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Tips on Technicals

Sat, Jun 7th, 2025
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Tips on Technicals - Relative Strength

When seeking to maximize the probability of a trade's success we often start with a top down approach and move to specific securities or commodities from there. For example, if the decision to invest in equities as an asset class has already been made, the next question is which equities market will lead the way higher. By comparing the relative strengths of each market to a common index, the decision can be quantified.

RS is not RSI

Without getting mired in the initials, relative strength (RS) is a measure of how one instrument is performing relative to another. The relative strength index (RSI), developed by J. Wells Wilder, in contrast, measures how a single instrument's momentum is changing over time. RSI is a useful tool for making a timing decision but relative strength is better when deciding which instrument to select out of a universe of favorable candidates.

The formula for RS is a simple ratio of instrument 1 divided by instrument 2 and the result is plotted on a line chart. Trend lines, moving averages and other technical tools can then be applied to analyze the plot like any single instrument. The most important aspects of the analysis are trends and trend breaks as we will see now.

Figure 1 shows the ratio of the Japanese Nikkei 225 Index and the Morgan Stanley World Stock Index for the past four years. The latter index represents the global market for equities in general. The long term trend line indicates that the Nikkei has been underperforming the global equities market for the past four years. The intermediate trend line shows that Japanese stocks have been outperforming the world from June 1995 until July 1996. The latter was a counter-trend move within an overall bearish relationship.

Figures 1 and 2 - Relative Strength
Figures 1 and 2

Keep in mind that trading pattern for the Japanese market over the past four years was a wide trading range (figure 2). If the global equities markets were rising while the Japanese market was flat, the ratio of the two will go down. In mid-1995, the Nikkei rallied at a faster rate than the world so the ratio went up.

Quick Visual Analysis

The charts below show the same four year period for major world stock markets relative to the World Index. Quick trend line analysis shows the UK market as represented by the Financial Times 100 (chart B in fig. 3) has broken a trend line to the upside and is therefore suggesting that it will outperform the world for a while. Hong Kong (chart E) has been matching the world pace for 2 1/2 years and France (chart C) and Australia (chart F) are locked in three year down trends.

Figure 3 - Relative Strenth
Figure 3

Again, this time period has been good for world equities but relative strength analysis would have helped make the decision of which markets to overweight and which to underweight in a global equities portfolio.

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