I am the middle of a series of articles where I use Beta adjusted portfolio performance (instead of just a straight "percentage gain vs the S&P 500" which is used by most Wall Street analysts) to rank stocks or ETFs and draw inferences about macroeconomic trends.
Quite a few readers sent me public or private letters. Thanks! One common question or problem people asked is: Why use beta? Can't you use relative strength to do the same thing more easily? Doesn't relative strength sort out portfolios that are "beating the market?"
I thought it best to write an article to clarify this specific issue, as Beta and relative strength are related; but often confused.
For example, suppose the cyclicals are "outperforming the S&P 500." By definition, cyclical stocks and ETFs such as SPDR Consumer Discretionary (NYSEARCA:XLY) would rank high on a relative strength scale. Many people feel this means the economy will soon strengthen.
In contrast, what if stodgy utilities and ETFs like SPDR Utilities (NYSEARCA:XLU) are feeling their oats? Their high relative strength would suggest many investors are worried about an imminent economic slowdown or even recession.
Also, many investors use relative strength as a screen criteria when trying to find stocks or ETFs that have price momentum, i.e. may be about rise further in the near future. Stocks or ETFs with poor relative strength would be avoided.
Unfortunately relative strength has one fatal flaw when considered in isolation. The standings depend on whether you are in a bull or bear market:
- in a rising market, high beta stocks will show greater relative strength.
- in a falling market, low beta stocks show greater relative strength.
Rather than show charts, which can a bit cluttered by all the issues involved, I'll illustrate the proper calculations below. Consider two funny firms: Consolidated Fuzz and American Bore, with betas of 1.8 and .35, respectively.
First, an advancing market. Suppose the S&P 500 rises ten percent.
We would expect Consolidated Fuzz to rise by eighteen percent:
(S&P500 gain) * (Beta) = expected gain by the stock.
(10%) * (1.8) = 18.00%
Since Consolidated Fuzz rose by such a larger amount than "the market," it would be very high in the relative strength ratings. But that is very deceiving: the stock performed exactly as we would expect it to, given the risk profile.
In contrast, American Bore gets the shaft in the rankings. A similar set of calculations for American Bore mean it should rise only 3.5%:
(10%) * (.35) = 3.5%
Boring indeed! But in fact the stock is doing perfectly fine given the firm's risk profile.
Now consider a declining market. Suppose the S&P 500 declines by ten percent.
We would expect American Bore to fall by only 3.5%. Since it fell much less than the broad market, it pops up on high on the relative strength list.
Poor Consolidated Fuzz! Now we would expect it to decline by eighteen percent. And it would fall to the near the bottom of relative performers.
Of course in reality nothing has changed: the stocks are both behaving exactly as we should expect them to. That is why the performance of stocks (and especially ETF portfolios) need to be adjusted for risk (beta).
I will continue to expand my list of "risk adjusted ETF performance" in the near future. I just wanted to spend some time on this particular issue.
By the way: a trivia question for Seeking Alpha readers. Which famous American TV Family made their fortune on Consolidated Fuzz?
Disclosure: I am long XLV, IHI, IYT. 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.