Systematic Relative Strength

Good primer on relative strength by CSS Analytics:

I have done a lot of research in this area and the first conclusion I can make is that it should be a major portion of any trader or investor’s portfolio strictly because it is so durable and robust. Whether it’s asset classes, sectors, stocks, commodities, currencies—-you pick a time frame over the last 40-50 years and this simple method of buying strength and selling weakness has outperformed traditional buy and hold strategies. This outperformance or alpha is also robust to most transaction cost assumptions.

Four-stage model depicting how relative strength occurs:

Based on my own observation and theory I feel that a simple four-stage model best depicts how relative strength occurs and why it takes time to develop rather than occuring instantaneously. The relative strength effect is driven by behavioural feedback loops where investors sequentially pour money into the asset du jour for a plethora of reasons including positive perceived fundamentals, psychological beliefs such as fear or greed, or for positive economic or default risk factor sensitivity. Essentially it starts when certain investors create a theory such as: “emerging markets will outperform because of the accelerated pace of development” and begin to accumulate investments in assets tied to this theory (Stage 1: the early adopters). As time goes on the theory itself becomes more widely known and the rationale becomes more widely accepted. Others quickly catch on and start investing in the same idea (Stage 2: recognition and acceptance). The next stage (and longest stage) is where initial investors wait for hard proof that the idea or theory is supported by tangible evidence in a variety of forms whether economic indicators, qualitative or anecdotal accounts to mention a few. (Stage 3: validation). The “Validation Stage” tends to last long as the early investors are looking for ongoing proof that supports or refutes their theory. The nature of economic data and other information sources is that they require multiple readings to establish that a trend is in fact statistically valid. This is why it is impossible for markets to adjust instantaneously even with purely rational investors. There are two paths the validation stage can take—either the evidence to refute the theory is strong, and as a consequence momentum will fail as early investors bail out. Or if the evidence continues to support and even exceed expectations, the early investors will add to their positions alongside the second stage investors. This added money flow cements the trend and the relative strength begins to really accelerate. At this point we reach the final stage where everyone agrees that a given market is and should go up and people are hopping on the bandwagon simply because the market is going up. This is both the fastest stage and the most rewarding per unit of time (Stage 4: mania).

—-this article originally appeared 12/29/2009. It’s still a good reminder of how robust and durable relative strength is. Human nature doesn’t change much.