BALTIMORE (Stockpickr)
-- Relative strength is one of the most important concepts in technical
analysis, especially when markets are as anxiety-ridden as they are now
-- but it’s also one of the most misunderstood. In this Technical Primer, we’ll take a look at what relative strength really is, as well as what it isn’t.

More importantly, we’ll look at how this concept can help you beat the market, even in challenging conditions.

For starters, relative strength isn’t the same thing as RSI. RSI, the initialism for Relative Strength Index, is a momentum indicator
based on a stock’s recent gains and losses. It measures one point in
time vs. another for a single stock. Relative strength, on the other
hand, is simply the relationship between two securities. Not
surprisingly, the fact that these two separate concepts have nearly the
same name is a major cause for confusion for aspiring technicians.

>>Are Stocks Headed for a Year-End Rally?

At its core, relative strength (also sometimes referred to just as
RS) is a tool for measuring a market’s potency just as RSI is, but the
key difference is in how they go about doing it. RS gets its name
because it measures the strength of one security relative to another -- as a result of that, it’s primarily a screening and selection tool.

The simplest way to compute relative strength is by taking a
stock’s price and dividing it by the price of another security -- most
often a broad market index. The resulting ratio doesn’t mean anything in
and of itself (after all, you’re dividing one price by another
unrelated price), but a plot of relative strength does. An increasing
relative strength line tells us that a security is outperforming its
denominator security, while a dropping line tells us that it’s
underperforming.

The key word in the name is "relative" -- a rising relative
strength line doesn’t mean that a stock is increasing in value. It only
tells us that it’s outperforming the broad market. We’ll get back to
that in a bit.

The Value of Relative Strength

So does plotting the ratio of one security to another really have any
value? According to academic studies, the answer is a resounding “yes.”
According to a number of academic research studies compiled by
Professors Charles Kirkpatrick and Julie Dahlquist in their texbook, Technical Analysis: The Complete Resource for Financial Market Technicians,
using positive relative strength to pick stocks has historically been a
viable strategy that produces outperformance over the broad market.

In brief, stocks that are outperforming tend to continue to outperform in the future.

As an investor or trader, that’s a valuable piece of information,
particularly when the broad market isn’t offering many compelling
trades. Obviously, outperformers aren’t going to continue to beat the
broad market forever -- time horizon is also an important consideration.
In general, positive relative strength trends led to positive returns
on a three-to-10-month time horizon in the studies compiled by
Kirkpatrick and Dahlquist.

How to Use Relative Strength

Relative strength is most often used as a subchart alongside a
stock’s price action. Like other indicators (including momentum), RS can
be used to find divergences and confirmation with a stock’s price.
Plots of relative strength can also have technical annotations such as
trend lines applied to them much in the same way price charts can. A
trend line break in a stock’s relative strength chart is often an
indication that its outperformance is starting to wane. Because RS is a
ratio, it’s also a good metric to put to work when using a quantitative
screen to generate investment ideas.

You don’t need to calculate relative strength manually. Most
charting packages are capable of determining relative strength, and
popular sites such as StockCharts.com can chart relative strength of a
stock -- let’s say the ticker symbol is ABC, for example -- vs. the
S&P 500 by inputting ABC:$SPX into the ticker field.

Keep in mind that relative strength measures the relationship between two
securities. That’s helpful to remember when you’re trying to find RS in
your charting package; if you’re not prompted to enter a second
security as the denominator, chances are you’re getting a chart of RSI
instead.

As a tool, relative strength can also be applied to a number of different types of markets.

Relative strength can be the cornerstone for a long-term asset
rotation strategy, identifying asset classes that are outperforming
stocks (popular methods combine RS and moving average crossover signals)
and signaling when it’s time to shift into a different asset class.
It’s also a valuable way to determine which sectors offer the most
upside -- which in turn can help to identify which stage of the
investment cycle we’re in at any given time.

Because RS is a numerical ratio, it can also easily be used as a
condition in a quantitative trading system to limit its investment
universe to outperforming names. That versatility makes relative
strength a must-have part of any trader’s toolbox.

There is one major caveat, however. Keep in mind that relative
strength is relative, not absolute. So a sector can be outperforming the
S&P 500 but still be losing money. Like most technical analysis
concepts, it’s crucial to go back to price to determine if an investment
makes sense.

On the quantitative side, one easy workaround is to require
positive relative strength versus cash, or to add a risk-free asset
(such as treasuries) to the system’s investment universe. That ensures
that sectors that are only “less bad” don’t make their way into your
portfolio.

As the market continues to lack decisive or directional
signals, tools like relative strength will likely become increasingly
popular -- after all, the current research tells us that RS is one of
the best ways to identify future outperformance. Next time, we’ll add to
your technical repertoire with another primer that will bring you
closer to implementing technical analysis for your portfolio.

In the meantime, do you have a burning technical analysis question? Get it answered by heading to Stockpickr Answers.

Jonas Elmerraji, based out of Baltimore, is the editor and
portfolio manager of the Rhino Stock Report, a free investment advisory
that returned 15% in 2008. He is a contributor to numerous financial
outlets, including
Forbes and Investopedia, and has been featured in Investor's Business Daily, in Consumer's Digest and on MSNBC.com.