One Of The Best Ways To Find Winning Stocks — And Ride Them Higher
When you think about it, just about every investor is following a trend in one way or another. Whether they make money doing it, of course, is another question altogether.
Regardless of your time horizon — minutes or months — a financial instrument must move in your favor to be profitable. It is that simple. So finding a reliable indicator to measure trend could be critical to your success.
As it turns out, there is a simple, quantitative indicator we can use to find stocks with the propensity for a big move…
It’s called relative strength (RS).
What Is Relative Strength (RS)?
Relative strength investing is pretty straightforward. It involves buying the best-performing stocks relative to a sector or index. We then hold these stocks until their momentum changes course.
To most investors, especially “value-minded” investors, this strategy probably feels counterintuitive. After all, one of the first things you learn as an investor is to “buy low, sell high.” But what we feel and what we can prove are two very different things. And there are decades of research to prove the predictive power of this indicator.
In the 1950s, George Chestnutt created one of the first newsletters using RS to rank stocks and industry groups. He also used RS to manage the successful American Investors Fund. This fund produced a cumulative return of 160% between 1958 and 1964, compared with 83% for the Dow.
In the late 1960s, Robert Levy published a study in the Journal of Finance discussing the direct correlation between the percentile ranking of RS and the performance of a stock over the next six months. He found that, in general, the higher a stock’s RS, the better its performance. It was groundbreaking for the time.
Levy planted a seed, and RS became the topic of numerous studies and papers over the ensuing decades. One of the most famous academic studies on RS was completed in 1993 by Narasimhan Jegadeesh and Sheridan Titman.
Their oft-cited study covered the 24-year period from 1965 to 1989. It clearly demonstrated that buying past high-performing stocks and selling low-performing stocks made significantly abnormal positive returns. More specifically, they found that buying stocks based on high past six-month returns and holding them for the next six months beat the market by an average of 12% a year.
In other words, a momentum-based strategy works.
In 2013, Christopher Geczy and Mikhail Samonov published “212 Years of Price Momentum — The World’s Longest Backtest: 1801-2012.” It showed there was a positive and statistically significant correlation between momentum and stock performance going back to the start of the 19th century.
A primary reason RS works is that stocks produce skewed, excess positive and negative returns. In other words, they do not follow the standard bell-shaped performance curve. Perhaps the most striking difference is that there are just as many, if not more, companies with extreme high and low returns as there are companies with average returns. Based on the normal bell curve, this isn’t supposed to happen. Yet it does because stock returns are not normally distributed.
How We Use RS (And You Can, Too)
There are several ways you can approach RS — the key thing to remember is that RS involves ranking a security’s performance over a certain time period against that of a wider group.
We prefer the method used by our premium Maximum Profit system, which ranks the performance of stocks over a six-month period, giving individual stocks a simple reading, ranging from 0 (weakest) to 100 (strongest). We only consider buying stocks with a RS above 70 — and typically a good deal higher than that.
However, to be transparent, price momentum isn’t the only thing that we use to determine buys and sells. And it shouldn’t be the sole determinant you use, either.
Depending on what brokerage platform or trading software you use, you can also experiment with various RS strategies — short/medium term, sectors, etc. The point is, RS can and should be a valuable tool for traders and investors alike. Many novice traders who spend their time with overly complex technical indicators and charts would likely be better off simply using RS, combined with a couple other simple (but reliable) tools. Likewise, investors who are looking for solid returns in the short to medium term would be well served by adding a tool like RS along with their fundamental analysis.
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