Table Of ContentStocks & 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).
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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.
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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
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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.
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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.
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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.
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