Relative Ratio Charts Explained
A Point & Figure relative ratio chart plots the stock price divided by the value of a comparison asset. The relative asset used may range from another stock, to a sector, or market index. Relative ratio may also be referred to as relative strength.
How is relative strength calculated?
The stock price is divided by the value of the S&P 500 to create the market index relative ratio. The resulting ratio is then multiplied by 2000 to provide a workable value. Values are calculated at the end of each trading session.
Relative ratio values are then plotted on a Point and Figure chart. Point and Figure relative charts for over 8000 U.S. stocks may be plotted via our P&F charting tool. The default setting is the S&P 500 but any major U.S. index may be selected. The S&P 500 is commonly used as the benchmark for a U.S. stock.
The chosen benchmark should be a relevant index. Therefore, when analyzing a technology stock, the NASDAQ 100 could be used. Alternatively, in the case of a U.K. stock, the FTSE 100 could be applied to the ratio.
Applications of relative charts
- Used to enable the identification of stock market outperformers via index relative ratio charts.
- Identify leading members of an industry via sector relative ratio charts.
- Pair trade analysis is possible via relative ratio charts. Two stocks may be compared against each other. The weaker stock is shorted. Conversely, the stronger stock is bought.
Benefits of the Relative Ratio
A P&F relative ratio chart is a simple yet effective means to compare a stock against the broader market. Consistent outperformers can be identified quickly. Additionally, under-performers can be spotted easily, the stocks an investor wants to avoid.
How to identify outperformers?
To beat the market an investor must consistently pick outperformers. Should an outperforming stock become an under-performer, then that stock needs to be weeded out and replaced with a fresh outperformer. Relative ratio's are the ideal tool to achieve successful portfolio stock rotation.
An outperformer is easily identifiable on a Point and Figure relative chart simply by the existence of a rising trend.
The late Mike Burke of Chartcraft would emphasize the importance of relative ratio charts, considering them to be of greater value than the price chart. Mike Burke also found that relative charts were a useful tool to help identify the next fad, young growth stocks. In his 1990 book¹ he writes "if you are able to notice this trend [fad] quickly, it is much to you advantage".
When a group of stocks from the same industry all start displaying outperformance on their relative charts, it may well indicate the start of something big. However, fads do not continue forever. Therefore, the same relative charts could be used to forecast a sector's demise, and in turn rotate into the next outperforming group of stocks.
How to identify underperformers?
A falling relative ratio simply indicates underperformance for a given stock against the market in question. Point and Figure relative charts that exhibit such a trend should be avoided on the long side. However, shorting opportunities may of course be identified using relative ratio charts.
Relative Strength P&F chart technical analysis
The same technical skills used for the analysis of standard P&F price charts may be applied to Point & Figure relative ratio charts.
- Breakout and breakdown patterns may be followed.
- Reversals from ley levels could be used to execute a stock rotation.
- A rally from relative support could be used to buy an outperformer.
- A failure from relative resistance could be the cue to exit a long position.
Investors apply analytical skills to Point & Figure relative ratio charts to achieve portfolio outperformance. Stocks owned in a portfolio should all exhibit relative strength. Obvious but often overlooked. Likewise, a short trader would only want to trade stocks that have bearish relative charts, the underperformers.
Divergences between price and relative charts
Divergences are an additional technical observation investors should watch for when analyzing Point & Figure relative charts.
Should a relative chart for a given stock make lower highs yet the price chart makes higher highs, the investor should take note. A divergence such as this is a warning sign that outperformance is waning. Therefore, the investor should consider a stock rotation into a fresh outperformer.
Relative Ratio Chart Examples
Stock market rotation within a sector
The P&F relative ratio chart between the Invesco Base Metals ETF and the CRB Index reveals underperformance by the former between 2017 and 2019. However, between 2014 and 2017, the DBB fund outperformed the basket of commodities, evident from the rising trend. Thus, sub-sectors of the market swing in and out of favor. P&F relative ratio charts enable these stock market rotations to be identified effectively.
Long-term sector outperformance against the market
The relative strength chart between the Consumer Discretionary ETF and the S&P 500 shows multi-year outperformance by the former. The long-term uptrend has been underway since 2009. Over that period, an investor should have demonstrated heavy stock rotation into the consumer discretionary sector. As a result, their portfolio would have outperformed the general market.
Pair trade example
The PnF relative ratio between the Emerging Market ETF and the U.S. stock market displays strong underperformance by the former, since 2011. Therefore, to avoid underperformance, in 2011 an investor ideally should have executed portfolio rotation into the S&P 500, from emerging markets. Alternatively, to capitalize on this inverse relationship, a trader could short an emerging market ETF and at the same time buy a U.S. index ETF, a pair trade.
In 2018 emerging markets were in a bear market, underperformance against the U.S. market continues. Therefore, a pair trade could be held for sometime.
How would the pair trade have been signaled from the beginning? The presence of a bearish High Pole in early 2011 on the relative ratio chart was the initial alert. A Double Bottom sell signal followed from the bearish trendline in August 2011. Thereby, providing the cue to follow the pair trade.
¹ Three Point Reversal Method of Point & Figure Construction and Formations, Mike Burke, published 1990 by Chartcraft, Larchmont, New York.