Category: Relative Strength

Relative Strength Can Signal Valuation (P/E) Expansion

A typical buyside analyst looks at the world in terms of business fundamentals, earnings estimates, quality of management, competitive position, competitive advantage, return on invested capital, P/E multiples and so forth.

You will often hear analysts talk about P/E’s being low relative to growth rates or low vs 10-year bond yields or low vs a group of comparable companies or the overall market etc.

Is the price/earnings (P/E) multiple a good indicator for future performance?  One interpretation of this fundamental valuation measure is rather than thinking in terms of the current valuation vs ‘fair value’ --- is simply to observe whether the valuation is expanding or contracting and decide if you believe this will continue.

If a P/E has just gone from 14x to 12x, its cheaper – but is that bullish?  How do we know its not headed lower?  We should probably test this and see if it works and then create some guidelines for portfolio strategy based on this.  Wouldn’t that make sense rather than just blindly believing that a lower multiple is bullish?

Relative strength can actually be thought of as fundamental analysis if you wish to think about it like that.  It would not be unusual for a fundamental analyst to say during a rally “the P/E multiple is still too low at 12x next years earnings” -- even though it’s up from a low of 9x and you bought the stock at 10x.  But this is not any different than watching relative strength and buying at the same price and looking for further valuation expansion.

Good relative strength analysis captures when a market segment is experiencing valuation expansion.  A low P/E is not actually bullish unless its low and then expands higher.  This is the crucial aspect – not the absolute level of valuation. 

Relative Strength vs R.S.I.

We have received this question a number of times in email and so we wanted to clarify something.

R.S.I. (known as the Relative Strength Index) and the way we at ETFreplay.com discuss ‘Relative Strength’ are not the same thing.   We wanted to briefly explain this.

R.S.I. is a technical analysis tool that involves only a single security  --  it measures the average amount of up closes vs the average down closes over a given period of time.   The most important distinction here is that R.S.I. only looks at the closing values of one security.  There is nothing in the calculation of R.S.I. that involves anything but the historical prices of this SINGLE security.

The way ETFreplay uses relative strength has nothing to do with R.S.I.   We use relative strength as a way to determine which among multiple market segments is relatively strong.

Many of you are probably familiar with Investors Business Daily.   The paper has for a long period of time used a ‘RS Rank’ --- this is more like what we use.   Note that IBD certainly did not invent the concept of relative strength  --  but they built a database of securities and then ranked everything relative to each other.   Institutional-oriented software programs do the same thing.  A RS Rank of 90 in IBDs method means that a stock has outperformed 90% of the other securities in their database over a given period of time.  High-end institutional software does something similar – except they proceed more mathematically by instead expressing the strength of the security as the distance from the average of a group  --- and this is usually stated in terms of the # of standard deviations away from the mean (think z-score).

This is all similar to what we have done – except we do it with ETFs and then allow you to backtest it yourself rather than just saying ‘you should buy relative strength because it works.’   We also allow the user to define relative strength themselves – using easy browser controls like drop-down menus and text boxes.   So for example you could simulate IBD’s method by using 12-month performance and ranking ETFs in a given universe like this:

ETFreplay Screener

Then you could go the ETFreplay.com backtesting module and see how 12-month relative strength has been holding up over the past 10+ years and see what kind of drawdowns its had.  

This is all a research process – its just that we are performing research that comes in a very practical form.   We aren’t researching stocks, we are researching strategies --- strategies based on baskets of stocks.   Backtesting is not the only thing that matters --- but its pretty darn good information for you to factor into your decision-making process.   Without some historical testing, you could easily go a lifetime of doing things that you thought worked – but actually don’t -- and never really did.

A Simple Example of Global ETF Relative Strength

We showed a few examples of some very basic relative strength techniques at a recent investor event.

This example was meant to show a relative strength strategy that easily could have been thought of as unbiased at any point in past 10 years -- or right now for that matter.

For simplicity, we have used the global regional ETFs and have simply covered the major parts of the 'developed world'.   We know that emerging markets have been excellent performers over the past 7-8 years -- as have selected other assets like Gold -- but we have intentionally left these out.   We wanted to show something that had some poor performing picks, a few good ones and therefore representative of someone who didn't pick ETFs particularly well but implemented a sound technique to stay with leaders and avoid large underperformers.

Importantly, we believe investors SHOULD decide first which ETFs they would like to be involved with and exclude those they have no interest in on a fundamental basis -- this is value-add to a basic, mechanical technique such as this.   

So for this example we use the World Index as a starting point and seek to just 'cover' the developed regions:

Current Approximate Weightings in Global Indexes are:

United States 42.0%
Developed Europe 25.0%
Japan 7.0%
Developed Pacific [1] 7.0%
Canada 4.5%

***Emerging Markets       Excluded

[1] Developed Pacific is ~97% Australia/Hong Kong/Singapore and 3% 'other' (New Zealand etc..)

From an indexing perspective, Canada is always kind of the lonely child.   Canada is generally not included within a broader regional ETF -- and is not generally lumped with the United States for a North American ETF.   For conservatism here, I will exclude Canada and use the first 4 only.  These are logical regions in our view.   We get coverage of many different countries within this regional framework so this seems quite fair and hardly something that could not have been thought of many years ago -- or even today.

We will include the first 4 from above and SHY, a <2-year duration U.S. Treasury ETF which will act as a benchmark for positive returns.   If no region of the world is beating 2-year maturity short-term fixed-income -- then SHY will by default be thought to be the highest Relative Strength ETF.  

Here is the result using a 6-mo / 3-mo 2-factor relative strength model with monthly re-balancing.

Note all historical results are purely hypothetical and meant to show the mechanics of the backtesting application.  This does not represent investment advice.

Symbol list here is:  SPY, EWJ, IEV, EPP, SHY

ETF List of New Highs Can Help You Understand Money Flows

This summer is a good reminder that ETF investing does not revolve exclusively around equities. After assuming a leadership role in early May, many non-equity forms of ETFs have made repeated new highs over the past few months.  Treasury Bond ETFs have been the most obvious example of relative strength but other groups performing well include: the Master Limited Partnership products (AMJ), Emerging Market Bond ETFs (EMB, PCY), Preferred Stock ETFs (PFF,PGX, PGF) and more recently, U.S. Utility Stock ETFs (XLU, IDU, VPU).  

What do the majority of these ETFs have in common? Most of the recent 6-month ETF list of new highs involves indexes associated with yield (and lower relative volatility vs the S&P 500).

 

Try the interactive functionality of the above webpage here: New Highs and Lows App

With regard to equities, we’ve seen some new multi-month highs made in some select Asian and Latin American equity indexes. We will be watching to see to what extent other equity country funds can confirm this new potential leadership area (emerging markets equity).

U.S. stocks made fresh six-month lows at the beginning of this month. The drawdowns of some of the primary indexes this year have been -15.7% for the S&P 500, -20.1% for the Russell 2000 (IWM) and -22.8% for the Vanguard Europe ETF (VGK) (drawdown is the maximum high to low correction using closing prices). These groups have rallied hard over the past 20 days but they appear to be in a holding pattern as evidenced by their poor/mediocre rankings on 3 & 6 month relative strength lists.

 

Another important item to point out is that owning bonds and yield-oriented hybrid securities (like those listed above) has been a LOWER volatility method to making money these past few months.

When the market gets volatile – as it does during corrections – buying inverse ETFs may seem like a good way to make money -- but remember, the Sharpe Ratio penalizes for volatility and you must expect large returns to offset taking on such rising volatility environments. Short-sellers have been punished hard this month while lower volatility funds (like those listed above) have appreciated.

In some respects, owning bonds -- particularly treasuries -- is a dominant method over shorting stocks.  The volatilities are far lower if you keep your maturities reasonable. Thus you can express a bearish view without taking the same risk as you do during hard short-squeezes in equity markets.

We think it’s important to stay abreast of what the market itself is telling us through relative strength.  When combined with your own fundamental ETF ideas, this market-generated information can be the key edge you have in terms of finding profitable entries and exits.

As we proceed further into the 2nd half of 2010, we have every intention of finding market segments that stay consistent with our global relative strength models.  Near-term, look for pullbacks in some of the improving relative strength ETFs to make any adjustments necessary to your portfolios net exposures.

The IBD 100 is Essentially A Relative Strength Index

The Investors Business Daily (IBD) 100 is at its core a Relative Strength backtest of the IBD stock universe. Note that IBD's method is to also use its larger market BUY and SELL signals and these do not show up in the chart below.

If you use fixed-income ETFs in your ETFreplay screening / backtesting lists -- you effectively automate the 'Buy-Sell' signals by naturally rotating into the higher relative strength bond ETFs as stocks breakdown and bonds rally. We suggest using intermediate or short-term bond ETFs in your lists. Long-dated treasury ETFs can suffer from very high volatility -- and a key concept is to avoid highly volatile securities UNLESS they offer high expected returns. This is unlikely the case for most bond ETFs -- bond ETFs best attribute is their stability in times of turbulence.

Note also that while the IBD 100 is compared to the S&P 500 below, it does often own foreign stocks that trade on U.S. exchanges. While we cannot calculate the volatility of the IBD-100 since we don't have the data series, we suspect its volatility is far greater than the S&P 500. Remember that when volatility is HIGHER, you would EXPECT larger relative drawdowns.

This image captures the cumulative return of the IBD 100 index up through June 18, 2010 (note the massive drawdown in 2008).

 

12345