Relative Performance:
Getting down to the very basics, relative performance is how well a stock is performing relative to a benchmark index or average. The most common of this would be using an S&P stock against the S&P-500, but it can be used however you like. It could be a biotech stock paired against the IBB ETF. Below is looking at IBM relative to the Dow Jones.
You can see at the bottom of the chart the actual ratio of IBM divided by the DIA. For a while it was trending lower, showing that IBM was very weak relative to the DIA. What conclusions can we draw from this? First.. that money is not flowing into IBM, however more money is flowing into DIA components than is not (since the Dow is above a rising 50 day average [trend analysis]). So we need to find the stocks that the money is flowing into.
This is a chart of MMM (3M Co.) relative to the DIA. Here we see that the ratio below the chart is rising, along with both MMM and DIA. This means that more money is flowing into MMM than is flowing into the average of the other 30 Dow Jones components which is causing price to increase faster in MMM. Simply put, this is one of the stocks money was flowing into and you can see it clearly in the relative strength line. That is a place you want your money to be working. You will see larger returns if you can just grasp this simple concept of out performance & money flow.
Now that 2013 is over, we all know CAT was dead money for the entire year. Relative performance is a tool that would have let you know something is wrong early in 2013.
I have drawn two arrows here. The first one is where there was first a sign of relative weakness and the second one is the current price. Ask yourself, what do you see happening here? For all of 2013 (a raging bull market), this stock was dead.. but now in 2014 relative strength is starting to pick up as the price continues to rise. This is the rotation of capital, and it is not going unnoticed by people like me looking for performance. If you go back and look at the first IBM chart, you can see the same thing happening here as well. Relative strength is starting to pick up and price is accelerating.
Here is another good example from 2013 of out performance and now in 2014 under performance. A chart of BA relative to the Dow: here. You can see this most recent rally in the Dow is the first rally the Boeing didn't participate with in over a year. This is causing relative performance to decrease quickly, and trust me the market notices this.
Participation:
Relative performance is a very simple concept here that the market abides by. Like most things that are key to being a successful trader, the hard part for most is knowing what to focus on. This is something you want to put your focus into because it matters. Another simple topic I wanted to touch on is participation. Participation is the reason I have the benchmark overlayed on the chart so I can make sure that the stock I am taking positions in is participating when the market is making a move higher. In this case when the market moves higher, I would want to see my stock make a larger move higher. If we were trading a bear market, I would want to see the stocks I'm shorting taking a hit at the same time the market is taking a hit. To be relatively under performing, I would want to see my short position being hit harder than the overall market and that would be reflected in the ratio. None of this is a perfect science though and you will need to go study more on this, but I am telling you that this stuff matters whether you are a swing trader, position trader, or investor.
Conclusion:
I'll go over some ideas of how you could use this now. Rather than going through each stock and seeing where the performance you are looking for is (not that anything is wrong with that), you could just take a quick look through the S&P sectors against the S&P. Once you find that healthcare is outperforming for example, you could look through healthcare stocks relative to the healthcare ETF. You could also pair the stocks against the S&P if you wanted.
Some people will take it even deeper than this and use relative performance to put on pair trades. Buying gold in yen terms is a pair trade where one is expecting gold to outperform the Japanese yen. People will use relative performance to find out which emerging markets the money is flowing into. The entire currency exchange system is built on relative performance (or relative purchasing power). Some will take competing stocks, figure out which one the money is flowing into, and put on pair trades like that. For example for years, being long HD and short LOW as a pair trade was profitable if they were equal weighted (chart here). Like I said none of this is a science and with some of your own research, you will find out what works for you and how deep you want to take it. The fact is that this is important to focus on.
I honestly believe that if you study trend analysis with multiple time frames and pairing that with using relative performance, you too will see how powerful these three tools can be for your trading rather than relying on a blind signal you get from the chart. I hope this gets you another step closer to understanding the big picture you have to stay on top of as a trader. If you have any questions, please use the comments so everyone can benefit from it.. thanks.
Trade well,
-Michael
