this we will re- turn to Halliburton (HAL) because it affords an excellent illus- tration of how the Positive Technical Attribute reading can change, and how to arrive at what the reading is. As mentioned, we need to analyze three different charts to ascertain what the Positive Technical Attribute reading is for HAL, as shown in Figure 4.12. As this series of charts displays, HAL experienced

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Figure 4.12 High Positive Technical Attribute Reading: Halliburton.

136 Learn the Point and Figure Methodology

an orderly march from being a technically weak stock to becom- ing a technically sound stock, and therefore one to consider for purchase in order to gain Oil Service exposure in late 2002. Over the course of roughly four months, Halliburton upticked from a 0 for 5 status to a 5 for 5’er, which is the best reading a stock can have with respect to Positive Technical Attributes. The first im- provement, not surprisingly, came from the shorter-term RS measurements—the column reading on both the Market RS and Peer RS charts. These two RS charts both reversed up into a col- umn of X’s on July 25, 2002, showing that HAL was starting to outperform both the market (SPXEWI) and the DWA Oil Service Index (DWAOILS) in the short term. This caused the Positive Technical Attribute reading to uptick to a 2 for 5 reading. By early October, Halliburton’s RS chart versus the market gave a buy signal, causing the attributes to uptick further, to a 3 for 5 status. Shortly after that, on October 21, 2002, the Peer RS chart for HAL gave a buy signal, moving the Technical Attribute read- ing up to 4. In other words, within a few months HAL vastly im- proved on a relative basis, both short term and longer term and moved into a condition of outperformance. Within a couple of weeks (November 6, 2002), Halliburton penetrated its Bearish Resistance Line, thereby changing its overall trend to positive, and by doing so caused the Technical Attributes to once more uptick, to a 5 for 5 reading.

When we initially started this discussion on Technical Attri- butes, we stated that you should relegate your buying to those stocks whose Technical Attribute reading is 3, 4, or 5 for 5. But we do want to add a general rule of thumb to that statement— focus your buying on those stocks that are a 3, 4, or 5 for 5’ers AND are in an overall positive trend. The trend component as- sures that you are seeing, over time, absolute price appreciation, too. So in the case of HAL, strictly speaking, you would not have considered the stock for purchase until November 6, 2002, when the trend turned positive. Even still, the returns henceforth for HAL are dramatic, showing how robust the Technical Attribute ranking system can be. In sum, HAL stayed in an overall up- trend, with either a 4 or 5 (for 5) Technical Attribute reading from November 2002 until May 2006. During this time, the stock posted an extraordinary gain of 311 percent while the av-

Foundations of Relative Strength 137

erage Oil Service stock gained 194 percent and the market posted a return of 72 percent.

Just as the example of Halliburton shows how important it is to focus your buying on those stocks in a positive trend with a high Positive Technical Attribute reading, it is equally important to avoid (or sell short) those stocks trending negatively with a low Positive Technical Attribute reading (of 2 or lower). A case in point is Wal-Mart (WMT). This blue-chip stock has long been an institutional favorite, and additionally is one that is often found in many investors’ portfolios. Throughout the late 1990s, you were rewarded handsomely for owning WMT, and the Technical Attributes supported such a posture. But lately, any long commit- ment to Wal-Mart has been a losing proposition.

Once again, this is where the Positive Technical Attributes could have been of great help, steering you away from this dis- count retailer when the indicators suggested it would be an un- derperformer. In Figure 4.13, the Technical Attributes are listed, chronologically, for Wal-Mart. Notice how on December 2, 2003, WMT’s Positive Technical Attributes reading slipped to the unacceptable 2 for 5 level. Said another way, WMT was fal- tering on an RS basis, and was starting to trend negatively, and therefore was a stock to exit or hedge in some way. For whatever reason, supply had taken control of this stock—Wal-Mart had become its own “blue-light” special and no one was buying. This lack of demand for WMT’s stock has persisted, as the Tech- nical Attributes reading has stayed at either a 0, 1, or 2 for 5 for close to three years now. Translated, WMT has been an unac- ceptable investment on a technical basis since falling to a 2 in late 2003. The numbers support this stance—WMT has strug- gled lower by 9.3 percent, while the market (SPXEWI) has forged ahead 30 percent. This is a classic example of the need to sepa- rate your love or admiration for a company from an actual in- vestment in the company’s stock. The notion of marriage is that we enter into it with the intention of remaining faithful until “death do us part.” But a stock is an investment—neither a com- mitment nor an attachment. A stock should not be held until “death do you part,” but rather “until Technical Attributes do you part.” I guess this suggests a stock can only be a bridesmaid, never a bride.

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Figure 4.13 Low Positive Technical Attribute Reading: Wal-Mart.

Foundations of Relative Strength 139 Summary of Relative Strength

We believe RS to be one of the most robust and adaptable tools for analyzing a particular stock. As you have learned in this chapter, RS is a very simple concept and is easily calculated. Clearly though, this does not diminish its effectiveness. Instead, by defi- nition and as the earlier examples attest, RS on a Point and Figure basis succinctly quantifies outperformance and underperfor- mance. Stocks that exhibit positive RS are typically able to navi- gate the uncertain waters of the stock market much more easily than a stock with negative RS. By staying abreast of changes in Relative Strength, you are guided to new opportunities, while being steered away from danger. This enables you to capture the large winners, or positive outliers. Remember size does matter when it comes to your hard earned money. Of course, not every trade is going to result in outsized gains; in fact, the bulk of trades (such as 80 percent) will produce small gains or small losses, but the key is to avoid the large losing trades. Relative Strength, and more encompassing—Positive Technical Attributes, provide a means for doing just that. Bringing an absolute measurement (Trend), together with RS in a concise ranking or reading, as the Positive Technical Attributes provides, the stock selection pro- cess is streamlined, yet without compromise to performance. As said, long positions should be focused on those names that are in a positive trend that carry a 3, 4, or 5 for 5 Positive Technical At- tribute reading, while those with a reading of less than 3 should be avoided.

Relative Strength has no bias; it tells you unemotionally what is really happening. By making RS a key component to your stock evaluation, you will increase your odds of success, and that’s the best you can hope for. It’s as simple as that.

POINTS AND FIGURES BY DORSEY, WRIGHT MONEY MANAGEMENT

Some months it seems like everything goes wrong. Your roof leaks in the rain, your refrigerator blinks out and turns your ice cream sandwiches into a sticky puddle, or your mailbox is filled with recall notices for your family car. It seems like trouble comes in bunches in the stock market too, but how often do things really go wrong?

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Columbine Capital did a study on common return factors and their monthly failure rates. They considered a return factor to be a failure if, for that month, the bottom decile in the ranking outperformed the top decile in the ranking. So, for example, if the top dividend yielders had a terrible month while the no-yielders had a great month, the dividend yield factor would be considered a failure for that month. All of these return factors worked over time—this just tells you how often you can expect an out-of- pattern month. The time period studied was rather extensive: 1971 through early 2003 (or from 1990 in the case of estimate-driven factors).

In fact, dividend yield failed as a return factor 49.7 percent of all months. Price/book failed 43.8 percent of the time. Price/cash flow wimped out 38.4 percent of the months. Earnings yield was the best of the value factors and had a 37.4 percent failure rate. Earnings surprise was a little better at 36.9 percent. Among the best factors were estimate revision with only a 31.9 percent failure rate and price momentum—what DWA subscribers would call relative strength—at 27.3 percent. In other words, of all of the return factors, relative strength is the most reliable, with nearly three of four months showing strong stocks outperforming weak ones.*

These factors are, of course, primary inputs into our stock selection process at Dorsey, Wright Money Management. We are searching for strong stocks in strong sectors and the return factor failure rates are part of the reason we manage money the way we do. (The technical attribute ranking system, pioneered in Money Management and implemented beautifully by our database guru, Jay, allows you to find the outliers in each sector with ease.) Relative strength is just one more way to stack the odds in your favor. Used alongside risk management, you have a viable method for portfolio management.

* Relative strength is often lousy in January, when the “January effect” works in favor of the downtrodden stocks and against those that are relatively strong. Avoid using it at year end.