Trendlines And Relative Strength

Trendlines provide insight into whether a market, sector, or security is trending up or down. Figure 1 shows the two trends. It shows that an uptrend has times when it goes down and a downtrend has times when it goes up. An uptrend is characterized by a succession of higher lows and a downtrend by a succession of lower highs. Studies have shown that in general, markets spend 30% to 50% of their time going sideways (that is, it is trendless), spend little time going down but make up for it by going down fast, and spend more time going up than down.

FIGURE 1: TRENDLINES. An uptrend is characterized by a succession of higher lows and a downtrend by a succession of lower highs. Sometimes uptrends go down and downtrends go up, but remember -- you're looking for an overall trend. A valid trendline requires two points of the price to be connected. The trendline with the most touches is the most valid. Each touch is a price retracement or retest of the trend. The more retests that are successful, the more valid is the trendline.

When you see an uptrend, you should connect as many of the lows as possible with a straight line. When a downtrend is evident, you want to connect as many of the highs as possible. The more times that prices touch a trendline, the closer the trendline is to an ideal. Two is a minimum. Three is better. Four is better yet. For an uptrend, each time the prices go down and then return to an upward movement, the market is testing the positive rate of change. For an uptrend, each of the successive lows is a retest of the trend. The same is true of downtrends, except we use successive highs. Retests are symptomatic of buyers and sellers reacting to the overall rate of increase. Along the way, there could be profit-taking. It could be a quarterly report that didn't quite meet expectations. In any event, the most valid trendline is the one with the greatest number of touching points or successful retests.

We chart stocks to show how their prices move over time. The points on the chart represent changes in time and price. If the stock is charted on the arithmetic scale, the distance between each point is the same. Each unit of time is an equal length along the x-axis, and each unit of price is an equal length along the y-axis. When you chart the constant rate of growth of a company on an arithmetic grid, the prices appear to curve upward and multiple trendlines are needed to fit the curve.

It's difficult to see an uptrend or downtrend when you are looking at multiple trendlines. To make it easier, I prefer to use a semi-logarithmic scale. A semi-log scale creates one straight line when there is a constant rate of change. How does a semi-log grid work? A semi-log grid is exponential. Each point on the y-axis shows a percentage change in price. A change in price from 30 to 60 (100% change) has the same y-axis length as does a change from 60 to 120 (100% change). So when you look at a semi-log chart, you are comparing relative price changes.

FIGURE 2: SEMI-LOG SCALE. A semi-log scale and a weekly period creates one straight trendline.

Several Internet sites provide either log or "regular" (arithmetic) chart scales for an array of securities. Figures 2 and 3 show the difference between the two. The chart in Figure 2 is created using a semi-log scale to plot price, whereas the one in Figure 3 uses an arithmetic scale. Figure 2 shows constant growth in price for Microsoft [MSFT] for the last four years. One trendline characterizes the price trend over four years. In Figure 3, it becomes necessary to use several trendlines.

FIGURE 3: MULTIPLE TRENDLINES. When multiple trendlines have to be drawn, there is always doubt as to whether the current trend line is valid.

The charts in both these examples are for weekly, not daily, data. Daily data has more price fluctuations, or noise, than the weekly chart. If you want to further reduce the noise, you should plot the chart using monthly data. An example using monthly data can be seen in Figure 4.

FIGURE 4: MONTHLY CHART. The use of monthly data removes the noise from weekly ups and downs, just as weekly removes the noise of daily ups and downs. Monthly data gives a longer-term perspective than weekly, and weekly a longer perspective than daily.

It is easy to see that there is less noise in the monthly chart than in the weekly one. Two distinct uptrends are seen in Figure 4. In addition, the current Microsoft dip is not nearly as dramatic in the monthly chart as in the weekly. Figures 2 and 4 illustrate just how strong Microsoft has become. As companies mature, their markets tend to become saturated. Just how many personal computers does a family or company need? To Microsoft's credit, the company evolves and sustains a strong growth rate.

Figure 5 shows a monthly chart of General Motors (GM). If you compare Microsoft and GM, you will see that the slope of the lines is visually similar, except the value of the slope in Figure 4 is 1.3 and the one in Figure 5 is 0.6. Microsoft's stock is growing at twice the rate of GM.

FIGURE 5: GENERAL MOTORS (GM) MONTHLY CHART. The slope of an uptrend (or downtrend) is the rate of change. For Microsoft (MSFT), rate of price change is twice that of GM.

The strength of a trend is also a function of its duration. A trend that sustains for a long period is typically stronger than a shorter one. During an uptrend, the strength of a trend is increased because investors are convinced that the stock will continue to grow in the long term.

RELATIVE STRENGTH

How strong is a market compared with other markets? A deceptively simple way to find out is to divide the values of one market by the other. The result of this division is relative strength. If you were to divide daily closing values of the Nasdaq by daily closing prices of the S&P 500, you would have the results in Figure 6. It shows that the Nasdaq is currently stronger than the S&P 500. It's not the actual value of the ratio you want, but the current value compared with a historical norm.

FIGURE 6: NASDAQ TO S&P 500 RATIO. The ratio between two items is relative strength (RS). The ratio between the Nasdaq Composite and the S&P 500 shows the Nasdaq is going up faster than the S&P 500, compared with previous levels. To establish the historical level, 1999 was chosen since RS for that year was approximately constant.

This technique can be applied to any pair of markets. You can extend this by picking a sector such as biotechnology and seeing how well it works within the Nasdaq.

The Internet supplies ample sources of data for comparison. Suppose you decide the Nasdaq is the market of choice. What is the trend of the Nasdaq? A semi-log scale is an appropriate measure to determine if a constant rate of change has occurred. Figure 7 displays the result. A monthly chart is used to reduce the noise and identify long-term trends. The chart shows the Nasdaq is a strong market -- one worth looking into.

FIGURE 7: NASDAQ GROWTH. A semi-log scale of monthly Nasdaq composite data shows constant rates of change. The trendline shows that in early 2000, exuberance carried the Nasdaq composite to levels not supported by constant change. Recent retracements in the Nasdaq have alleviated the problem for the most recent trend, established from 1996 to the present. However, the Nasdaq is above the trend, established from 1991 through 1998.

PUTTING THE TWO TOGETHER

Now that you know about trendlines and relative strength, a combination of both these tools can help identify strong and weak sectors. Suppose you want to compare the performance of the biotech sector against the Nasdaq. Is the biotech sector itself trending up?

FIGURE 8: BIOTECH TO NASDAQ RATIO. Relative to the Nasdaq, the biotech sector is above its historical average.

In Figure 8, you can see the performance of the biotech against the Nasdaq. It looks as if biotechs are doing well relative to the past performance of the Nasdaq. This is not surprising, considering the chart of the biotech index in Figure 9 shows it is experiencing a steep rate of growth; in fact, the slope is 35. One of the rules is that steep rates are difficult to maintain. You could argue it is not likely to sustain. The relatively short duration of the trend, two years, is also a cautionary flag. There's no question it's hot. Too hot?

FIGURE 9: BIOTECH PERFORMANCE. The performance of the biotech sector is almost explosive. Compared with Microsoft (MSFT), with a slope of 1.3, Ixbt with a slope of 35 will have problems sustaining that level.

SUMMARY

The most desirable investment area is the one that is in the strongest market with the strongest uptrend. Relative strength is an indicator that aids you in selecting a market. Once you identify this market, you may choose to invest in the entire market or a portion of it. Funds specialize in large-capitalization growth, technology, small cap, biotech, and so on. The list is enormous. Trendlines help us see if a market, sector, or stock has had constant sustainable growth. Sectors with slow rates of growth are generally less risky than those with high rates. We must keep in mind that with high reward also comes high risk.