It's unfortunate that many in the investment community adhere to their chosen method of analysis with near religious ferocity. For the Grahamites it would be unconscionable to introduce technical analysis into one's decision-making framework. Likewise for the technical analyst, only price matters; valuations and fundamentals are abstractions that are already reflected in the stock price. Each can point to their tattered copy of Security Analysis or Reminisces of a Stock Operator and each can point to their investment legend.
While I've made many investments without considering the price chart I never begin my week without consulting the investment landscape. I do several things to create this framework, but it all begins with relative strength analysis. The premise behind using my framework for relative strength analysis is that real uptrends -- and vice-versa for downtrends -- begin for a particular stock when there is broad participation in the sector in which the stock belongs and in the supply chain in which it participates. One can measure these effects by monitoring the relative performance of sectors and industries versus a common benchmark. Momentum analysis for a particular sector can be useful, but relative strength tells you which among all the sectors is drawing the most interest from investors. While most of this is fairly straightforward, there are several considerations that we need to touch upon in this article. We can start with the major sectors of the economy: Energy (NYSEARCA:IYE), Financials (NYSEARCA:IYF), Basic Materials (NYSEARCA:IYM), Real Estate (NYSEARCA:IYR), Transportation (NYSEARCA:IYT), Tech (NYSEARCA:IYW), Telecom (NYSEARCA:IYZ), healthcare (NYSEARCA:IYH), Consumer Discretionary (NYSEARCA:XLY), Staples (NYSEARCA:XLP), and Utilities (NYSEARCA:XLU). I plot these against the SPY. For instance, consider the following chart:
On the top pane we have the Consumer Discretionary sector as indexed in the XLY ETF. On the bottom pane is a relative strength, which is a simple time series devised by dividing the XLY by the SPY. It shows that the XLY has been outperforming the SPY for several years now. Let's look at another.
Here we have the IYR, which is a sector ETF for the Real Estate sector. Unlike the XLY, the bottom pane relative strength has not been in a steep uptrend and is now below a 26 week moving average (half a year). So Consumer Discretionary is outperforming the Real Estate sector, right? Not quite. Each sector has its own peculiarities. Real estate companies (in particular REITS) pay out most of their earnings in dividends, which caps the return that is based on capital appreciation. For whatever reason, many technical analysts seem to ignore the fact that the return profile of a company impacts the manner in which its stock trades. Does this tarnish the whole exercise? I don't think so. There are problems with any analysis. The question that matters is whether the analyst can wrestle meaning from his data. I have worked with relative strength for quite some time, and while I only use it as a guidepost, it's proven to be a useful framework for assessing the landscape and for finding investment candidates.
For each of the sectors we can fill out the following table each week. You can define uptrend however you want, but I choose to think of it as the relative strength line above or below a 26 week simple moving average.
I then do the same analysis --defining the trend of the relative strength--for a host of industries (below). However, in this sample table I also include the value for the sector in which that industry group participates. So taking the first industry, Asset Managers, we see that on a relative basis its trend and the trend of the sector in which it belongs, Financials, are both up. We can see that Industrial Metals, the last industry in this sample table, and its sector, Basic Materials, are both in downtrends.
We are left with several industry/sector trend combinations: Up/Up, Up/Down, Down/Up, and Down/Down. Each category should be able to tell you a different story, but for the sake of this article I'll concentrate on the two extremes, namely Up/Up and Down/Down. While many can draw their own insights from the above tables, I disregard the more simple interpretation that Up/Ups are strong stocks and therefore buys and Down/Downs are weak stocks and therefore sells. Rather I look at each category as telling me something about how I should proceed when I evaluate a company within those dual categories.
For industries like Industrial Metals that are in downtrends that belong to a sector that is in a downtrend - in this case, basic materials - I demand a stock within those categories to be cheap on an absolute basis. That is, I'm not looking for the stock to be cheap relative to peers. I want the stock to be cheap relative to itself historically, cheap on a replacement value basis or private market value, have a safe balance sheet, and I want the stock to be lower than 60% of its five year peak. At least from a technical perspective, we can come up with a list for stocks to investigate quite easily. Let's look a few:
Here we have a chart of US Steel (NYSE:X). While not shown here, this company (and the steel industry in general) has been in decline for many years. Is this the bottom? That's impossible to know -- in fact, I doubt it -- but at the very least the stock is worth considering for investigation. At some point the tide will turn for industrial metals and you want to be prepared. A seasoned analyst would decipher the drivers of Steel in particular, or industrial metals in general, and would track the strength or weakness of those drivers as it relates to the price performance of the steel group. We will touch on this below. You might want to look at AA, CLF, AKS, FCX as potential turnaround candidates, or even long/short pair trading.
I don't typically buy momentum, but there are plenty of people out there who look for the strongest sector, the strongest industry within that sector, and then use simple entry techniques to buy the strongest stock within that industry. That's not my game, but I've seen others make a good living doing precisely that. I like buying relative value. Let's look at the Asset Manager industry. Here we have the opposite of the Basic Materials/Industrial Metals combination: Asset Managers are in an uptrend as are the Financials as a sector. Let's look at two charts: TROW and LM.
Clearly TROW has outperformed Legg Mason. The question is why? It may well be that TROW is a better company or is better positioned should bond outflows create equity inflows (which typically get a higher multiple), but one thing is certain, eventually the divide in performance becomes too great and assets rotate from rich names to less rich names. While I will never buy a stock that is expensive on an absolute basis, I'll certainly consider a stock that is only slightly below fair value if I get the potential for catch up in performance to its peers. (A quick look at LM reveals that there are activists involved in the name clamoring for a sale of the company or a spin-off, valuations look attractive, and that underperforming segments are masking the strength of outperforming segments, which could make this an interesting investment candidate should management of LM actively pursue more strategic actions).
Sticking with our Asset Manager theme we could then look for economic drivers that may explain the strength in the financials. Clearly each sector has different economic drivers, but financials of course are highly impacted by the movements in interest rates. The following graph looks at the XLF on the top pane, which is the ETF for the financial sector, and the relative performance of long-dated bonds vs. short-dated bonds (TLT divided by the IEF) on the bottom pane.
While I'll save the economic discourse for a different article, we can clearly see that significant bottoms in the XLF are found when the TLT is outperforming the IEF (and vice-versa for significant tops). Over the course of 2012-and the end of 2011-the interest rate environment has remained highly beneficial for financials. Currently, our indicator is rolling over but it remains at elevated levels. I would probably wait for a pullback in the Financial sector, and would seek confirmation that the uptrend remains intact by seeing if the TLT/IEF relative strength line pops back up, and I would particularly look for a potential entry in Legg Mason (NYSE:LM) or any other relative value play.
Every sector has its drivers: input costs, interest rates, disposable income, inflation, etc. Tracking the relative strength of drivers is another way to find and confirm the trends you are looking at.
Finally, the last way to use relative strength that I'll introduce in this article is supply chain analysis. Much like confirming the strength of a stock by looking at strength of the industry and sector it participates in, another potential framework is confirming the strength of the supply chain that supports the company in question. Let's look at the following graph:
Here we have an index for automobiles. The trend is up for the industry as it is for its sector. However, the cross from downtrend to uptrend in the relative strength line is relatively recent. Is there way to tell if this is a potential head-fake? While there are no guarantees I would recommend looking at the drivers and, as we'll see here, examining the supply chain. We know automobiles are made from auto parts, so checking the strength of the auto parts index should be our first step.
The chart is very similar to the automobile segment as it too sports an uptrend in relative strength. So far so good. But how about looking at something less intuitive. We know that cars are made from aluminum and sometimes steel, but both base metals are used for a variety of other goods, which would distort our supply chain analysis. We also know from having looked at the industrial materials industry group that these metal companies are in steep downtrends. We then discover that palladium is an industrial metal whose main purpose (by far) is as an input for catalytic converters that must go into every automobile. Luckily for us, there is an ETF for the palladium with the ticker PALL, and there are companies that exclusively mine this metal.
This chart shows the palladium metal appears to be outperforming the SPY on a relative basis even though every industrial metal (that I can find) is substantially underperforming. While it's not a slam-dunk case that the recent move in the automobile industry is the start of a real uptrend, it's certainly indicative of that possibility. When investors are exciting about the whole supply chain for a particular industry, there is likely some very large positive (and likely enduring) trend at work. One could also have looked at the relative performance of SWC against the SPY - Stillwater mining is the largest pure-play palladium producer in the US. And in fact, it confirms what we see in the PALL ETF - a recent significant uptrend.
Hopefully this article provides the reader with several new ways of looking at relative strength. I believe it serves as a highly useful adjunct to fundamental analysis as it can help show us where to look and, importantly, when to get more interested in the companies we track. I personally try to come up with as many drivers as I can for every stock that I look at, delineate the supply chain in which it operates, and monitor these variables as their performance relative to a benchmark-usually the SPY-harmonizes.
All of the charts I use are from stockcharts.com, a truly great resource.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.