The chart below shows the Spread for three well-diversified but different stock lists over the same two-year time period. Compare the three Spreads.
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Each of these distinct universes of stocks produces a Spread with unique features. But their similarity, not their difference, is most telling. The fact that these three tend to rise and fall together demonstrates that each is influenced by an underlying and pervasive dynamic.
The rise and fall of the Spread detects and records the rise and fall of traders' confidence in the trend.
When traders are confident, they are willing to chase strong stocks into new high ground. Stocks which do not participate in the trend are ignored or sold, and the proceeds are used to purchase performing issues. As a result, strong stocks outdistance laggard stocks, and the Spread rises.
In truly bullish moves, three conditions are met: 1) RS leaders advance; 2) RS laggards advance, too; 3) RS leaders advance more strongly than RS laggards--the Spread rises.
Imagine a train. When all is well, power is supplied by the locomotive out in front. Although there is a tendency for the locomotive to separate from the caboose as couplings stretch, the caboose is nonetheless pulled along more or less apace with the locomotive.
In a bullish move, power is supplied by relative-strength leaders out in front. RS laggards are pulled along as well, though better performance is realized from RS leaders.
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On the other hand, when confidence in the trend weakens, profits are taken in stocks which have rallied well, and capital is redirected into sold-out "bargains". As a result, laggard stocks outperform those which have been strong, and the Spread falls.
There is a relationship between the direction of the Spread and the trend of the overall market. During periods when the Spread is falling, the market may churn as leaders tumble and laggards begin to rally. This two-way affair often nets an overall flat, range-bound market. The 1994 market is typical.
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When the Spread falls, stock revert to the mean. Former leaders fall toward the benchmark while laggards rise. This process is a kind of tilling; the old RS leaders are turned under, and laggards seed a new crop of potential RS leaders, setting the stage for a new phase of strength-following.
At market bottoms, the Spread falls as laggard stocks which have become most deeply oversold rebound sharply. The 1987 bottom is a good example.
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Once the market rallies convincingly from a bear market bottom, traders' confidence in the trend returns. At that point, a falling Spread gives way to a rising Spread, and a new, usually very profitable, strength-following phase begins.
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At market tops, sensitive RS leaders are often the first to round over as confidence in the trend begins to wane. As a result, the Spread may flatten out or decline even as the market continues to climb during the final stage of a bull market. The divergence between the benchmark and the Spread may begin as much as six months before the market begins to decline.
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During contrarian markets, strong hands sell into strength and buy into weakness. To stay on the side of strong hands, adopt a contrarian strategy when the Spread is falling. Reduce or eliminate positions in stocks which have led the market in recent months, and review laggard issues for new opportunities.
Contrarian markets are mixed markets and very often the overall trend is not supportive. For that reason alone, contrarian markets are far more difficult to trade successfully than are strength-following markets, and any trader should expect the failure rate of trades, and therefore the cost of trading, to rise.
New long positions should be taken close to support and low in the range, where strong hands are most active. Should support fail, this tactic will allow you to exit your position quickly and take a small loss.
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Stocks which have passed through accumulation and which exhibit renewed strength are the most desirable candidates during contrarian markets. Because the overall trend of the market is likely to be weak, stocks which break out of a range of accumulation are likely to return for a test of support before continuing upward. Since confidence in the new trend is typically low and the temptation to take profits is high, the deepest reactions are likely to occur early on, before the uptrend has gathered momentum.
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Because the main body of stocks tends to trade trendlessly during contrarian markets, traders place a scarcity premium on the few strongly trending groups and issues. As a result, contrarian markets may offer unusual, if very narrow, speculative opportunities.
Strong performers during contrarian markets are likely to be issues which lagged the market during the previous strength-following market phase. The Alcoholic Beverage Group is a case on point. During the two-year period from early 1992 to late 1993, this group lagged badly as the broad market advanced.
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As the contrarian market of 1994 got underway, capital began to flow into laggards. The Alcoholic Beverage Group was now viewed as a bargain, and traders began to bid up stocks within the group.
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Laggards which perform well during contrarian markets often become RS leaders during the next strength-following phase. After a convincing indication of both nominal and relative strength early in the year, the beverage group dipped in a normal test of support late in 1994. This bullish setup was the last and best opportunity to buy before the group asserted its leadership during the ensuing strength-following market, which began with the new year (1995).
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During the strength-following market of 1992 -93, Worldcom ran with the leaders, more than doubling, while Microsoft lagged, finishing at the end of the period about where it started.
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However, as the Spread began to fall in early 1994, the tables turned, and the Tortoise overtook the Hare. During a year in which former leaders sagged and most stocks traded irregularly, Microsoft rose by 45%. Worldcom drifted irregularly lower with the broader market.
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