Relative strength: Meaning, Criticisms & Real-World Uses

What Is Relative Strength?

Relative strength is a concept in technical analysis that measures the price performance of a security or asset against another security, a relevant benchmark index, or the broader market. It identifies which assets are outperforming or underperforming relative to their peers or the market as a whole. Unlike absolute returns, which simply show how much an asset's price has changed, relative strength focuses on comparative performance, often within the broader financial category of momentum investing. Investors and analysts use relative strength to gauge the underlying demand for an asset and to identify potential investment candidates based on existing trends.

History and Origin

While the concept of comparing the performance of one asset against another has likely existed informally for a long time among market participants, formalizing relative strength as an analytical tool gained traction with the rise of modern technical analysis. The academic community significantly contributed to the understanding and validation of related concepts, particularly "momentum," which is often used interchangeably with relative strength. Influential research in the early 1990s, such as the work by Narasimhan Jegadeesh and Sheridan Titman, spurred substantial academic interest by documenting that stocks with strong past returns tended to continue performing well, a phenomenon closely linked to relative strength¹¹. Firms like AQR Capital Management have since conducted extensive research into the dynamics of momentum and reversal in markets, further integrating these concepts into quantitative investment strategy and portfolio management ¹⁰.

Key Takeaways

Relative strength measures an asset's price performance compared to a benchmark or another asset.
It is a core concept in momentum investing, seeking to identify securities that are outperforming.
The underlying assumption is that past relative outperformance may continue into the future.
Relative strength analysis helps identify market leadership and potential investment opportunities.
It is distinct from the Relative Strength Index (RSI), which is a specific momentum oscillator.

How Relative Strength is Calculated

Relative strength is typically calculated as a ratio of the price of one asset to another, or to a relevant index, over a specified period. This ratio is then tracked over time to observe the comparative performance.

A common way to calculate relative strength (RS) for a single asset against a benchmark is:

\text{RS} = \frac{\text{Asset Price}}{\text{Benchmark Index Price}}

Where:

Asset Price is the closing price of the individual asset.
Benchmark Index Price is the closing price of the chosen comparative index, such as the S&P 500.

This calculation is performed at regular intervals (e.g., daily, weekly, monthly) and then plotted on a chart. An upward-sloping line indicates that the asset is outperforming the benchmark, while a downward-sloping line suggests underperformance.⁹

Interpreting Relative Strength

Interpreting relative strength involves analyzing the trajectory of the calculated ratio. When the relative strength line is ascending, it suggests the asset is stronger than its comparison point, demonstrating better price performance over the period. Conversely, a descending line indicates the asset is weaker. Analysts often look for sustained upward or downward price trend in the relative strength line, as these trends can signal shifting market leadership or persistent outperformance/underperformance. For example, if a sector's relative strength against the broad market is consistently rising, it might suggest that capital is flowing into that sector, indicating potential future strength. This analysis helps in identifying robust segments of the market or individual securities within various asset classes.

Hypothetical Example

Consider two hypothetical technology stocks, TechCo A and TechCo B, over a six-month period. Both started at $100 per share.

Month 1: TechCo A rises to $105, TechCo B rises to $103.
Month 2: TechCo A rises to $110, TechCo B falls to $101.
Month 3: TechCo A falls to $108, TechCo B falls to $98.
Month 4: TechCo A rises to $115, TechCo B rises to $100.
Month 5: TechCo A rises to $120, TechCo B rises to $104.
Month 6: TechCo A rises to $125, TechCo B rises to $105.

To calculate the relative strength of TechCo A against TechCo B, we'd divide TechCo A's price by TechCo B's price at each interval:

Start: $100 / $100 = 1.00
Month 1: $105 / $103 = 1.02
Month 2: $110 / $101 = 1.09
Month 3: $108 / $98 = 1.10
Month 4: $115 / $100 = 1.15
Month 5: $120 / $104 = 1.15
Month 6: $125 / $105 = 1.19

The increasing relative strength ratio (from 1.00 to 1.19) indicates that TechCo A has consistently outperformed TechCo B over this six-month period. An investor employing a trading strategy based on relative strength might conclude that TechCo A exhibits stronger momentum and could continue to do so. This comparative analysis is a key component of identifying performance leadership.

Practical Applications

Relative strength is widely used in various facets of investing and market analysis. It forms the foundation of certain momentum investing strategies where investors seek to "buy high and sell higher" by focusing on assets that have shown recent strength. These strategies often involve rotating capital into leading sectors or individual stocks that exhibit superior relative strength compared to the overall market or specific indices.

For instance, portfolio management firms may implement systematic relative strength strategies that invest in securities demonstrating favorable relative strength characteristics within a defined universe, such as U.S. mid- and large-cap equities. Such approaches often include an industry overlay designed to overweight sectors with the greatest relative strength, aiming for long-term capital appreciation⁸. This approach differs from pure value investing, which typically seeks undervalued assets. Relative strength analysis also contributes to factor investing by identifying the "momentum" factor, one of several recognized characteristics that can explain asset returns⁷.

Limitations and Criticisms

Despite its popularity, relative strength has limitations. The primary criticism often levied against relative strength strategies, particularly those focused on short-term momentum, is their potential vulnerability during periods of sharp market reversals or significant shifts in market cycles. While strong trends can persist, sudden changes in market sentiment or economic conditions can lead to abrupt and substantial drawdowns for relative strength portfolios⁶. This is sometimes referred to as "momentum crashes," where previously strong assets suddenly underperform significantly⁵.

Additionally, the effectiveness of relative strength can vary depending on the investment horizon and the specific methodology used for calculation. Research has shown that while relative strength strategies can be profitable over medium-run horizons, their performance may be substantially lower when including transitions between market states (e.g., from bull to bear markets)⁴. The assumption that past performance will continue is a key risk, and there is no assurance that forecasts based on relative strength can always be relied upon³. As with any investment strategy, diversification does not eliminate the risk of experiencing investment losses. Investors must consider these drawbacks and integrate relative strength analysis within a broader framework of risk management and diversification, understanding that it does not guarantee outcomes. Some studies also suggest that profitable opportunities using widely known technical indicators like the Relative Strength Index (RSI) may diminish over time as the information becomes more broadly adopted, implying a degree of market efficiency ².

Relative Strength vs. Relative Strength Index (RSI)

While both terms include "relative strength," they refer to distinct concepts in financial analysis.

Relative Strength is a broad concept measuring how one asset performs against another or a benchmark over time. It's a foundational idea in momentum-based investment strategy, indicating leadership or lagging performance. An investor might analyze the relative strength of the technology sector against the overall market or a specific stock against its industry peers.

The Relative Strength Index (RSI) is a specific, popular technical indicator developed by J. Welles Wilder Jr. in 1978. It is a momentum oscillator that measures the speed and change of price movements, typically ranging from 0 to 100¹. RSI helps identify overbought or oversold conditions in an asset. For example, an RSI reading above 70 traditionally suggests an asset is overbought, while a reading below 30 suggests it is oversold. The RSI uses a specific formula to smooth price gains and losses over a set period, most commonly 14 days, to produce a single value. Therefore, while relative strength is a general comparative measure, the Relative Strength Index (RSI) is a defined technical indicator derived from specific calculations of price momentum.

FAQs

What is the primary purpose of relative strength analysis?

The primary purpose of relative strength analysis is to identify which assets, sectors, or securities are outperforming or underperforming relative to others. This helps investors pinpoint areas of market leadership and potential price trend continuation.

Can relative strength be used for any type of asset?

Yes, relative strength can be applied to various asset classes, including stocks, bonds, commodities, and currencies. The core principle involves comparing the performance of one asset to another over a specific period.

Is relative strength a reliable indicator for future performance?

Relative strength is based on the assumption that past performance trends may continue, a concept central to momentum investing. While historical analysis shows periods of effectiveness, it is not a guarantee of future results. Market conditions can change rapidly, leading to reversals.

How does relative strength differ from absolute return?

Absolute return measures the total percentage gain or loss of an investment over a period, without comparison to anything else. Relative strength, conversely, is always a comparative measure, showing how one asset performs in relation to another or a benchmark.

Is relative strength related to systematic risk?

Relative strength primarily focuses on specific asset performance compared to others, which can be influenced by both systematic and idiosyncratic factors. While strong market trends (a form of systematic risk) can impact overall relative strength, the analysis itself aims to identify relative outperformance, which may or may not correlate directly with specific systematic risk factors.