Relative Strength

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Learn about using relative strength to create rankings within a group of assets (e.g. a 401(k))

 

In a traditional asset allocation model you would typically own positions in a variety of asset classes, each to varying degrees (as seen in Figure 1) - a methodology aligned with Modern Portfolio Theory (MPT).

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

One important thing to note is that MPT generally doesn't recognize cash as a truly viable asset class (more on this later). The idea behind this methodology is that diversification across multiple asset classes will provide us with a measure of safety while also creating consistent returns. As we saw in 2007-2009, however, this thinking does not always prove to be true; it's possible for all asset classes to lose value at the same time. We believe there's a better way to grow your assets and protect your hard-earned gains: using relative strength to identify leading and lagging classes, and investing accordingly.

 

In a nutshell, relative strength tracks price movements to measure how one asset (or asset class) is performing compared to another. We can use relative strength to see how Apple is doing versus the S&P 500, how Apple is doing compared to IBM, or how a large-cap growth mutual fund at Vanguard is doing versus a similar fund at another fund company. We contend that using relative strength will point us towards outperformers and steer us clear of underperformers, giving us more opportunities to capture "winners" and avoid "losers".

 

As mentioned earlier, traditional asset allocation models generally do not recognize cash or money market accounts as a truly viable asset class. This creates major problems when a portfolio sees all of its asset classes lose value simultaneously - where can you go to find protection?

 

In the spring and fall of 2008, essentially all asset classes experienced decline in value. The MPT way of thinking held that declines in a portfolio were normal and that there should be no need to change strategy. Again, the idea here is that by holding a variety of asset classes creates a portfolio that lessens the impact of market declines. In October 2008, however, all of these asset classes became positively correlated and all experienced declines - all asset classes, that is, except for CASH.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

On the other hand, relative strength calculations (see Figure 2, above) that viewed cash as a viable asset class indicated several instances in which equities and fixed income securities were to be avoided - that is, cash as an asset class was relatively stronger than equities and fixed income. Adjusting your portfolio according to these signals would have provided valuable capital preservation to set you up with more wealth to reinvest in 2009 when other classes once again became stronger than cash (Figure 3, below).

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Since that bear market, studies are challenging the way Modern Portfolio Thery has traditionally been applied: "Investment results in 2008 showed clearly that correlation of asset classes varied unpredictably and without warning. This brings into question the very basis for MPT and its ability to forecast an efficient frontier. MPT simply cannot be used in isolation. Instead it should be thought of as only one reference point for modeling the behavior of a potential portfolio. It is only one dimension of a more comprehensive investment-management process."

 

We believe that it's time to separate ourselves from the "buy-and-hold" MPT way of thinking and instead embrace the tools of relative strength. We see there being value for our clients in multiple facets: in bearish conditions relative strength should assist us in capital preservation, and in bullish conditions it should improve our ability to separate "winners" from "losers" so we can better participate in investment gains.

 

Perhaps it's time to review your investments and study their strength.

 

Do you have one or more holdings that are causing you concern?

 

Should you continue to hold them? Or could you be better-off re-allocating those funds?

 

Send us an email now to request a complimentary portfolio analysis!

 

 

Figure 1 - Example of a Typical Asset Allocation Model

Figure 2 - Indicators to Avoid Domestic Equity and Fixed Income Securities in Favor of Cash

Source: Dorsey Wright & Associates

Figure 3 - Indicators to Re-Enter Domestic Equity and Fixed Income Securities as Opposed to Cash

Source: Dorsey Wright & Associates

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