I suspect that most of us like to think of ourselves as pragmatists, as opposed to ideologues. Politicians have certainly picked up on the fact that people like to hear much more about pragmatism than ideology. What politician doesn’t describe them self as someone who champions “common sense solutions?” Yet, how much of what comes out of Washington actually has a positive effect on the country as a whole? But, I digress. Most understand that theories have to be backed up by evidence in order to have any real positive effect in our lives.
Wall Street is filled with theories. Some work, some don’t. After years of being fed a steady diet of a given investment ideology (buy and hold, strategic asset allocation, etc.) and then not seeing the theory materialize into reality, many investors are feeling a bit jaded these days. The ranks of the skeptical pragmatists are rising.
Pragmatism is the essence of relative strength investing – in theory and practice! In this vein, consider our commentary from several years ago as we discussed the foundations of relative strength:
The Dorsey Wright Daily Equity Report talks a lot about relative strength and every Dorsey, Wright subscriber knows by now—or should—that Dorsey, Wright Money Management uses a systematic application of relative strength to manage all of our products. What is perhaps not so apparent is WHY we choose to use relative strength as our primary tool.
Simply stated, relative strength is “best by test.” Relative strength has been around in many forms for at least seventy years. Dorsey, Wright Money Management didn’t invent it, but we think we have refined it into a powerful tool for portfolio management.
The most widely-known modern treatment of relative strength was done by James O’Shaughnessy in his book What Works on Wall Street. He tested, in a rigorous manner, what investing strategies can actually be proven to work in the stock market. He got access to the Compustat database and tested everything that had been purported to work—investing based on market capitalization, P/E ratios, price-to-book ratios, price-to- cashflow ratios, price-to-sales ratios, dividend yields, earnings per share, profit margins, return on equity, and relative strength—over a long period from 1951 to 1996. He tested them independently and in conjunction with other variables. He found that the market clearly and consistently rewarded certain attributes and consistently punishes others over a long period of time.
His results were rather conclusive. He wrote, “Relative strength is one of the criteria in all 10 of the top-performing strategies, proving the maxim that you should never fight the tape.” In addition, he pointed out that the worst strategy he tested was the anti-relative strength strategy of bottom fishing.
The next piece of the puzzle was provided by John Brush at Columbine Capital, in his study of common return factors and their failure rates. He considered a return factor to be a failure if, for that month, the bottom decile in the ranking outperformed the top decile in the ranking. So, for example, if the top dividend yielders had a terrible month while the no-yielders had a great month, the dividend yield factor would be considered a failure for that month. A long time period again was studied, from 1971 to 2003.
In fact, dividend yield failed as a return factor 49.7% of all months. Price/book failed 43.8% of the time. Price/cash flow wimped out 38.4% of the months. Earnings yield was the best of the value factors and had a 37.4% failure rate. Earnings surprise was a little better at 36.9%. Among the best factors were estimate revision with only a 31.9% failure rate and price momentum—what Dorsey, Wright subscribers would call relative strength—at 27.3%. In other words, of all of the return factors, relative strength is the most reliable, with nearly 3 of 4 months showing strong stocks outperforming weak ones.
Finally, the portfolio staff at Dorsey, Wright Money Management published a study on relative strength in the August 2005 issue of Technical Analysis of Stocks & Commodities magazine. This paper is unique because of the way in which we tested relative strength on a portfolio basis. Our study made it clear that relative strength can be used to run actual portfolios by itself. In other words, it is not necessary to use relative strength as a starting point from which further analysis is done. It is an incredibly robust and powerful tool on its own.
By now, the WHY should be clear. We don’t use relative strength because it happens to be only what is available to us. We use relative strength because it shows the best performance over long periods of time and because the probability of outperformance any given month is higher than in other strategies. That’s what we mean when we say “best by test.”
To read more documented relative strength research, please visit our website. Given that relative strength is the consummate pragmatic approach to investing, an increasing number of investors are ready to learn more.
