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Stocks & Commodities V. 12:11 (451-454): The Relative Strength Ratio-Macd Crossover by Gilbert Raff The Relative Strength Ratio-M Crossover ACD by Gilbert Raff Here's an indicator to identify positive and negative trading signals for stocks and mutual funds. The heart of the indicator involves applying an oscillator to the relative strength line. Trading signals result from identifying strong relative strength, which is a positive indication, while weak relative strength is considered a negative sign. Here's how to lower the volatility of returns by applying the popular moving average convergence/divergence (MACD). M ost stocks and mutual funds are more volatile than the Standard & Poor's 500 index. The first two quarters of 1994 amply demonstrated this, with most equity mutual funds losing more than the stock indices, and most bond funds losing more than the Shearson Lehman bond index. In what may seem like a paradox, I have used in my financial management practice an indicator based on the relatively greater volatility of stocks and mutual funds to produce less volatile investment returns. I call it the relative strength ratio-MACD crossover indicator. MONITORING MUTUAL FUNDS Let me illustrate this first in mutual funds. The first step is to divide the weekly close of the mutual fund in question by the weekly close of the S&P 500 index, and you'll have a graph of the relative strength ratio of that fund (Figure 1). I use this term to distinguish this ratio from the similarly named but completely different relative strength indicator (RSI). When the ratio is falling, the fund is underperforming the S&P index, and vice versa. Next, apply the classic moving average convergence/divergence (MACD) indicator to this graph. When the MACD is over its nine-week exponential moving average (EMA), called the trigger line, buy the mutual fund. When the MACD is below the trigger line, move into a money market fund if you are conservative or into a higher-performing fund if you are aggressive (Figure 2). Article Text Copyright (c) Technical Analysis Inc. 1 FIGURE 1: RELATIVE STRENGTH RATIO. Here, the relative strength ratio of the mutual fund 20th Century Ultra versus the S&P 500 is plotted in the upper chart. Notice in the upper chart that the relative strength of the mutual fund was in an upward trend with countertrend declines. FIGURE 2: RELATIVE STRENGTH RATIO-MACD CROSSOVER INDICATOR. By applying the MACD indicator to the relative strength line, we can use crossovers of the MACD (solid line) and the trigger line (dashed line) to generate buy (up arrows) signals and sell (equal sign) signals. Copyright (c) Technical Analysis Inc. Stocks & Commodities V. 12:11 (451-454): The Relative Strength Ratio-Macd Crossover by Gilbert Raff As you can see, there was considerable time spent in money market funds. Even so, gains exceeded losses in frequency and amount in testing this approach in multiple funds. The result was very satisfactory, and it was all dependent on the excess of volatility of the mutual fund compared with the S&P 500 index! The one caution to be noted is that when the entire market is falling faster than the fund, its relative strength ratio will be stronger, and so in some cases using an additional indicator such as a moving average crossover will be useful as a second line requirement. Why does this work? First, the relative strength ratio indicates positive or negative performance relative to the market. This is an excellent first step, but that indicator is noisy and difficult to quantify for trading signals. Applying the MACD indicator smoothes or removes the noise because the first step in calculating the MACD is to use two moving averages of the relative strength ratio. The moving averages remove the noise from the data. The MACD line is the difference between the two moving averages; the result of measuring the difference between the two moving averages is a leading indicator of the relative strength ratio. When the MACD changes direction, a change in the trend of the relative strength ratio is indicated. Finally, by using the MACD line in reference to the trigger line (the nine-period EMA of the MACD line), we can identify important changes in the trend of the relative performance of the mutual fund we are following. For details, see sidebar, “Calculating the relative strength ratio-MACD crossover indicator.” MONITORING STOCKS Now let's apply the same method to stock trading, with minor modifications. Now, because a single stock is generally even more volatile than a mutual fund, use the following rules: Go long only if: 1 The MACD of the weekly stock/S&P ratio is greater than zero, and 2 The MACD is above its trigger line. The MACD line is the difference between the two moving averages; the result of measuring the difference between the two moving averages is a leading indicator of the relative strength ratio. I added the additional rule requiring the MACD to be in positive territory to increase the chance that the performance of the stock compared with the S&P index has improved in a meaningful way. Figure 3 is a recent example of trading the security Nike (NIKE) with this technique. Again, you have the option of switching to money market funds or Treasury bills after sell signals if you are conservative, or into another stock on a buy signal if you are aggressive. You can go short using the inverse of the same rules, but I recommend that you be sure that the fundamentals of the stock support the technical signals. ASSET ALLOCATION Another application is in asset allocation. This technique can be applied to a portfolio of stocks to decide Article Text Copyright (c) Technical Analysis Inc. 2 FIGURE 3: NIKE. Equities tend to be more volatile than mutual funds, and therefore, buy signals incorporate the added rule that the MACD line be in positive territory. While this may increase the chance of late entries, it will reduce the likelihood of false signals. FIGURE 4: ENERGY SECTOR. You can apply the relative strength ratio-MACD crossover indicator to market indices to identify which sectors are outperforming the S&P 500. Here, the S&P energy sector was a strong performer in early to mid-1993 and then underperformed for the rest of 1993. Copyright (c) Technical Analysis Inc. Stocks & Commodities V. 12:11 (451-454): The Relative Strength Ratio-Macd Crossover by Gilbert Raff how much capital should be in stocks and how much should be in money market funds. For example, if you monitor 50 of your favorite stocks and 35 have sell signals, you might well decide to reduce your equity portfolio to only 30% invested. In addition, if your investment horizon includes foreign stocks and if 70% of your US stocks are on sells but 65% of your foreign stocks are on buys, you might decide to increase your foreign allocation. The same approach can be used for foreign equity mutual funds. When the relative strength ratio-MACD crossover is positive, foreign funds should be considered and analyzed by their performance relative to the S&P, or the Europe, Asia and Far East Index (EAFE). This analysis will help you avoid long trendless periods in foreign equities that in the past have lasted for years, at least in dollar-denominated funds. Finally, if you do what I prefer to do — that is, follow the relative strength ratio/MACD of the S&P sector indices (Figure 4) — you might find that, as an example, energy stocks are outperforming software stocks and make appropriate adjustments such as purchasing energy stocks (Figure 5). CONCLUSION The relative strength ratio-MACD crossover indicator is an effective tool with which to screen stocks and mutual funds based on performance. Calculating the indicator and the rules are straightforward and can be easily tested in most software. I have found this to be a useful and precise investment timing and portfolio allocation tool. Gilbert Raff, is president of MarketSpace Financial, a money management firm located in Albuquerque, NM. ADDITIONAL READING/RESOURCES Hartle, Thom [1994]. “Gilbert Raff: From medicine to money management,” interview, Technical Analysis of STOCKS & COMMODITIES, Volume 12: May. ___ [1994]. “Gerald Appel, with Systems and Forecasts,” interview, Technical Analysis of STOCKS & COMMODITIES, Volume 12: March. Figures Copyright (c) Technical Analysis Inc. 3 FIGURE 5: MOBIL CORP. Here’s an example of trading a security, in this case Mobil Corp. (MOB), based on signals from the sector it is from. Copyright (c) Technical Analysis Inc.