The strong get stronger (and the weak get weaker), so the saying goes and this is often one of the keys to deciding which markets to invest in when utilising charts.

In our view one of the problems with technology these days is that it's ubiquitous, whereas 20 years ago the average retail trader didn't have access to a computer or at least one with any real power or ease of use.

So today with all the number crunching in the markets by anyone with a £300+ computer it may actually defeat the purpose simply because there's no edge anymore. Back in the old days people who used charts drew and updated them by hand and therefore the shape of the chart was usually far more important than anything else. But now the shape of the chart or 'what does it look like' seems to have been replaced with all sorts of different mathematical formulas.

So maybe a better strategy is to chuck out the computer power and go back to basics.

In the April and May Newsletters we did some simple analysis on both the FTSE 100 and US markets suggesting that the long term trend was up and therefore further strength was to be expected. This analysis has proved to be right.

But were there any clues to suggest that the FTSE 100 was a better investment than backing Wall Street? For example, an investor might have had £10,000 to invest but couldn't choose whether to put that money to work in the UK or US stockmarkets.

Simple charting combined with relative strength held some useful clues.

What is Relative Strength?

Simply put it's looking at two related markets to see if one is outperforming the other, and if so betting that the outperforming market will continue to outperform. Relative strength is really a simple probability play. It doesn't always work but if you do enough trades the probabilities will usually rise to the surface.

Let's look at the recent FTSE 100 and US S&P 500 charts for confirmation of this

Which Stockmarket Should We Invest In

• Take the assumption that you wanted to invest in either London or Wall Street around Easter of 2005 (the area on both charts that is circled in red)
• Stockmarket education 101 tells us that all western markets generally move up or down together
• We've drawn a significant horizontal line from the important 2004 highs on both markets
• Look closely at the red circled areas and see the difference between the two charts
• The FTSE 100 had clearly moved significantly higher from the 2004 highs whereas the S&P500 had not
• Therefore using the concept of relative strength the FTSE was by far the better performer and had been for some time
• No computers or spreadsheet calculations were needed for this analysis just eyeballs

So using the probabilities of the statement 'the strong get stronger' the FTSE was likely to continue to outperform the US market which is in fact what happened.

To Summarise

• Look at the charts of two related markets and buy the outperformer
• This type of relationship can also be used for so called 'Pairs Trading' where the actual up/down movement of an index or stock is taken out of the equation
• With a Pairs Trade one market is bought and the other is sold short so making money wholly by the relationship of the two rather than the overall direction of the underlying market
• It's therefore possible to make money in a downward market because the stock you bought moved lower by 10% but the short stock moved 20% lower

We'll have a further look at Pairs trading in next month's newsletter because it's certainly an interesting trading strategy.

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