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Relative Strength as Technical Analysis

At a recent client review meeting, the term “Relative Strength” was used extensively.  The client was patient and listened closely.  However I could tell that there was some hidden assumption that I was making, that I was not doing a good job of communicating.  So I decided to go back to the basics of market analytics to see if I could clear up the confusion.  Let me share with you what I said.

An article from James Minich…

Essentially all security analysis is broken down into two schools of thought:  fundamental analysis and technical analysis. Fundamental analysis looks at the fundamentals of corporate structure, and balance sheet numbers.  In a sense, fundamental analysis is what a CPA would do if you hired him to go over your books and give you his opinion about the fiscal soundness of your business.  Debt levels, cash flow, account receivables, cash on hand, gross sales etc.  In the world of the capital markets, AKA the stock and bond markets, the issue that fundamental analysis addresses:  Is the corporate stock fairly valued?  Fair value is defined as the total value of the corporation divided by the number of shares of that same corporation that are outstanding- total of all publically owned shares of stock.  Let say that the price of the stock was $50.00 and the appraised value was $40.00, that would mean the price of the stock was overvalued, and vice versa, if the stock was valued at $40.00 and appraised value was $50.00 the stock would be considered undervalued.  Fundamental analysis determines whether the current price of a stock is a fair price based on the fundamentals.  Bargaining hunting is the best analogy for what fundamental analysis is all about. 

Let’s assume that we do our fundamental analysis and determine that XYZ stock is undervalued.  We buy the stock at $40.00.  Naturally we expect the price to go up based on the homework we did.  In fact what happens is the price goes to $35.00.  Ouch, a 12.5% loss.  We vow never to let that happen again.  And in the process we discover that there is another school of thought called Technical Analysis.  Technical Analysis looks only at the price of the stock.  There is nothing fundamental, in a sense, about tracking the price of the stock.  The price of the stock reflects what buyers and sellers think a fair price for the stock should be.  If you have ever been to an auction, you have seen Technical Analysis in action.  The price says it all.  Supply and demand, the core ingredients of economics, sets the price.  If there is more demand than supply the price goes up.  If there is more supply than demand, the price goes down.  Technical analysis is essentially the process of tracking security prices.  The tracking takes the form of charts and graphs.  We use a charting process call Point and Figure.  When price is going up then a column going up is shown in X’s.  Just think of the graph paper you used in school with all the little boxes filled in X’s going straight up when the price is going up.  And when the price is going down, a line of boxes going down is filled with O’s.  This produces a graph.  The graph when properly understood tells at a glance the price history.  If the trend of the graph is down, getting back to our $40.00 purchase of XYS stock, then yes it is a good value, but just not a good time to buy.  There may be further decline in the price, and you want to buy when it has bottomed and the trend is up!

Merging fundamental analysis and technical analysis, gives the answer to the question:  is this a fiscally sound company, is its current price a bargain, and has demand asserted control of the supply such that the price is headed up.

OK, now we get to the issue of relative strength.  Let’s assume that there are many stocks that are undervalued and are in a positive price trend.  The question becomes: which one of these stocks should we buy.  The answer may well depend on which of the stocks has the strongest relative strength.  Relative strength belongs to the technical analysis school.  The analysis is all about the price.  Let’s say XYZ stock goes from $10.00 a share to $80.00 a share.  And for comparison we have ABC stock, in a similar sector, which goes from $10.00 to $100.00 a share.  From a relative strength point of view, we say that ABC stock has a stronger relative strength.  You and I may be very strong.  But when we have a contest at a local gym, you can lift more weight than I can.  I can lift a lot, just not as much as you can.  You have stronger relative strength!

You know the expression, “It’s all relative.”  That is precisely the point.  You want to buy the stock that relative to all other similar stocks has the greatest potential for price appreciation. 

(Next Time:  I will address the issue of Growth vs. Value stocks.  Can a growth stock continue to appreciate when the price seems to be so high currently, and can a value stock ever be TOO much of a bargain?)