HOW TO COMBINE ABSOLUTE AND RELATIVE STRENGTH TO GET THE BENEFITS OF BOTH -- THE TRICK IS BY USING 5O-DAY AVERAGES
RELATIVE STRENGTH ALONE ISN'T ENOUGH ... I place a lot of importance on relative strength. As a rule, I generally recommend market groups -- or individual stocks -- that are showing relative strength. In other words, they're outperforming the S&P 500. But relative strength by itself isn't enough. I also like to see a purchase candidate showing "absolute" strength as well. In a down market, a group (or stock) may be showing relative strength simply by falling less than the S&P 500. In other words, a group might be showing relative strength but "absolute" weakness. I'd rather see it showing absolute as well as relative strength. In other words, I prefer a market group that's not only doing better than the S&P 500, but is actually rising in price. In a rising market, a group (or stock) may be rising (showing absolute strength) but rising slower than the S&P 500 (relative weakness). In a rising market, I prefer a market that's rising faster than the S&P 500. In other words, absolute and relative strength. There's a way to get both. As you know, I've recently recommended the basic materials group which is showing both absolute and relative strength. I determine absolute strength by ensuring that the group is trading over its 50-day moving average. Chart 1 shows the Materials Select Sector SPDR crossing over its 50-day average at the end of October and the start of February (see blue circles). That displayed absolute strength and fulfilled half of the requirement for a buy recommendation. But what about relative strength?
Chart 1
Chart 2
USING A RATIO CHART ... Chart 2 is a ratio of the Materials Select Sector SPDR (XLB) divided by the S&P 500. [I explained earlier today how to create that ratio]. I simply apply a 50-day average to the ratio line. My requirement for relative strength is that the ratio line cross over its 50-day average. That happened at the start of November and the start of February (see blue arrows), and confirmed the upside crossings by the Materials ETF shown in Chart 1. That meant that the XLB was not only showing relative strength (a rising ratio), but absolute strength as well. The fact that the XLB is breaking through its fourth quarter high is another positive technical sign.
