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 Stock Investor, relative strength index fields compare the stock’s performance to that of the S&P 500 large-cap index. These four relative strength index fields measure a stock’s performance relative to the S&P 500 over the last four, 13, 26, and 52 weeks.

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. Reuters, our primary data provider for Stock Investor, 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.

Figure 1: Relative strength index and percentile rank data in Stock Investor is located on the Share Statistics subtab of the Overview tab. CLICK ON IMAGE TO SEE FULL SIZE.

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 uses a base level of zero; relative strength figures are reported on the Share Statistics subtab of the Overview tab. As an example, Netflix, Inc. (NFLX), has a four-week relative strength index value of 2% (Figure 1) as of March 30, 2007, which indicates that the performance of Netflix was 2% higher than the S&P 500 over the same four-week time period (see the box below for the calculation).

Relative Strength Calculation

Relative strength price performance of a stock (Netflix) compared to the price performance of an index (S&P 500), over the same time period. It is a measure of price trend that indicates how a stock is performing relative to the overall market as well as to other stocks. Closing Prices as of 3/30/2007: S&P 500, 1420.86; Netflix, $23.19 Closing Prices as of 3/2/2007: S&P 500, 1387.17; Netflix, $22.29 Four-Week Relative Strength Calculation: [(($23.19 ÷ $22.29) ÷ (1420.86 ÷ 1387.17)) – 1] × 100 ((1.04038 ÷ 1.02429) – 1) × 100 (1.01571 – 1) × 100 = 1.57%, rounded to 2%

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 why 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.

For example, let’s say you invested in a stock that was up 10% for the year, a gain almost every investor would welcome, especially if you were focused strictly on absolute terms. However, if the market was up 20%, an investor interested in relative performance would not be nearly as happy. The same holds true on the downside as well. Some stockpickers, including well-known investor 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.

Figure 2: Over the last 52 weeks, Blockbuster outperformed the S&P 500 by 48%, placing it in the 91st percentile of all stocks. CLICK ON IMAGE TO SEE FULL SIZE.

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 Netflix, Inc. and Blockbuster Inc. (BBI), both of which are in the retail (specialty non-apparel) industry and best known for offering movie rentals. Comparing the 52-week relative strength of both stocks as of March 30, 2007, we find that Netflix’s relative strength index value for the period was –27% (Figure 1) and Blockbuster’s was 48% (Figure 2). The negative 27% reveals a stock that significantly underperformed the S&P 500 index. Again, zero reflects stock performance equal to the market index. Blockbuster, relative to its industry competitor Netflix, has been a much stronger price performer over the last year.

Relative Strength Percentile Ranks

The other way in which relative strength is communicated in Stock Investor is through percentile ranks.

Figure 3: Field definitions located in the Help System indicate whether Percent Rank data is available for a given data field. CLICK ON IMAGE TO SEE FULL SIZE.

Percentile rank shows you how a particular company “stacks up” to the competition—in this case all of the companies in the Stock Investor database. Applicable to only certain fields in the database, these percentile rank fields are useful in comparing a company’s results in a certain area against that of the entire universe of companies. Within the program tabs, the percentile rank data, when 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 each data field listed, including a 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 (Figure 3). 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 (Figure 4).

Figure 4: The % Rank data category lists all the percentile rank fields you can use for screening in alphabetical order. CLICK ON IMAGE TO SEE FULL SIZE.

Referring back to the 52-week relative strength of Netflix, its –27% index value placed it in the 25th percentile (Figure 1). Blockbuster landed in the 91st percentile with its 52-week relative strength index of 48% (Figure 2). This means that, over the last 52 weeks, Netflix has a relative strength that is better than only 25% of all companies in the Stock Investor database, while Blockbuster has bested 91% 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 and price-to-book-value ratios.

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 and when these expectations are revised, or are proven too optimistic or pessimistic, stock prices often adjust rapidly to these altered expectations.

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.

Such situations may be playing out with Netflix and Blockbuster. Netflix, which was lagging most of the companies in the Stock Investor universe with its 52-week relative strength, has seen an improvement over the last four weeks. As Figure 1 shows, the stock has had negative relative strength index values over the last 52, 26, and 13 weeks. However, over the last four weeks, Netflix has outperformed the S&P 500 by 2%, placing it in the 66th percentile. Only time will tell if this is a prolonged turnaround.

In contrast, Blockbuster has had impressive relative strength index numbers over the last 52, 26, and 13 weeks, each of which has placed the stock in the 80th percentile or higher. However, over the last four weeks it has underperformed the S&P by 4%, placing it in the 28th percentile.

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 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.