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I am formally a data analyst for a non-financial services organization. I have an undergraduate degree in business and I am currently working on my masters degree in predictive analytics. My background as an investor has been in setting and forgetting my 401k. In my recent job change I was... More
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  • Should DGI's Try And Time The Market Using The Relative Strength Metric?

    Introduction

    In the comment section of a recent article, someone suggested Single Best Investment, the great work by Lowell Miller. I do not normally take the time to read books or recommend books, but this one is a bit different. If you are new to DGI, or a seasoned pro, I would recommend you read his book.

    While reading the book, I ran across a section in Chapter 7 - Charts Can Help You, that looked interesting. The premise of the section is after an investor has done his or her research on selecting a candidate to purchase that the investor can use the metric of relative strength to help in the decision process. Please note, the metric of relative strength is different than the metric that you will find on most screeners of RSI or Relative Strength Index.

    Mr. Miller writes,

    "The key item is not breakouts or moving average crossings or penetrations or support or resistance or cycles or any of the other terms technical analysts are wont to sling about. The key item is relative strength. Let me repeat that, for emphasis: the key item is relative strength…When companies are doing the right things and/or conditions in the market are right for them, investors tend to move in their direction, generating higher relative strength." (Miller, 2006)

    Please note that the previous section of this chapter highlights that charts and technical analysis have historically shown that there is not a system or methodology that works every time in every situation in every business cycle. Instead, the suggestion is that charts and technical analysis are tools that can be used along with all the other tools that an investor has at hand to make a decision on when to purchase a stock.

    Seeing as oil has been on the downtrend lately, and I have made a few purchases, I want to test the relative strength metric against my decision making. As highlighted in a previous article (here), I have started a new, public DGI portfolio. I have made 4 purchases so far - GPS, SLB, HAL and TUP. I have also included a more traditional DGI stock, JNJ, which I have not yet purchased due to my opinion that it is currently over valued.

    Calculating the Metric

    The Relative Strength metric is pretty simple to calculate and understand. First you will need to decide on the correct comparison / benchmark that you want to make. This should be similar to the metric that you would use to compare your portfolio. For me, I would use and recommend the S&P500. For this article, I am using the ETF SPY to represent the S&P 500. Second you need the historic price information for your stock and the comparison. For this article, all historic information is done relative to the daily close price from Yahoo Finance. Then you take the price of your stock divided by the price of the index. That is it. Pretty simple, right? Next, chart this value over time. When it is on the way up, things are in your favor. When it is on the way down you should stay away. This falls in line with the age-old statement, "The trend is your friend."

    Using the Relative Strength Metric

    I have previously provided commentary as to why I selected each stock. I will not repeat that commentary here as it is not the focus of the article. For the sake of this article, assume that each stock met my criteria for purchase, including price, and so I made a purchase. What is relevant is whether or not I made the purchase in good timing with a relative strength trend or not.

    Johnson and Johnson

    Below is the chart of each price and relative strength for JNJ from Jan 3, 2006 to Dec 16, 20014. This date range is chosen at random, but purposefully inclusive of the 2008-2009 recession. The blue line below is the relative strength metric as compared to the S&P500. It is in relation to the axis on the left. The stock price is shown in red and is judged in relation to the axis on the right.

    Chart 1: JNJ Stock Price & Relative Strength from 2006 to 2014.

    As always, we want to view the stock in context of its valuation. Below is a FAST Graph of JNJ. It highlights a slightly longer time period starting in 2001. I have placed a red line on the chart to show the location of the start of the comparable chart above - 2006. As you can see, JNJ spend a long time post recession in the undervalued territory. For those unfamiliar with FAST Graphs, the black line represents share price, the orange line represents the fair value line and the blue line represents the valuation at its historical P/E average. Our goal as value investors is to find quality companies that are selling below their fair value. Currently, JNJ appears to be fairly valued relative to its historic P/E (blue line), but not the market P/E (orange line).

    Chart 2: FAST Graph of JNJ

    (click to enlarge)

    One of the trends that is interested in the JNJ data is relative to the 2008/2009 time period. The stock price is on the decline, but the relative value is up. Remember that the relative strength is compared to the S&P 500. This chart is showing that JNJ lost less than the market. Even though the price is declining, it was performing better than the market. After this corrected out, since around 2011, the relative strength has been rather flat. The trend is our friend, and the relative strength plus the FAST Graph both support my decision to stay on the sidelines for now.

    The Gap

    Chart 3: GPS Stock Price & Relative Strength from 2006 to 2014.

    (click to enlarge)

    Chart 4: FAST Graph of GPS

    (click to enlarge)

    As can be seen on the FAST Graph, GPS has had a good growth string since late 2009. It has followed the earnings and fair value line on the way up. But looking at the relative value chart, you see a different story. The 2008 to 2012 period you have a growing relative strength. Since then, there has been a subtle decline from 0.25 to 0.20. Here, it looks like I have made a decision independent of the relative strength. It does not change my interest in owning the stock, but it will be interesting to track going forward.

    Tupperware

    Chart 5: TUP Stock Price & Relative Strength from 2006 to 2014.

    Chart 6: FAST Graph of TUP

    TUP is a great example of the trend is your friend. Starting in 2006, you can see the earnings start to grow. You can also see that the price followed in the FAST Graph. Looking at the relative strength, you can see that it followed in lock step. Things start to take a turn around the beginning of 2014. On the FAST Graph you can see where 2014 shows a significant price drop as earnings have flattened out. Since then, the relative strength trend has been declining, as has price. We are in catch a falling knife territory. More conservative investors will want to wait for the trend to turn. I attempted my hand at catching the knife against the trend. Once again, we will see how this plays out.

    Halliburton

    Chart 7: HAL Stock Price & Relative Strength from 2006 to 2014.

    Chart 8: FAST Graph of HAL

    HAL does something I like to call falling off the cliff. You can see this trend in 2009, 2011 and today. As soon as there is fear in the market about flattening earnings, HAL sells off like crazy. This provides great opportunity to get in for new investors. With this change in price goes its change in relative strength. It climbs back more aggressive than market performance, but it makes it a challenge to call the bottom. It also makes it a challenge to identify a trend. We shall see what the coming months do in the relative strength measure. Right now, it appears as history is repeating itself.

    Schlumberger

    Chart 9: SLB Stock Price & Relative Strength from April 2006 to Dec 2014.

    Note: I start this chart in April 2006 as opposed to the others in January 2006 to make it easy on myself with the stock split in April 2006.

    Chart 10: FAST Graph of SLB

    SLB loves to trade around 0.50 in relative strength. It floated around there from 2012 to 2013. Relative strength started to deviate in 2014 up until oil price declines of the past few months. The downward trend is working against me, but the price relative to historic fair value is right. In this case, it is once again another metric to look at for the investor.

    Conclusion

    Lets do a quick recap.

    JNJ - Trading Sideways, I am on the sidelines

    GPS - not with trend.

    TUP - not with trend.

    HAL - Unclear, but good entry point relative to history.

    SLB - Not with trend.

    As you can see from the recap, I have not successfully been trading with the Lowell Miller recommendation on relative strength. What you can see from my review is that some do show the trend following relative strength while others do not. The recommendation from the book is to wait until you see a turn from a negative decline back towards a positive incline. We shall see how each of these does over the next few months. As a DGI, I am more concerned about purchasing at fair value than following a trend. That might change in the future. Lets open the discussion - does anyone out there use relative strength to help time their purchase?

    Work Cited

    Miller, L. (2006). The single best investment creating wealth with dividend growth (2nd ed.). Chicago: Independent Group.

    Disclosure: The author is long GPS, HAL, SLB, TUP, SPY. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

    Dec 19 5:07 PM | Link | Comment!
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