Using Relative Strength to Detect Future Rallies
Everybody knows that the U.S. economy emerged from the 2008 financial crisis better than any other country. That’s why the U.S. equity markets have been the strongest global asset class to invest in since 2011.
But not everybody knows how to turn this into a well-hedged investment in stocks.
Today, I’ll show you how to do just that by using a relative strength chart. And, perhaps more importantly, I’ll show you how to use the chart as a tool that detects future U.S. stock market strength.
First look at the five-year chart below. I’m not going to tell you what it represents yet. But, just like any price chart, it plots values as time passes. Pretty simple, right?
If you have an understanding of charts, then you’ve probably already identified past resistance and support levels. (And if not, I’d recommend taking some time to check out articles tagged “technical analysis” on InvestmentU.com.) When the chart breaks through a past resistance level, it tends to continue to push much higher.
Conversely, if a chart breaks through a previous support level, most often it will continue to fall.
The chart above represents a simple calculation dividing the value of the S&P 500 by the value of the iShares MSCI Emerging Markets ETF (NYSE: EEM). It gives us a view of the strength of the U.S. stock market versus that of various emerging stock markets like China, Korea, India, South Africa and Brazil.
We call this a “relative strength chart.” It goes up when the S&P 500 is outperforming EEM and declines when the opposite is true.
How to Turn This Into Profits
Between 2000 and 2010, this chart was used in the exact opposite way we use it today.
In those years, emerging markets were starting to outperform U.S. markets, so it showed a downward slope. This confirmed strength in most global equity markets.
Assuming an investor had no interest in buying foreign stocks, they would want to load up on U.S. stocks whenever this chart broke through support levels.
Basically, when emerging markets were outperforming the U.S., it implied “risk on” stock market sentiment. As a result, the relative strength chart would decline.
When investors became fearful, they would exit emerging markets and buy U.S. stocks as a safe haven. And the chart would, in turn, go up.
So for U.S. stock investors, seeing this chart go up was bad – and down was good.
But that all reversed when the chart bottomed out in 2010.
Now, up is good and down is bad.
With that in mind, the trick to using this as a tool is to view it like any old stock chart.
Notice those blue horizontal lines? The dark parts show historic resistance levels and the light parts show how those past resistance levels, once penetrated, became new support levels.
The green line and red arrow illustrate that we have just broken above a six-year high. When that happens to an individual stock or sector, people see it as a major event. This should be viewed similarly.
Let’s zoom in…
If you want to own the stock market but would like to hedge your position, then it might make sense to buy the SPDR S&P 500 ETF Trust (NYSE: SPY) and sell short the same dollar amount worth of the iShares MSCI Emerging Markets ETF. This is called a “pairs trade.” (I explained how this strategy works in a previous Investment U article here.)
Boost Your Confidence as an Investor
Do you remember the mid-2011 stock market “collapse,” when the S&P 500 was down 19.5% from its May high?
Well, at the same time, the relative strength of the S&P 500 versus EEM spiked sharply higher.
That means anyone who was in the pairs trade I just described made money.
This is because EEM declined by more than the S&P 500 during that time frame.
Now let’s zoom back out to the five-year relative strength chart of the S&P 500 versus EEM…
Notice how the first green arrow on the far left points to a breakout (past resistance level being penetrated).
This coincided with what I consider to be the starting point (October 2011) of the bull market we are in today. And this type of activity can be used to assess current, as well as signal coming, strength in the U.S. stock market.
Now look at the black arrows below. They’re pointing to the same time periods as the green arrows above.
Can you remember what you were thinking or wondering about the U.S. stock market during those periods?
Relative strength buy signals helped savvy investors remain confident.
Finally, let’s zoom in to the two-year relative strength of the S&P 500 vs. EEM…
Check out the green circle. Does that look like a new buy signal to you? Because it sure looks like one to me.