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The Relative Strength

Here's an indicator to identify positive and negative trading signals for stocks and mutual funds. The heart of the indicator involves applying an oscillator to the relative strength line. Trading signals result from identifying strong relative strength, which is a positive indication, while weak relative strength is considered a negative sign. Here's how to lower the volatility of returns by applying the popular moving average convergence/divergence (MACD).

Most stocks and mutual funds are more volatile than the Standard & Poor's 500 index. The first two quarters of 1994 amply demonstrated this, with most equity mutual funds losing more than the stock indices, and most bond funds losing more than the Shearson Lehman bond index. In what may seem like a paradox, I have used in my financial management practice an indicator based on the relatively greater volatility of stocks and mutual funds to produce less volatile investment returns. I call it the relative strength ratio-MACD crossover indicator.

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MONITORING MUTUAL FUNDS

Let me illustrate this first in mutual funds. The first step is to divide the weekly close of the mutual fund in question by the weekly close of the S&P 500 index, and you'll have a graph of the relative strength ratio of that fund (Figure 1). I use this term to distinguish this ratio from the similarly named but completely different relative strength indicator (RSI). When the ratio is falling, the fund is underperforming the S&P index, and vice versa.

Next, apply the classic moving average convergence/divergence (MACD) indicator to this graph. When the MACD is over its nine-week exponential moving average (EMA), called the trigger line, buy the mutual fund. When the MACD is below the trigger line, move into a money market fund if you are conservative or into a higher-performing fund if you are aggressive (Figure 2).

FIGURE 1: RELATIVE STRENGTH RATIO. Here, the relative strength ratio of the mutual fund 20th Century Ultra versus the S&P 500 is plotted in the upper chart. Notice in the upper chart that the relative strength of the mutual fund was in an upward trend with countertrend declines.

FIGURE 2: RELATIVE STRENGTH RATIO-MACD CROSSOVER INDICATOR. By applying the MACD indicator to the relative strength line, we can use crossovers of the MACD (solid line) and the trigger line (dashed line) to generate buy (up arrows) signals and sell (equal sign) signals.

As you can see, there was considerable time spent in money market funds. Even so, gains exceeded losses in frequency and amount in testing this approach in multiple funds. The result was very satisfactory, and it was all dependent on the excess of volatility of the mutual fund compared with the S&P 500 index! The one caution to be noted is that when the entire market is falling faster than the fund, its relative strength ratio will be stronger, and so in some cases using an additional indicator such as a moving average crossover will be useful as a second line requirement.

Why does this work? First, the relative strength ratio indicates positive or negative performance relative to the market. This is an excellent first step, but that indicator is noisy and difficult to quantify for trading signals. Applying the MACD indicator smoothes or removes the noise because the first step in calculating the MACD is to use two moving averages of the relative strength ratio. The moving averages remove the noise from the data. The MACD line is the difference between the two moving averages; the result of measuring the difference between the two moving averages is a leading indicator of the relative strength ratio.

When the MACD changes direction, a change in the trend of the relative strength ratio is indicated. Finally, by using the MACD line in reference to the trigger line (the nine-period EMA of the MACD line), we can identify important changes in the trend of the relative performance of the mutual fund we are following. For details, see sidebar, “Calculating the relative strength ratio-MACD crossover indicator.”