When Not to Use Relative Strength in Your Trading: Avoiding Pitfalls in a Downward Market

Today was a great example of how pointless it can be to try and buy a strong stock in the face of a weak overall broader market. As illustrated in the above chart, Nucor Corporation (NUE) exhibited relative strength compared to the SPDR S&P 500 ETF (SPY), indicating that NUE was outperforming the broader market. However, despite its relative strength, NUE wasn't able to rally much because the overall bearish market sentiment eventually pulled it down, resulting in a losing trade. This scenario underscores the futility of relying solely on relative strength in a declining market, as even strong stocks are often unable to resist the downward pressure from widespread market weakness.

Understanding Relative Strength

Relative Strength measures a stock's performance against a benchmark index, such as the S&P 500. A high RS indicates that the stock is performing better than the market, while a low RS suggests underperformance. Traders often use RS to pinpoint strong stocks during bullish phases, but its effectiveness can diminish during bearish periods.

The Downside of Using Relative Strength in a Declining Market

When the overall market is trending lower, using Relative Strength to identify and buy strong stocks can lead to significant pitfalls. Here are the key reasons why:

1. Fighting the Overall Trend: The market's overall direction is a powerful force. Even strong stocks, as indicated by high RS, are not immune to the broader market sentiment. In a downtrend, most stocks, regardless of their relative strength, are likely to face downward pressure. Buying strong stocks in a bearish market is akin to swimming against the tide, often resulting in losses.

2. False Sense of Security: High RS in a declining market can create a false sense of security. Traders might believe that because a stock is performing relatively better, it is a safe buy. However, "relatively better" does not mean it will rise; it may simply mean it is falling less than the market. The stock can still decline, leading to potential losses.

3. Limited Upside Potential: In a bearish market, even strong stocks have limited upside potential. The prevailing negative sentiment and broader economic conditions can cap the gains of these stocks. Traders might enter positions expecting significant upside, only to find that the stock's performance is subdued by the overall market environment.

4. Increased Volatility: Stocks with high RS in a declining market can experience increased volatility. As the market fluctuates, these stocks can exhibit sharp price movements, making it challenging to manage risk effectively. This volatility can result in larger-than-expected losses if the trade goes against the trader.

5. Sector-Specific Risks: Certain sectors might show relative strength due to temporary factors, but they can still be vulnerable in a broader market downturn. Relying solely on RS without considering sector-specific risks can lead to misguided trades. For example, defensive sectors like utilities might show relative strength, but they can still decline significantly during a severe market downturn.

When to Avoid Using Relative Strength

Given these pitfalls, here are specific scenarios when traders should avoid using Relative Strength as their primary indicator:

1. Market-Wide Sell-Offs: During periods of market-wide sell-offs, such as financial crises or major economic downturns, the overall bearish sentiment can drag down even the strongest stocks. In such environments, it is best to avoid using RS as a buying signal.

2. Bearish Market Trends: When the market is in a clear downtrend, characterized by lower highs and lower lows, relying on RS to buy stocks can be risky. The downward momentum can overpower any relative strength signals.

3. Economic Uncertainty: In times of economic uncertainty, such as during recessions or geopolitical crises, the market can be highly unpredictable. High RS stocks can be adversely affected by sudden shifts in investor sentiment, making them unreliable buy candidates.

4. Sector Rotations: During sector rotations, where investors shift their focus from one sector to another, stocks showing relative strength might lose their appeal quickly. If the market sentiment shifts, these stocks can experience abrupt declines.

Alternative Strategies

Instead of relying on Relative Strength in a declining market, consider the following alternative strategies:

1. Short Selling: Rather than fighting the trend, align with it by short selling stocks that are underperforming. This approach allows you to capitalize on the downward momentum.

2. Cash or Defensive Positions: Consider holding cash or investing in defensive assets like bonds or gold. These positions can provide stability and protect your capital during turbulent times.

3. Inverse ETFs: Exchange-Traded Funds (ETFs) that move inversely to the market can be used to profit from declining market conditions. These funds increase in value as the market falls.

4. Technical Analysis: Use other technical indicators, such as moving averages, support and resistance levels, and trendlines, to make informed trading decisions. These tools can provide additional context and help you navigate bearish markets more effectively.

Conclusion

While Relative Strength is a valuable tool in bullish markets, it can be misleading and risky in declining markets. Attempting to buy strong stocks based on RS during a bearish trend can result in losses, increased volatility, and limited upside potential. Instead, consider alternative strategies that align with the prevailing market conditions to safeguard your capital and make more informed trading decisions. Understanding when not to use Relative Strength is crucial for adapting your trading approach and achieving long-term success.