How Relative Strength Can Help You Thrive Amidst Macro Shocks

Introduction to Relative Strength in Trading

I always start by commending those who are eager to learn and understand the diverse trading and investment strategies out there. It’s a journey I embarked on years ago and continue to tread today. You never know when you’ll come across a trading style or philosophy that resonates with you. So, if you’re a newbie or facing challenges in trading, you’re on the right path. The more perspectives you gather, the closer you get to that ‘aha’ moment.

So, let’s dive straight into the topic: using relative strength to adapt to macro shocks in the market.

We’re navigating through yet another significant macro shock in the markets, and it seems these “once-in-a-century” events are becoming more frequent. The strategy for dealing with these macro shocks that I will explain here, is rooted in the principles of the Chartered Market Technician (CMT) program, and is widely adopted by many traders.

Understanding Relative Strength in Trading

Before diving deep, let’s clarify some terms. Relative strength in trading is not about the RSI indicator, which often confuses many. Instead, it’s about comparing one asset’s performance to another to determine which one is stronger. This comparison is crucial in identifying which assets are outperforming others.

Case Study: ELF vs. S&P 500

Take, for instance, ELF, a beauty supply company. When compared to the S&P 500, ELF has consistently outperformed the market index. This outperformance is evident in the upward trajectory of ELF’s stock price compared to the S&P 500.

Case Study: Pfizer vs. Eli Lilly

Another example is comparing two stocks in the same sector, like Pfizer and Eli Lilly. While Pfizer’s stock performance has been lackluster, Eli Lilly’s stock has doubled in value in a relatively short period. Such comparisons can guide traders in making informed decisions about which stocks to invest in.

The Quantitative Approach to Trading

Many traders have a fundamental bias and use technical analysis to confirm or refute that bias. However, as a quantitative trader, the approach is different. Being a quantitative trader and technician, I rely on mathematical models to guide my trading decisions. And when it comes to relative strength, there’s ample evidence to prove its efficacy.

Does Relative Strength Truly Work?

Several studies have shown the effectiveness of relative strength in trading:

Jegadeesh Study (1993): Spanning from 1965 to 1989, this study simply focused on stocks that performed best over six months. The strategy was straightforward: invest in top-performing stocks, hold for six months, and repeat. This method yielded an excess return of 12.1% annually.

Blackstar Fund Study: This study revolved around building a portfolio based on stocks hitting new 52-week highs. The only criterion for selection was the stock’s recent performance. The results showcased a distribution of returns, with some stocks immediately hitting their stop after reaching a new high.

Macro Shocks: The Unpredictable Market Events

Macro shocks are significant events that drastically alter the market’s behavior. Let’s take a look at the S&P 500’s monthly chart, where three major macro shocks are highlighted:

The Trump-Powell Twitter Feud (2018): This period was marked by public disagreements between President Trump and Federal Reserve Chair Powell. The core issue was interest rate adjustments. While Powell leaned towards raising rates, Trump advocated for keeping them low. This tussle, coupled with trade wars, led to market fluctuations. The December 2018 dip was particularly notable, dampening many investors’ holiday spirits.

The Global Pandemic (2020): The COVID-19 pandemic needs no introduction. Its impact on global markets was profound. Investors had to rapidly adjust to a new reality, considering lockdowns, government responses, and the biological implications of the virus.

Russia-Ukraine Invasion (2022): The geopolitical tensions between Russia and Ukraine further roiled the markets. This event, combined with interest rate concerns, presented a fresh set of challenges for traders.

These macro shocks underscore the unpredictable nature of the market. To navigate such events, one would need to be a jack-of-all-trades, mastering everything from interest rates to biology to geopolitics in rapid succession. But is that feasible?

The Myth of the “Know-It-All” Trader

In the ever-evolving world of trading, it’s tempting to believe that staying updated with every piece of news will give you an edge. But let’s be real. The landscape changes rapidly, and what’s relevant today might be obsolete tomorrow.

Imagine having to switch your expertise from understanding interest rate dynamics to predicting a global pandemic’s economic implications and then diving deep into Eastern European geopolitics. It’s a Herculean task, and let’s be honest, most of us aren’t equipped for it.

We’ve all seen them on Twitter – traders who claim expertise in every domain, from vaccines to foreign policies and now nuclear science. But the truth is, no one can be an expert in everything.

There’s a meme that humorously captures this sentiment: A person claims to be an expert on vaccines one day, a foreign policy specialist the next, and then suddenly a nuclear scientist. While it’s amusing, it also highlights the impracticality of such an approach. Large institutions, like hedge funds, might have the resources to hire experts in various fields, but individual and retail traders often don’t have that luxury.

Leveraging Relative Strength Amidst Uncertainty

So, how can traders navigate these tumultuous waters? The answer lies in relative strength. By focusing on assets that showcase strength compared to others, traders can sidestep or at least mitigate the impact of these macro shocks.

Instead of trying to predict the next big event or becoming an overnight expert in a new field, traders can rely on the proven strategy of relative strength. This approach allows them to make informed decisions based on asset performance, offering a more stable and consistent method amidst market uncertainties.

The TI Swing Picks and TI Strength Alerts

Trade Ideas has developed a unique system known as the TI Swing Picks or TI Strength Alerts relative strength scanner. This system is designed to identify stocks that are showing relative strength in various market conditions.

How the System Works

Combining Indicators: By combining various indicators like position in range, absolute return, and the slope of moving averages, we create a composite score for each stock. This score helps us determine which stocks are showing the most strength relative to the rest of the market.

Adjusting Scores: We can adjust the scores based on certain conditions. For instance, if a stock is too far from its moving average, we might subtract points from its score. Conversely, if it’s close to an upward-sloping moving average, we might add points.

Ranking and Alerts: At the end of each day, the system ranks the stocks based on their composite scores. The top-ranked stocks are then sent out as alerts to our clients. These alerts can be received via email or viewed in real-time on the Trade Ideas platform.

The TI Ranking System

The TI ranking system was inspired by Ned Davis. The idea is to combine various indicators to identify relative strength. By integrating factors like position range, absolute return, and moving averages, the system can pinpoint stocks that are likely to perform well.

Stacking Indicators for Success

The key to the system’s success is stacking multiple indicators. For instance, ensuring an upward sloping 200-day moving average or an RSI that’s also upward sloping can help identify stocks that are showing strength. By combining these indicators, the system can provide a comprehensive view of the market’s potential movers.

The Bottom-Up Approach to Market Analysis

While many traders adopt a top-down approach, starting with a broader market perspective and then narrowing down to specific sectors and stocks, there’s another way. The bottom-up approach begins at the stock level. By scanning through stocks that are showing strength, traders can identify emerging themes or sectors that are gaining momentum. This method can sometimes offer a head start, allowing traders to spot trends before they become mainstream.

Benefits of the System

The beauty of this system is its adaptability. It doesn’t rely on predicting macro events or becoming an overnight expert in various fields. Instead, it focuses on the strength of individual stocks relative to the market. This approach allows traders to sidestep or at least mitigate the impact of macro shocks.

For instance, during the global pandemic, the system identified pharmaceutical stocks as strong performers. It didn’t know about the pandemic or its implications; it simply recognized that these stocks were showing strength relative to the rest of the market.

Similarly, during the interest rate fluctuations, the system favored utilities and oil and gas stocks, both of which are high dividend-paying sectors. Again, the system wasn’t aware of the macro events; it simply identified sectors that were outperforming.

Day Trading vs. Swing Trading

While the discussion so far has revolved around swing trading, these principles can also be applied to day trading. The key difference lies in the timeframe. Day traders are looking for stocks that are moving significantly within a single trading day, whereas swing traders are focused on potential movements over several days or weeks.

The TI Strength System

The TI Strength system, inspired by the market-beating performance algorithm, updates every few seconds. This real-time update allows traders to sift through the top-performing names and identify potential investment opportunities. The system ensures that the stocks it highlights are relatively strong compared to others based on the algorithm.

Conclusion

In a world filled with uncertainty and unpredictable macro events, having a system that focuses on relative strength can be a game-changer. The TI Strength Alerts system provides traders with a tool to navigate these tumultuous waters, identifying strong performers and helping them make informed decisions. By focusing on what’s working and ignoring what’s not, traders can achieve consistent returns and navigate the market’s ups and downs with confidence.