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Understanding Support and Resistance


Systems Using Relative Strength

It is a well-documented fact that the stock market experiences a rotation between various component industry groups. At the beginning of a bull market, defensive and interest-sensitive stocks tend to outperform the averages. As the cycle progresses, earnings driven stocks, such as basic industry and resource-based equities, take over the leadership role. This is not strictly speaking an intermarket relationship, but it does build on the rotational process that results from a developing business cycle.

Chart 1 shows the smoothed long-term momentum of the relative strength of the Dow Jones Financial and Energy sectors. See how the financial momentum is the first of these two sectors to bottom in the cycle. As this series is in the process of peaking, the energy relative momentum starts to bottom out. You can see this rotation of fortunes between the two is more or less a continuous process. Occasionally, it gets out of kilter, such as in the 1996/97 period, when the financials experienced a rally simultaneously with the energy series, but for the most part, this is a pretty sound relationship. Actually, the financials paid for this exceptional strength by experiencing a sharper than normal correction in 1998.


Chart 1: Energy RS Momentum vs. Financial RS Momentum


Not all industry groups fit so well into the business cycle rotation process, but the concept of relative strength can nonetheless be used to an advantage when constructing mechanical trading systems.

A relative strength line is calculated by dividing a stock or an industry group by a market average such as the S&P Composite. In Chart 20.2, we can see the Dow Jones All Banks Index together with its relative strength against the Dow Jones Composite, a broad-based measure of the whole market. If the Relative Strength, or RS line is rising, it means the stock or group in question is outperforming the average. If it is declining, this means it is the market that is performing better. In many instances, the relative strength line turns ahead of the absolute price of the stock or group, and this gives us a warning of strength or weakness under the surface.


Chart 2: Dow Jones All Banks Index vs. All Banks RS


Chart 3 shows a classic example as the RS line turns down well ahead of the 1987 peak. By combining indicators measuring the trend of both the absolute and relative price, it is possible to devise a system that helps us not only to purchase stocks, mutual funds or industry groups that are rising, but that are advancing faster than the market. Greater profits can also be attained from short sales using the same criteria.


Chart 3: Dow Jones All Banks Index vs. All Banks Relative Strength


Excerpted from Breaking the Black Box


Don't forget to check out the glossary - it has over 300 technical terms! 

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