Visit Lion's Head in the summer and you'll be in for a treat. The small town is nestled on the shores of Ontario's Georgian Bay and is surrounded by the natural glory of the Niagara Escarpment.
While that section of the bay is placid most of the time, if the winds howl in the right direction, the waves can be powerful enough to rearrange its pebble beaches and chase swimmers back to shore.
When it comes to the markets, the difference between a large wave on a fairly calm day and a huge wave on a stormy day is similar to the contrast between relative strength and absolute strength. But both momentum measures have provided outsized returns over the long run.
The idea behind relative strength is to take a group of stocks and rank them based on their returns over a particular period in the recent past. Stocks with the best returns have the highest relative strength and are loved by momentum investors.
Absolute strength does away with ranking stocks and simply opts for those that have gone up a great deal in percentage terms. The actual performance hurdle one uses in this case can be determined using the historical distribution of stock returns.
Purdue professor Huseyin Gulen and Case Western Reserve professor Ralitsa Petkova studied both momentum measures in a recent paper called Absolute Strength: Exploring Momentum in Stock Returns. They favour absolute rather than relative strength, but both have their merits.
For absolute strength they figured that stocks had to climb by at least 64 per cent, over an 11-month evaluation period, to make it into the top tenth (decile) of performers based on data from 1965 to 2014. At the other end of the spectrum, the bottom tenth of stocks saw declines of more than 43 per cent.
The difference between relative and absolute strength is most noticeable during big bear (or bull) markets. Users of relative strength will always be able to find a set fraction of stocks that pass muster, but in bear markets some of those top performers might have actually declined during the evaluation period. On the other hand, absolute strength investors stick to stocks that have gained a great deal and they might find only a very small number of them in hard times.
It's an important difference for money managers who want to remain invested in a diversified portfolio of equities at all times and will therefore favour relative strength. But it's not as big a deal for individuals who don't mind moving to cash or holding less diversified portfolios.
When it comes to performance, absolute strength was the winner for long-only investors. (It fared even better for the minority who were able to buy past-gainers and short-sell past-losers.)
For instance, the study looked at portfolios composed of U.S. stocks in the top decile based on absolute strength, and relative strength, as measured by returns over the prior 12 months with monthly rebalancing.
The portfolio that followed the top decile of absolute strength stocks went on to gain an average of 1.60 per cent monthly from 1965 through 2014. The top relative strength portfolio trailed with monthly gains of 1.50 per cent. But both fared quite well overall.
On a practical note, you can use The Globe and Mail stock screener to find momentum stocks. I did so this week while steering clear of penny stocks trading for less than $1 per share and stocks with market capitalizations of less than $500-million.
The top three momentum candidates in Canada were Concordia Healthcare (CXR), Valeant Pharmaceuticals (VRX) and AirBoss (BOS). All of them have more than doubled over the past year and would meet the approval of both absolute and relative strength investors alike. With a bit of luck, they'll continue to ride the momentum wave for a few more months.
Norman Rothery is the value investor for Strategy Lab. Globe Unlimited subscribers can read more in the series at tgam.ca/strategy-lab.
Norman Rothery