Relative strength investing is a popular strategy—buy high and sell higher or, as Livermore put it, “stocks are never too high for you to begin buying or too low to begin selling.” In Smarter Investing in Any Economy: The Definitive Guide to Relative Strength Investing (W&A Publishing, 2008), Michael J. Carr takes the reader on a journey from various relative strength calculations through backtesting to a comprehensive trading plan. I should confess up front that I’m ambivalent about relative strength investing, so the author was not preaching to the choir.
As its name implies, relative strength (RS) is a comparative measure. For instance, it can be used to rank the components of the S&P 500 in terms of performance over some fixed period of time. But it’s not a measure with a single formula; in this respect it differs from, say, the 20-day simple moving average of a stock’s price. There are, Carr claims, at least a dozen currently accepted methods of calculating RS—all incredibly simple mathematically and easy to define in popular trading software programs. For instance, he describes and provides the formulas for such RS techniques as normalized rate of change, ratio of prices, back- and front-weighted rate of change, price/moving average ratios, averaging different time periods, and momentum of RS. With basic charting software only junior high math is required.
In backtesting RS techniques Carr uses the 33 Fidelity Select Sector Funds; the test period is January 1, 1990 through December 31, 2007. He provides detailed results for long-only systems, the upshot being that every RS strategy outperformed buy and hold but that even the optimized strategy that traded only a single fund at a time with a pretty tight initial and trailing stop had a maximum drawdown of over 42%. That can be gut-wrenching for the average investor. So comes the Sir Galahad for every strategy with an edge—risk management. Carr’s suggestions aren’t original, but they help make RS a more tradable concept. He adds three key risk management ingredients to the final system—trading the equity curve, diversification, and volatility-based trailing stop losses. He also suggests some screens for fundamentals to improve the outcome.
And he sent me, the RS skeptic, back to the drawing board. That’s the power of the book. I’ve toyed with formulas defining relative strength breakouts compared to the moving average of a benchmark index. And for some perverse reason I then put them on the back burner. But Carr has convinced me to hone the strategy and follow it for a fraction of my portfolio. I may have an aversion to the greater fool theory, but done wisely there’s money to be made by going with the flow--as long as the flow doesn’t all of a sudden become a waterfall. If I’m richer next year than I am today, I will have this book in part to thank.