Systematic Relative Strength

Source: Jatrophatrends

What makes the existence of trends possible, you ask?

From Ivanhoff:

At the foundation of every major price trend there is either an improvement in fundamentals or (as it is in most cases) rising expectations for future improvement in fundamentals. From a bird’s eye view major changes in expectations for fundamentals are based on new social trends, business cycle, economic cycle or new regulations – all of them are sustainable sources of change and don’t just disappear overnight. This is what makes the existence of trends possible.

Momentum then becomes an effective means of capitalizing on those trends.

Momentum investing is based on the premise that past price performance is a good indicator of future price performance. Stocks with the highest relative strength over the past 3-12 months often remain among the best price performers over the next 3-12 months. The central idea behind this investment approach is to find an already existing price trend and a proper point of entry.

The chart below is the spread between the relative strength leaders and relative strength laggards (universe of mid and large cap stocks). When the chart is rising, relative strength leaders are performing better than relative strength laggards. As of 6/28/2010:

The relative strength spread continues to mark time at this point, neither rising nor declining. Nobody knows how soon we will again see a rising spread. However, we do know that relative strength tends to move in and out of favor over time. It is quite possible that the transition that we are seeing now could be setting the stage for a very favorable environment for relative strength investing in the coming years.