William O'Neil on Relative Strength

This week, I sold IBB, which is the biotech ETF.   Although the chart is still looking okay, the relative strength of IBB was starting to wane and that is the reason that I sold it.

To determine relative strength, one simply divides the stock in question by the general market in order to get a ratio.   Most trend followers ideally want to hold a stock that has strong relative strength.

William O'Neil, who combines elements of trend following trading along with fundamental analysis, devotes an entire chapter to relative strength in his excellent book, How to Make Money in Stocks.  O'Neil discusses the importance of limiting buys to the strongest stocks in the strongest sectors:

It seldom pays to invest in laggard stocks, even if they look tantalizingly cheap. Look for, and confine your purchases to, market leaders. 

Let's look at some specific examples of stocks showing strong relative strength:

The green area at the bottom of the chart shows the ratio of the stock divided by SPY.  The fact that it is rising shows that this particular stock has been stronger than the general market.

The next chart is a gold stock, and the relative strength this time looks at the stock divided by GDX, which is a gold stocks ETF.   A rising green area above means that this gold stock is doing better than the sector.

Buying the strongest stocks, especially if they are making new all-time highs, while the general market itself is also behaving strongly, definitively places the odds of success in your favour.

Silver Trend Analysis, ZSL

One sector that caught my eye this week was precious metals.  In particular, silver, which has been technically moribund for months, showed some promising signs of life this week.

The chart below is a chart of SLV that goes back one year:

The chart above shows that SLV entered a long term down trend in late November of last year.  Since that time, the ETF has remained in a bear market, so no long positions would have been permitted since that time.

Although the long term trend still remains down, the shorter term trend has turned up.  That's not good enough for me to buy into this quite yet, but it is a step in the right direction.  Remember, the odds are most strongly in your favour when both the long and the short term trends are both up.

There is an ultra short silver ETF that also caught my eye this week - the symbol is ZSL:

I am always on the look out for weak ultra ETFs to short.   I talked about this strategy before, but now I'd like to discuss yet another benefit of shorting ETFs.

Often people who want exposure to precious metals are looking for safety and security and are naturally concerned about investing in ETFs.   One concern in particular is counter-party risk - the risk of the ETF provider going bankrupt.

The beauty of shorting ETFs is that in the unlikely event of this occurring, you would profit massively, since being short, there is nothing that you have to pay back - the ETF would have no value. Of course, this reason alone is not enough to short an ETF, but it merely is one of the many advantages of doing so.

Anyway, I will attempt to short ZSL on Monday at the open.

SPY Hits New All Time High

Yesterday, the ETF that I use to define the general market, SPY, hit a new all-time high.   It's been five years since this could be said, so I consider this to be a significant event.

The chart below is a daily chart of SPY that goes back to inception, which is about 18 years:

In addition to showing that the market is pretty much at a new high, this chart serves another important function - the chart above illustrates what I consider the long-term trend of the market:

  • 100 day moving average greater than 150 day moving average = uptrend
  • 100 day moving average less than 150 day moving average = downtrend 

For example, throughout the entire mid-90's, the long term trend was up, which means forget about shorting stocks during that time.  I only trade in the same direction of the long term trend.

The long term trend is now up, which is why I've only been long stocks (or short inverse ETFs). 

Here are 2 stocks that I think look good this week:


I've got a (small) retirement account that I rotate between 3 mutual funds:  bond fund, monthly income fund, and equity index fund.   Although I was in the bond fund for most of 2012, two weeks ago my mechanical system suggested that I switch to the monthly income fund, which I did.  

The mutual fund I hold is very similar in composition to the ETF above and is comprised mostly of Canadian dividend paying stocks and long term Canadian government bonds.

Stan Weinstein on Buying All Time Highs

The US market as well as foreign markets rose this week.   My indicator of global market strength rose from +2 to +4, which to me shows that the path of least resistance is up. 

Here are two stocks that my weekend scanning session identified this week:

I like this chart for several reasons.   The long and short term trends are up, which is key.   The dark blue cloud in the chart above measures the 150 day moving average.  The 150 day moving average is equivalent to the 30 week moving average and anyone who is familiar with Stan Weinstein's work realizes the importance of this.   Specifically, not only should the stock be above this line, but the line itself should be rising. 

I also prefer to buy stocks making new all time highs.  Why are new all time highs desirable?  Again, Stain Weinstein hits the nail on the head:

Whenever a breakout occurs with a stock moving into virgin territory (it's never traded there before), this is the most bullish situation you can buy. 
Think about it. There isn't one person who is long and has a loss.

Buying new all time highs can be difficult psychologically, but I think that it's another reason why it works.  Here's some logic as to why it works: Successful speculators win the money that average traders lose.  There must be many more losing traders than successful speculators. Therefore, successful speculators must necessarily be doing something that average investors find nearly impossible to do. 

Put another way, successful speculators are a small minority that are doing the opposite of what the majority find psychologically easy to do.  Perhaps that is what Richard Dennis, a speculator who turned a small account into over $100 million, meant when he said, "if it feels good, don't do it".

Just as buying new highs is hard, buying new lows is easy, which is why I like to do the opposite of what is easy and short new lows. 

Here is a chart that I would consider shorting if it broke to a new low:

After working at one of Canada's discount brokerage firms and being able to peer inside clients' accounts, I can definitely say that new traders find it irresistible to buy something that hits a new low, sell it quickly if it goes up, and hang on to it forever if it goes down.  These ultra leveraged ETFs were always a crowd favourite, which is why if I ever touch these products, it is on the short side only. 

Breakout Stocks of the Week

Here are 3 stocks that my scans identified this week:

The chart immediately above, SNA, I posted before and continue to like.  The price action shows a breakout to new highs, then a re-test of support.   I will be buying this stock on Monday.

Talking About Market Type

I bought one new stock this week, PPG.   The reason I am buying stocks now is that my system indicates that the general market is in a bull market and my hypothesis is that buying strong stocks in a bull markets gives me an edge that will produce profits over time.

Although the general market (the S&P 500) is in a bull market, other markets around the world are not. While buying stocks when the general market is up does give me an edge, I think I would have even a stronger edge if other markets were in support of this trend.

To determine the strength or weakness of the general market as well as foreign markets, I have created an index called the Global Market Strength Index.

The GMSI looks at 5 major ETFs:

  • SPY (US Large Caps)
  • EFA (European, Australasian, Far East)
  • IWM (US Small Caps)
  • XIU.to (Canadian Large Caps)
  • EEM (Emerging Markets)

The GMSI adds 1 point if the ETF is in a short term up trend, and adds one point if the ETF is in a long term up trend.   For example, SPY is in a short and long term up trend, so SPY adds +2 to the index.  

If the ETF is in a short term downtrend, -1 is added to the total, and if the ETF is in a long term down trend -1 is also added to the total.   For example, XIU.to is in a short and long term downtrend, so -2 is added to the total. 

The lowest possible value for the index is -10.   A score of -10, which we saw in 2008, would indicate a time which would be extremely conducive for short selling breakdowns. 

The highest possible score is +10.   A score this high would indicate a raging bull market, like what we had in 1999, 2005, or 2006.   Throwing darts at the stock listings of a newspaper would most likely be profitable.  

What is the value of the GMSI now?   The table below illustrates:

A value of +2 means that we are slightly bullish, but not definitively so.   On average, numbers that are closer to zero will likely be less conducive to trend following traders, while numbers further away from zero would bring a more favourable environment to trend traders. 

So, I am long stocks, but the odds of success are not as great as they could be.   How does this translate into my actual real life trading?   I bet less - just as professional card counters bet less when their odds are uncertain and bet aggressively when they know their edge is real.  

Finally, if you would like another opinion on this very topic, please have a look at this video presented by author Van Tharp: