Relative Strength

Relative Strength is the study of the price movement of a security relative to the price movement of another security. In more simplistic terms, it is a line graph that shows which security is outperforming. If the line is rising, the numerator is outperforming. If the line is falling, the denominator is outperforming. Analysts frequently use this simple concept to ensure they are invested in the right areas (i.e., the areas that are outperforming) relatively. Therefore, it becomes a great tool to assist with asset allocation and equity sector rotation, but there are other useful applications.

Below is a chart of two securities: the MSCI Emerging Markets ETF (EEM) in red and the S&P 500 Dividend Adjusted Index (SP-DA) in green. The line in orange at the bottom of the chart is the relative strength line of EEM/SP-DA. When EEM is outperforming the orange line rises, and when EEM is underperforming the orange line falls. The start date for this chart is 1/23/2009 (to help illustrate my point), and it shows strong outperformance of EEM versus the S&P 500 through yesterday. But the chart can also be used to identify divergences, or differences between the S&P 500 and the relative strength line.

There are a few divergences that I can point out on this chart, which will hopefully highlight the leading characteristics of Emerging Market stocks. At the very far left of the chart, the S&P 500 fell into March 2009 while the orange line was rising. The market bottomed shortly after this positive divergence as the emerging market stocks led US stocks higher. Another positive divergence occurred in June/July 2009 as the relative strength line started moving higher while the S&P 500 made its bottom in July. There are also negative divergences, like when the relative strength line started to head lower before the S&P 500 top in April, and most recently the relative strength line has moved lower from the October peak as the S&P 500 continues higher. Does this negative divergence foretell of another correction in the S&P 500?