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STOCK INVESTOR PRO > January 2013

Measuring Performance With Relative Strength

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There are several ways to measure the performance of a stock, typically on either an absolute or a relative basis. Price change over a specified time period is an example of absolute performance, while relative performance communicates how well a stock has performed compared to some benchmark, usually a market or industry index. In this issue of Stock Investor News, we discuss a relative performance measure, the relative strength index. In Stock Investor Pro, relative strength index fields compare the stock’s performance to that of the S&P 500 large-cap index. There are four relative strength index fields, measuring a stock’s performance relative to the S&P 500 over the last four, 13, 26 and 52 weeks.

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Calculating Relative Strength

The most basic means of calculating relative strength is by dividing the percentage price change of a stock over some time period by the percentage change of a market index over the same period. Depending on the source you use for this data, you may find varying calculations, but the results are essentially the same. Thomson Reuters, our primary data provider for Stock Investor Pro, calculates the four-week relative strength using the number of trading days for the calendar period. Therefore, four calendar weeks, which has 28 days, has 20 trading days. If there are no holidays, 20 days will be used in the calculation. However, if there are any holidays over the four-week period, the day count will be lower so that the four-week relative strength only covers the number of trading days for that period. Assuming a “normal” four-week trading period, the four-week relative strength calculation will use the percentage change in the stock price and the S&P 500 index between the latest (Friday) close and the Friday close 20 trading days prior. Relative strength may be reported with a base level of zero or one; the base level represents stock price performance equal to the index. Numbers above the base level reflect stock performance above the index, while below-market performance is portrayed by figures below the base level. Stock Investor Pro uses a base level of zero; relative strength figures are reported on the Share Statistics subtab of the Overview tab. As an example, the four-week relative strength index for Microsoft Corp. (MSFT) was –3.1 as of December 14, 2012, which indicates that the performance of Microsoft was 3.1% lower than that of the S&P 500 over the same four-week time period.

Using Relative Strength

The concept of relative strength can help you identify promising investments and judge whether your own performance was successful or not. Many investors only concern themselves with absolute price performance or whether they made or lost money. However, the market can play a role in the price movement of stocks, irrespective of company-specific factors. If the market is up, most stocks should also be up, and vice versa. The real question is whether the broader market or industry outperformed individual stocks, because the reason we invest in individual stocks is to outperform the overall market. Otherwise, it would be more cost-efficient to invest in a market index mutual fund. If stock holdings fail to keep up with the overall market, relative outperformance is not achieved, and opportunity losses may be incurred. However, keep in mind that stocks with lower volatility generate lower returns, and vice versa.

For example, let’s say you invested in a stock that was up 10% for the year, a gain almost every investor would welcome, es-pecially those focused strictly on absolute terms. However, if the market was up 20% over the same time period, an investor interested in relative performance would not be nearly as happy. The same holds true on the downside as well. Some investors, including well-known guru William O’Neil, advocate sell rules based on absolute measures—such as selling after a stock falls 7% from its high following purchase. While such a strategy does limit the maximum loss you can incur on an investment and is a good idea when investing in highly volatile stocks, you may find times when you are selling based more on the movement of the overall market than that of the company itself. As you can imagine, it would be impossible to hold onto any stock during the 2008 recession (which was a good thing, as it turned out).

Relative strength can also be used to compare two companies in the same industry. This comparison examines the relative strength performance of two stocks and can help you decide whether you should hold one versus the other. Take Dell Inc. (DELL) and Hewlett-Packard Co. (HPQ), both of which are in the computer hardware industry. Comparing the 52-week relative strength of both stocks as of December 14, 2012, we find that Dell’s relative strength index for the period was –40.5 and Hewlett-Packard’s relative strength index was –50.6. Both negative figures show stocks that significantly underperformed the S&P 500 index. Again, zero reflects stock performance equal to the market index. Dell has been a slightly stronger price performer over the last year relative to its industry competitor Hewlett-Packard.

Relative Strength Percentile Ranks

Another way relative strength is communicated in Stock Investor Pro is through percentile ranks. Percentile rank shows you how a particular company compares to all the companies in the database. Percentile rank fields are useful in comparing a company’s results in a certain area against that of the entire universe of companies, but they are not available for all data points. Within the program tabs, the percentile rank data, if available, is usually designated by Rank or % Rank.

To find those fields that do have available Percentile Rank data, go to the Help System and select Contents and Index (Help – Contents and Index). In the Contents tab of the Help Topics window, double-click on Field Definitions; then select a field from the alphabetical or category list. Here you will find the characteristics of a data field, including the definition, the field’s data table name, the data category under which it is listed and whether or not it has an available percentile rank field. To screen for percentile ranks in the Screen Editor, access these fields from the % Rank data category at the top of the list within the Screen Editor’s field picker. All percentile rank fields are listed here in alphabetical order.

Referring back to the 52-week relative strength of Dell, its –40.5 index value placed it in the 25th percentile. Hewlett-Packard landed in the 21st percentile with its 52-week relative strength index of –51.6. This means that, over the last 52 weeks, Dell’s relative strength is better than only 25% of all companies in the Stock Investor Pro database, while Hewlett Packard fared a bit worse, besting 21% of all stocks over the same period.

Keep in mind that with price momentum, a higher relative strength percentage rank is usually desired. However, this is not always the case. Value investors are probably looking for lower rankings for fields such as price-earnings ratio and price-to-book-value ratio.

Analyzing Trends in Relative Strength

When monitoring investments based on relative strength criteria, it is important to focus on the trend rather than the figure for a single time period. This is premised on the notion that relative strength persists over time. By examining the trend in relative strength over the last four, 13, 26 and 52 weeks, you can develop an idea of where the stock price may be going in the future. Relative strength is a price momentum indicator that confirms investor expectations and interest. What moves a stock is not just earnings (good or bad), but how those earnings compare to expectations. If expectations are revised, or are proven too optimistic or pessimistic, stock prices often adjust rapidly.

A stock may have very high relative strength over long periods, but it could also be losing momentum. Likewise, a stock may have been a consistent underperformer over a long period, but may be enjoying a recent resurgence. Looking at shorter-term relative strength for Dell and Hewlett-Packard paints a slightly different picture. Both these firms lagged the S&P 500 over the longer term, but have come back over the last four weeks. Both stocks have had negative relative strength index values over the last 52, 26 and 13 weeks. However, over the last four weeks, Dell and Hewlett-Packard have outperformed the S&P 500 by more than 10%. This trend makes sense from an industry trend view. Over the past year, both companies have seen demand muted due to the overwhelming popularity of tablets. However, recently investors have been hopeful that Windows 8 can help prop up demand for these two firms.

Conclusion

When interpreting relative strength, remember that even a stock that is rapidly rising in price may have weak relative strength if the market is rising more rapidly than the stock. Likewise, a stock that is falling in price will show positive relative strength if it is declining more slowly than the overall market.

When applied properly, the concept of relative strength can be a revealing and useful investment analysis tool. However, analysis of a stock should involve not only a stock’s relative price performance but also a full review of the firm’s finances, sales and earnings growth prospects, and industry performance. A stock’s relative strength trend adds an additional dimension of relative price behavior to the investment decision.