The first thing most people learn about the stock market is that they should buy low and sell high. It is irrefutable logic and is the foundation of value investing.
It is an approach that can work well if you pick something that really has unrecognized value, but in recent years, the style that has generally performed that best is just the opposite. Rather than buying weakness buying the stocks that are the strongest in the market has been a superior approach since the bottom in 2022.
Relative strength measures how a stock acts compared to all the other stocks in the market. Different time frames can be used and some calculations use price weighting, giving more weight to recent action but overall it is simply a way to identify stocks that are the strongest in the market. For a great discussion on relative strength investing, check out John Lewis’s interview on Ep. 22 of the podcast, “Fill The Gap”.
In part the logic behind relative strength is that stocks don’t immediately discount good news. The academic theory that stocks are efficiently priced and tend to reflect all news very quickly simply doesn’t work very well. In reality good news is priced in incrementally. For example analyst generally increase earnings estimates and price targets gradually. They will be conservative as they raise their numbers and then eventually will raise them more as the stock acts positively.
Another reason that buying high relative strength works is that the psychology of strong stocks draws in many buyers. People hate to miss out on the ‘hot action’ they want to be in the ‘best stocks’ which is defined as those that are going up the fastest.
One of the ironies of relative strength is that the more people chase relative strength the more it works. Strong stocks feed on themselves as they attract more and more interest. Market players want to be where the action is and that is in the stocks that are, on average, stronger than the average stock.
Some of the old timers on Wall Street are offended by those focus on relative strength. It ignores valuation and quite often the moves are totally unjustified on a fundamental bases. In some cases this skepticism makes relative strength work even better as the shorts are squeezed and hesitant chasers are sucked in.
The key to applying this approach is cultivating the right mindset. You can’t be afraid to buy stocks that have gone up quite a bit already. The list of new highs is a good starting point while fundamentals are a secondary consideration. The biggest stumbling block for many is that they focus too hard on trying to establish a valuation argument. It is understandable because in many cases, the movement is little more than new buyers buying simply because they expect even more buyers to emerge.
Relative strength is a simple concept but understanding its dynamics can help investors tune out noise and focus on what’s working rather than trying to guess what’s next.
