The Nature of Strength-Following Markets

Rising strength-following markets are the best of times. If contrarian markets are a time of tilling and sowing, then strength-following markets are a time of harvest.

When both prices and the Spread are rising, the most profitable strategy is to buy and hold the strongest stocks. During these periods the trend is strong, and the best performing stocks attract a large and enthusiastic following. Avoid weak issues, even those which have built impressive bases. These stocks are likely to underperform stronger issues.

The signal feature of strength-following markets is that, on average, the higher the RS rank, the better the forward performance. The chart below shows a period during which the Spread rose. The black (lowest) line indicates the average performance of all stocks in the subject universe. The solid blue line shows the cumulative forward performance of the set of all stocks with an RS rank of one (1) or more. The dashed lines show the performance of increasingly highly ranked subsets of strong stocks. The higher the RS rank, the higher the forward performance.

Strength-Following Market

Strength Following Market

During strength-following markets, the higher the RS rank, the higher the forward performance.

By contrast, the performance of strong stocks during contrarian markets turns the above chart on its head. The chart below shows the performance of stocks with an RS rank of one or better during a contrarian period, as the Spread declines. Again, the benchmark is shown in black. The solid blue line is the forward performance of all stocks with an RS rank greater than one (1). Note that the average strong stock underperforms the benchmark. As RS increases, performance deteriorates further. The dashed lines show the performance of increasingly highly ranked subsets of strong stocks. The higher the RS rank, the lower the forward performance.

Contrarian Market

Contrarian Market

Ranking Stocks

When traders are in a strength-following mode, the most profitable information is the relative-strength ranking of stocks and groups.Focus on the strongest stocks within the strongest groups.

Once RS is determined for each target in the universe of interest, ranking by RS is easy. Shown below is the rank, from strongest to weakest, of 84 groups as of late August, 1999.

Because the benchmark is always equal to 100, groups above 100 are relatively strong, while those below 100 are relatively weak.

Group RS Ranking

Group Rank
Semiconductors 138.65
Oil Drilling 131.01
Aluminum 130.70
Computer Systems 127.31
Oil Service 122.50
Paper 120.13
Telecomm Equip 119.88
Copper 119.18
Cellular Equip 117.07
Oil & Gas Explore 116.80
Bluechip Tech 115.31
Chemical 114.81
Asian Equity 114.50
Biotech 112.64
Steel 111.55
Oil – US Integrated 111.48
Pollution 111.42
Heavy Equip 111.10
App & Furn Mfg 110.25
Personal Credit 110.01
Manufacturing 109.54
Trucking 108.78
Utility Natural Gas 108.56
Natural Gas 108.44
Gaming 108.34
Cellular Service 108.24
Computer Network 108.05
International Oil 106.34
Retail Computers 105.97
Airfreight 105.88
Specialty Chem 105.82
Software 105.16
Radio Broadcasting 105.06
Utility Telephone 104.72
Diversified 104.49
Autoparts 103.03
Publishing 102.74
Newspapers 101.96
Gold 101.95
CATV 101.66
Retail Dept Stores 100.44
Shoes 99.78
Railroads 99.65
Building Products 98.45
Retail Bldg Prods 98.27
Media Diversified 96.90
Latin Amer Equity 96.46
Tobacco 96.33
Food Stores 95.55
Aerospace 95.50
Restaurants 94.86
Textiles Apparel 93.75
Home Builders 93.61
Money Cntr Banks 93.04
Food 92.45
Medical Prods 92.43
Comp Service 92.34
Retail Office Supp 91.58
Computer -PC 91.34
Utility Electric 91.22
Household Prods 90.59
Airline Regional 90.47
European Equity 90.21
REIT 90.02
Beverage 89.78
Retail Apparel 89.75
Mortgage 88.45
Brokers 87.46
Cosmetics 87.29
Retail Discount 87.10
Health Services 86.54
Bank Regional 86.28
Property Insurance 84.99
Thrifts 84.98
Drug Stores 84.33
Life Insurance 83.07
Long Distance Tel 80.99
Airlines 80.10
Hotels 79.84
Internet 79.30
Autos 77.97
Comp Peripherals 74.75
Drugs 74.52
Mfg Housing 66.25

While not necessary, it is nevertheless useful to normalize RS rank as a percent of maximum and minimum extremes. Entries equal to or greater than 100 (the benchmark) are compared to the maximum entry. The top group in the above list (Semiconductors) is, of course, 100 percent of the maximum entry. The next, Oil Drilling, has an RS which is 80 percent of the maximum, and so on.

Entries below 100 are compared to the minimum entry. To get this calculation right requires that 100 be subtracted from each entry before a comparison is made. So, for instance, the bottom group, Mfg. Housing, converts to a reading of -33.75 (66.25 minus 100). The next group up from the bottom, Drugs, converts to a reading of -25.38, and so on.Then divide each converted entry by the absolute value of the lowest in the list, in this case Mfg. Housing,to arrive at a percent of the minimum. For Mfg. Housing, divide -33.75 by 33.75 and then multiply by 100.The result is 100 (-33.75 / 33.75 * 100 = -100).

A similar calculation is carried out for all other groups with an RS rank of less than 100.The calculation for Drugs is: (74.52-100) / 33.75 * 100 = -75. The Drug group is only 75 percent as weak as Mfg. Housing.

Below is a truncated version of the RS ranking, converted to indicate percent of maximum and minimum RS (allow for rounding errors).

Normalized Group RS Ranking

(Partial)

Group Rank
Semiconductors 100
Oil Drilling 80
Aluminum 79
Computer Systems 71
Oil Service 58
Paper 52
Telecomm Equip 51
Copper 50
Cellular Equip 44
Oil & Gas Explore 43
Bluechip Tech 40
––– –––
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––– –––
Thrifts -45
Drug Stores -46
Life Insurance -50
Long Distance Tel -56
Airlines -59
Hotels -60
Internet -61
Autos -65
Comp Peripherals -75
Drugs -76
Mfg Housing -100

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