Each and every week I present to you a table known as the ETF Relative Strength Monitor. Many novices get confused about this term because there are two indicators in technical analysis with nearly identical names, yet these are only related in a very distant manner.

The one I am not going to discuss here is Welles Wilder's Relative Strength Index, or RSI. RSI is a calculation that measures momentum, which we covered last week a bit in our discussion on divergences. I will cover this and other indicators in future issues of this newsletter.

Relative Strength has been popularized by William O'Neill of Investor's Business Daily (IBD). He uses relative strength in his combination technical/fundamental system, CANSLIM, to help select potential stocks for investing purposes.

The usual definition of relative strength compares how a stock, industry or sector's price performance compares with an index, such as the S&P 500 or the Nasdaq Composite. In analyzing relative strength, you might produce a chart that shows how the stock has traded relative to that index. For example, the chart below clearly shows how the iShares Nasdaq Biotech Fund has substantially outperformed the S&P 500 since last July. The price ratio moved from a low near 0.0439 to nearly 0.075.

However, the more common representation of relative strength allows you to compare how a stock, industry or sector is trading, over a period of time, when compared against other stocks, industries or sectors.

This is how IBD uses relative strength, showing the percentile rank a stock's total return stands. For example, if in the universe of all New York Stock Exchange listed operating companies, the shares of IBM are in the 90th percentile over the past year, then that would mean that IBM's shares have out performed 90% of all companies' shares on the exchange.

One method of using relative strength is to attempt to find shares that are not only performing well, but are also moving up in the rankings. In essence, you'd be looking for stocks that are in an uptrend and are performing better than most other companies.

Along those lines, I created a proprietary ranking indicator for the ETFs that I follow for this newsletter. Rather than using percentiles, I just show the rank, with "23" representing the fund with the highest relative strength and "1" the lowest. The indicator is a weighted average of how the fund has performed over the past one, four and 13 weeks.

The key to understanding relative strength is to realize that stocks, industries and sectors often move in cycles. To purchase a stock that sits at the very top of the heap may not be a very good idea for a swing trade, because there is substantial risk that the stock is at least slightly overbought.

In the ETF world, one must use extra caution when examining relative strength. It is unlikely that broad indices will ever rank far from the middle ground, as they include many of the same stocks and funds that other ETFs hold. With this in mind, a good strategy is often to own the indices when they are weak and to exit them when they begin to show up at the top of the rankings.

Steven Poser
Editor
The ETF Authority
New York, NY