The winners of the past six months are likely to be among the best performers in the next six months, according to research published in a number of academic studies. And relative strength (RS) can be used to find the biggest winners of the past six months. We can calculate RS to find the best trades in the U.S. market, or even apply the calculation to all of the stocks and ETFs trading around the world.
Using U.S. markets, we can identify the strongest trades from more than 7,000 stocks and ETFs. Adding global stock markets, we can find the top trading candidates from a list of more than 26,000 stocks and ETFs. Although I would only trade stocks or ETFs that trade in the United States, knowing that the trade is one of the strongest in the world boosts my confidence that this trade is likely to be a winner.
One way to apply RS is to buy stocks when their RS rank is above 80, meaning the stock or ETF has outperformed 80% of the alternative investments during the past six months. Right now, I was surprised to see one ETF on the buy list using both the U.S. and global calculation methods: iShares MSCI EAFE Index Fund (NYSE: EFA).
With an RS rank of 99, this ETF has outperformed more than 99% of U.S. investments during the past six months. In addition, EFA has a global RS rank of 82. This strength makes EFA a buy.
The ETF holds the largest stocks in the world's leading stock markets, including Nestle (OTC: NSRGY), BP (NYSE: BP), Novartis (NYSE: NVS) and GlaxoSmithKline (NYSE: GSX). Because EFA is a benchmark for international stock performance, it points toward potential strength in global large-cap stocks. These are the kind of stocks that could do well if economic growth is better than expected around the world, or if traders become interested in dividend-paying stocks as an alternative to the low interest rates available in global bond markets.
There are a number of reasons why EFA could go higher in the months ahead, but RS doesn't tell us why prices should go up. The indicator simply tells us that EFA is likely to be among the best performers in the next six months and is a buy.
In the past, EFA's global RS rank has topped 80 thirteen times since it began trading in 2001. Buying when RS crossed above 80 would have delivered winning trades 10 times (77% of the time) and the average gain a month after the signal was given is 11.35%. This time, I think the gain could be almost twice that level within six months.
During the past year, EFA has formed a double-bottom pattern. The depth of that pattern provides a price target of $64.49, about 20% above the recent price. Based on the combination of RS indicators, that target seems realistic.
The last time both U.S. and global RS were on a buy was in 2009, and the ETF gained more than 39% over 28 weeks. There have only been three signals like this in the past, and all were winners over the next three months. But three trades is a very small sample size, so we can't really draw conclusions from that.
Risk can be managed with the 10-month moving average. This long-term indicator is useful for spotting long-term trend changes. If EFA closes below that average, which is at $52.29, it could indicate that stocks have entered a bear market. Using that price as a stop-loss level limits risk to less than 3%, an exceptionally small amount of risk for any trade.
Action to Take --> Buy EFA at the market price. Set stop-loss at $52.29. Set price target at $64.49 for a potential 20% gain in six months.
Surprising Investment Beating 99% of the Market is Signaling a 'Buy'