Lesson 3: Part 1 - Relative Strength

Sector relative strength is a very important part of our work. Studies have suggested that anywhere between 75% to 80% of the risk in any particular stock is in the market and the sector. The economic forces that affect one stock within a sector, most often affect the whole school of fish.

There are a number of different Point & Figure indicators we examine to determine whether supply or demand is in control of a sector and one of those is relative strength based. Sector Relative Strength (RS) is a means of measuring how a particular sector is performing compared with the market in general. At Dorsey, Wright & Associates, we have created 40 different broad sector indices. These are equal weighted indices and once an index is created, we can then create a relative strength chart of that sector.

The relative strength calculation is essentially the same as a stock's relative strength calculation, merely substituting the sector index price for the stock price. Each day we take the price of the DWA Sector Index and divide by the S&P 500 Equal Weighted Index. Multiply this by 100 and the resulting reading is plotted on a Point & Figure chart.

When evaluating a Sector Relative Strength chart, we look at it slightly different than a stock relative strength chart. Because the sector is a basket of stocks, it typically moves slower than an individual name. Therefore, we will look solely at the column of the relative strength chart as our guidance. If the Sector Relative Strength chart is in a column of X's, that suggests the sector has positive relative strength and should likely outperform the market. Conversely, if the Sector Relative Strength chart is in a column of O's, that would suggest the sector has negative relative strength compared to the overall market and is likely to underperform.

Let's take a look at the DWA Non-Air Transportation Sector (DWATRAN) as an example. Like stock relative strength charts, these are designed to be longer term in nature. A look at this chart shows that the DWATRAN sector was in a column of O's from June 12th 1998 to January 4th 2001. During that time, the DWATRAN sector was down 11.8% while the S&P 500 Equal Weighted Index was up 21.2%. The sector performed just as expected - not doing as well as just being in the overall market.

In January 2001 the future prospects for the DWATRAN sector improved vastly when the relative strength chart reversed up into a column of X's. The relative strength reversal up to X's would suggest that if you don't already have exposure to the sector, it would now be warranted or if you already have exposure to that sector, it could be overweighted in the portfolio. From January 2001 to the second quarter 2006 the DWATRAN sector is up 166.4% while the SPXEWI is up 32.7%. The sector is up five times that of the market! We will know that the underlying supply and demand picture has changed for the DWATRAN sector when this RS chart reverses down into O's, whenever that happens.

In summary, sector relative strength can be a very important tool in your overall portfolio strategies. RS charts are available for broad sectors, as well as for equal weighted DWA sectors and sub-sectors. While the signals in sector relative strength charts generally last several years like stocks, in a sector relative strength chart you look at the column of the chart instead of the signal.