Our analysis, thus far, has been from an absolute price perspective of the market, but as investors, we are always painfully aware of the opportunity cost of investing. Quite simply, this is the cost of the next best investment alternative that is forgone.
To help build a picture of what we’re talking about, let’s take the example of being invested in HSBC from the 31 December 2009 to April 2011.
Performance of HSBC vs index since Jan-2010
Source: Financial Express Analytics
Measured in absolute price terms, this stock has traded sideways over the period, leaving the investor no better or worse off in price terms.
When measured relative to the FTSE 100 index, however, we find that the stock underperformed the index by 18 per cent over this period. In other words, the opportunity cost to the investor for having invested in this stock, as opposed to the FTSE 100 index, was significantly high.
Relative Strength (RS Indicator) is a simple but effective technical tool that allows us to measure the price trend of a stock/asset class versus a benchmark in order to determine the opportunity cost of investing. (It is important to highlight that the RS Indicator should not be confused with the relative strength indicator [RSI], which is used to identify over-bought and over-sold positions in the market.)
Referring to the chart for HSBC, the opportunity cost remains high, as the RS Indicator is trending lower.
The calculation and use of the RS Indicator is very simple. Having identified a comparison benchmark to compare a stock/asset class to, we divide the price of the asset class we are interested in with the price of the benchmark, and observe the trend of the RS Indicator over time.
If the trend is rising or moving sideways, then the opportunity cost of investment is low, as the stock/asset class is outperforming or is in-line with the benchmark. If the trend is negative, then the opportunity cost is high as the investment is underperforming the benchmark.
The RS Indicator allows investors to choose between two investment alternatives, based on relative performance. However, asset allocation is not about making binary bets (i.e. equities versus bonds) as much as it is about deciding on relative weightings between asset classes against a strategic benchmark.
To this end, we use the RS Indicator to decide whether our weighting in a particular asset class, determined primarily from a fundamental standpoint, is justified by the technical picture. When the two resonate, we have greater conviction in our asset allocation decisions; when they don’t, we have reason to pause and re-evaluate.
For asset allocation purposes, one of the key RS indicators we follow is the stock-bond ratio, measured as the price of global equities versus global Government bonds, to determine key relative trend changes between the two asset classes as a guide for adjusting our relative weightings.
We find that when used in conjunction with leading economic indicators (LEIs) such as the OECD LEI – an anticipatory series of global growth conditions – the two frequently move in harmony, allowing us to identify major relative trend changes without being misled by market volatility.
This is only one of a few relative strength indicators we follow – there are others. For example, we also monitor the relative strength of regional equity benchmarks versus the global average to determine those equity markets that are displaying positive relative strength versus those that are lagging.
Clearly, the RS Indicator is one of a set of very useful tools in our technical armoury, but as always, we find it is most effective when used in synthesis with other forms of analyses and not in isolation.
Rashpal Sohan is asset allocation analyst at Rathbone Unit Trust Management. The views expressed here are his own.