Howard Marks makes a compelling argument for using relative strength (without even referring to relative strength):
“If you are a value investor and you invest whenever you find a stock which is selling for one-third less than your estimate of intrinsic value, and you say, I don’t care about the macro, nor what I call the temperature of the market, then you are acting as if the world is always the same and the desirability of making investments is always the same. But the world changes radically, and sometimes the investing world is highly hospitable (when the prices are depressed) and sometimes it is very hostile (when prices are elevated).
“I guess what you are saying is we just look at the micro; we look at them one stock at a time; we buy them whenever they are cheap. I can’t argue with that. On the other hand, it is much easier to make money when the world is depressed, because when it stops being depressed, it’s like a compressed spring that comes back.
“…I think it is unrealistic and maybe hubristic to say, ‘I don’t care about what is going on in the world. I know a cheap stock when I see one.’ If you don’t follow the pendulum and understand the cycle, then that implies that you always invest as much money as aggressively. That doesn’t make any sense to me. I have been around too long to think that a good investment is always equally good all the time regardless of the climate.”
Buyers and sellers respond to the very same fundamental factors in very different ways depending on the environment. A stock can be cheap (and get cheaper) for a long period of time until which time as there are more buyers than sellers and the price begins to rise. Relative strength doesn’t even make an attempt to estimate intrinsic value. To a relative strength strategy, the concept of intrinsic value is meaningless. A security is worth whatever the market says it’s worth. Relative strength models simply allocate to the strongest trends in the market and therefore avoid the potential problems of sitting around waiting for the market to come around to your way of thinking.
As Marks correctly points out, the world changes radically over time. However, one constant is the law of supply and demand.
HT: Business Insider