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By Robert Bacarella | October 23, 2019

Even if you aren’t a Star Wars fan, you have probably heard the phrase, “May the Force be with you.” Non-fans probably hear the phrase mostly as an equivalent to “good luck” in the face of an impending challenge. But as fans will explain, there’s more to the Force than that.

As Obi-Wan Kenobi explains, the Force is as “an energy field created by all living things. It surrounds us and penetrates us. It binds everything together.”

In investments, the energy field that surrounds and binds the markets together is trading activity. Trading activity is the lifeblood of the market, always surrounding us. It reflects investors’ demand for securities, which impacts both market prices and direction. (Generally, greater demand for a security means a rising price, whereas lesser demand means a falling price.)

Like the Force, trading activity in and of itself is neither good nor bad—until the information it conveys is channeled for a purpose. For example, if a company’s outlook is improving, the stock price will usually move higher, toward the “light” side of the force—whereas a negative outlook suggests a shift toward the “dark” side.

Relative Strength

If you are making a decision about a particular stock—whether to buy, sell or hold—you need information about both the company and the broader market. It’s not enough to know the company inside and out. That’s the equivalent of having outstanding light-saber skills but no awareness of the Force.

As Yoda said, “Difficult to see, always in motion is the future.” No one—not even a Jedi—can see the future. But by looking at company-specific characteristics in the context of the broader market, you can increase your awareness and potentially make decisions more in line with a more likely future.

A measure called Relative Strength is particularly useful for this purpose. It’s a measure of how a security performs relative to the overall market (e.g., the S&P 500 Index). The usefulness of Relative Strength is premised on the expectation that once a price is in motion it will continue in that motion in the future.

At core, Relative Strength reflects a sense of direction:

  • If a stock is trending upward while the market is trending flat or downward, that reflects a positive trend.
  • If a stock is trending downward but less sharply than the overall market decline, this is also a positive trend.

In simplicity can lie great power. A company’s Relative Strength simply reflects the changing views of all market participants. It is important to realize that “other people actions” matter…it’s their activity that has the potential to drive a stock price higher or lower.

Like the Force, sometimes investors sense a company’s prospects are tilting toward the light side due to improving revenue and growth expectations. This trend is reinforced by generally higher trading volume and upward pressure on the stock price. To quote Darth Vader, “The Force is strong with this one.”

But sometimes investors sense a stock may be headed toward the dark side…perhaps due to lowered company prospects. A security’s declining Relative Strength, in either an up or down market, suggests changing investor growth expectations. This is a “red flag” that should not be ignored. With declining Relative Strength, you are likely to also observe increased trading volume for that security as investors step away from it.

 

Relative Strength Is Not an Investment Strategy on its Own

Luke had great gifts as a Jedi, but he still had to train long and hard. He needed to develop his light saber skills (investment knowledge) as well as his awareness of the Force (trading activity, made more useful by Relative Strength).

To quote the well-known investor James O’Shaughnessy: “Relative strength is a much better indicator of a company prospects than factors such as earnings growth rates.” Numerous studies have shown Relative Strength’s usefulness in predicting a stock’s future price performance, but that doesn’t mean Relative Strength is a sufficient investment strategy in and of itself.

Investors sometimes talk about “confirming” their sense of a stock’s tilt toward either the light side or the dark side. They might use Relative Strength or another technical indicator to “confirm” (or to call into question!) a view they’ve developed through fundamental research. Or, it could be the other way around: they might use research to “confirm” a signal they’ve seen in trading activity.

Either way, the key point here is not to fall into the trap of making decisions that are either (a) just focused on your own views, without considering the broader market, or (b) just focused on stock price movement without factoring in company fundamentals.

Instead, do both. Like Luke, build and practice your own skills (research) while increasing your awareness of the Force (trading activity). If your research makes you think a company’s about to prosper or wither, then check Relative Strength as a way to see what others think.  It’s always possible that others are more attuned to the Force at that moment than you are.

Now, Go. And may the Force be with you!

Relative Strength

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