Relative strength and momentum. The two terms have different meanings, but many investors incorrectly use them interchangeably. Let’s start with some basic definitions.
Relative Strength: Relative strength is the comparative performance of two securities over a predefined interval. If “A” outperformed “B,” then “A” is showing superior relative strength. This is independent of whether or not either one made money. If “A” was down 10% but “B” was down 15%, then “A” still had the better relative strength. Relative strength can be measured over days, weeks, months, years, or any period, so be sure to understand the time-period involved.
Momentum: Momentum is typically measured as the percentage price change over a predefined interval. If “A” gained in value over the period, then “A” is displaying positive momentum. Likewise, if “B” lost value over the period, then “B” is said to have negative momentum. Momentum is often the underlying calculation used to determine relative strength.
Absolute Strength: In my opinion, absolute strength is the same as momentum. In the example given for relative strength above, one security is always better than the other one, even if both are declining in value. Absolute strength and momentum bring another dimension to relative-strength analysis and can help investors avoid buying a declining security just because it may be falling slower than the alternatives.
Adding to the confusion, I call my approach Relative Strength Momentum (“RSM”), which signifies it is a relative-strength ranking system that uses momentum as the ranking factor.
The length of time used for the predefined interval plays an enormous role in the results of any relative strength or momentum measuring system. For example, much of the academic research on the momentum factor defines momentum as the past 12 months of performance minus the most recent month. Said another way, it measures the performance over 11 months and then delays implementing any changes for a month.
Short-term swing traders use intervals of just a few days. They are focusing on the most recent data, the same data that academic research has tended to ignore. It is easy to see that these two approaches will produce different results.
Everyone needs to find the time interval they are comfortable with. For me, the 12-month academic approach to momentum is much too long of a time interval. An ETF, mutual fund, or stock can take a nasty dive in the most recent three months and still have a great 12-month momentum reading. With these slow systems, too much of the gains are given back before the trading system signals a switch into a different security.
Likewise, using too short of a time interval can lead to false starts, whipsaws, and excessive trading. While this is true with nearly every conceivable time interval, it seems to be more frequent with short-term systems. That is why I settled on an intermediate-term approach. Not only does it provide a compromise between the long-term and the short-term, it seems to work over a broad range of market conditions. My intermediate-term RSM system incorporates data from the most recent three to four months.
The Edge Charts I produce each week are market momentum snapshots. They provide a quick and easy way to help you visually get a handle on the overall state of the market. With these charts, you can assess both the relative strength and absolute strength (momentum) of more than 30 global equity market segments.
Reading an Edge Chart is very easy, once you know how. Let’s use the Sector Edge chart here as an example. First, the numbers and bars on the chart represent the RSM values, which is my measurement of absolute strength based on intermediate-term momentum.
The displayed values are annualized to give you a better feel for their current trend. For example, in the Sector Edge chart here, Telecom has a value of +13, which means that over the intermediate term, it is trending higher at the rate of +13% per year. This is not a prediction that it will be up 13% a year from now, just an indication of its current trajectory. By definition, the intermediate-term trend will not last a year.
Two places lower on the chart is the Utilities sector, which has a value of -12, implying that if its intermediate-term trend were to continue for the next year, it would decline by about -12%.
The relative strength of each sector can be determined by the ranking. In this example, the Health Care sector is stronger relative to the Real Estate sector, but both are weak (negative) on an absolute basis. Sectors with positive intermediate trends are readily identified by their green color and positive RSM value. Likewise, sectors with unfavorable trends have a red color and a negative number.
The same approach is applied to investment factors and global investment categories. You can find additional details on the 11 categories within each group here:
About the RSM Values
The RSM readings can take on any value, although there are practical limitations. The reading for a money market fund is typically equivalent to its yield. Equity readings between -10 and +10 usually indicate weak or changing trends. Values greater than 25 are usually considered strong. Very large values, whether they are positive or negative, typically represent momentum spikes that are not sustainable. The Technology sector saw extremes of about +200 in 1999 and -200 in 2002.
Additionally, to help smooth out the noise that often accompanies a traditional two-point momentum calculation, the RSM calculations use an anchored momentum approach. It is described in “The Anchored Momentum Indicator,” which was published in the March 19, 2015, issue of Proactive Advisor Magazine.
Disclosure: Author has no positions in any of the securities mentioned and no positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) is received from, or on behalf of, any of the companies or ETF sponsors mentioned.