Morning Market SnapShot for Tuesday, July 06, 1999
Investors often hear the term “relative strength”. What does this mean, and how do investors use it? First, relative strength should not be confused with the Relative Strength Index (RSI) which was developed by Welles Wilder, Jr. in the late 1970s. A more appropriate term would be “ratio analysis”. John Murphy describes ratio analysis as follows.
“The use of a ratio to compare the relative strength between two entities. An individual stock or industry group divided by the S&P 500 Index can determine whether that stock or industry group is outperforming or underperforming the stock market as a whole. Ratio analysis can be used to compare any two entities. A rising ratio indicates that the numerator in the ratio is outperforming the denominator. Ratio analysis can also be used to compare market sectors such as the bond market to the stock market or commodities to bonds. Technical analysis can be applied to the ratio line itself to determine important turning points.”
In English, Mr. Murphy is saying that looking at ratios can be useful in stock selection for traders and sector selection for mutual fund holders. For example, aggressive mutual fund switchers can monitor various sectors, such as the S&P Bank, Chemical, Healthcare, Insurance, Retail and Transportation indices, etc and compare them to the S&P 500 Index. Funds can be rotated out from sectors that begin to underperform the S&P 500 to sectors that begin to outperform the S&P 500.
Stock traders can take this step even further. They can perform ratio analysis on individual stocks within a sector as the sector begins to outperform the S&P 500. This has the effect of singling out the strongest stocks within the strongest sectors and allows the trader to concentrate long positions in stocks with the strongest momentum. This analysis can be done in reverse to take short positions in weak stocks within the weakest sectors where momentum is working in reverse.
In this chart, we can examine some key indices relative to the S&P 500 Index. The Dow Industrials broke a period of outperformance in the second week of May and has been holding it's own since then, but the S&P 500 appears to be starting relative outperformance. The Dow Transportation index has totally underperformed since May and that trend is still intact. The Dow Utilities index broke its trend of outperformance during the second week of June. The 30-Year Treasury bond is still continuing its trend of underperformance. The CBOE Internet index outperformed the S&P 500 from mid-February to the first week of April when it broke the trend and began to underperform until last week, when it broke that trend. For mutual fund switchers, ratio analysis performed on the daily chart is very helpful in entering sectors near bottoms and exiting near tops.
Mr. Murphy's book, Intermarket Technical Analysis can be found at amazon.com His web site is located at murphymorris.com
Charts specific to these comments have been posted to
intelligentspeculator.com
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