Every Tuesday, I share with Cycle 9 Alert subscribers my Leaders & Laggards Board.
This ranking system is meant to give readers a general idea of which sectors are on the rise… and which ones are lagging behind.
It’s based on something called “relative strength.” As its name suggests, it measures how strong something is relative to something else.
But there’s a mathematical nuance that you should be aware of. That is, since the calculation is designed to capture only the relative, there are two ways a sector can achieve a positive ranking.
First, if it has gained in price, at a faster rate than the S&P 500. And second, if it has fallen in price, at a slower rate than the S&P 500.
And there’s clearly a meaningful difference between those two scenarios.
For bullish positions, the first scenario (gaining faster) means profits in your pockets, while the second scenario (falling slower) simply means you’re “losing less” than the next guy – and we all know that doesn’t pay the mortgage!
That’s why relative strength, alone, can be misleading. And it’s why I insist Cycle 9 Alert subscribers also take the absolute trend into consideration, since it nicely answers the question that relative strength cannot.
Here’s an analogy, where we pretend stocks are like cars on an interstate…
Relative strength gives a lot of valuable information about these cars (stocks). It can tell us which cars are moving faster than average… and also which ones are now moving faster than they had been moving before.
But relative strength cannot tell us whether the vehicle is heading northbound or southbound! For that… we need a direction, or absolute trend, indicator.
This absolute trend indicator ensures we only buy stocks that have been trending higher… and only bet against stocks that have been trending lower. Essentially, that we’re trading with the trend.
I’ve hit this topic before, but it’s worth repeating: Trading against the dominant, longer-term trend is a recipe for disaster.
I’ll give you a concrete example, via the energy sector.
On February 5, 2015, the energy sector triggered a relative strength score that typically leads me to issue a buy recommendation on the sector. But… the sector’s absolute trend was down, so the rules of my system stopped me from recommending a bullish play on the sector.
Turns out, that was a trade we were glad to skip – the sector is down 15% since!
So while relative strength measures might have tempted us into a bullish trade on energy stocks back in February, the absolute trend measure told us the trend was bearish and not worth fighting.
Essentially, energy stocks were still in the “southbound” lane… and wishing for a northbound route would have only spelled disaster.
We avoided that disaster, just as we’ve avoided countless others in the three years that I’ve shared my Cycle 9 system with subscribers.
Chief Investment Strategist, Dent Research