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Measuring Market Strength: Technical Analysis 101

BALTIMORE (Stockpickr) -- There's an old saying on Wall Street that "it's a market of stocks, not a stock market." In large part, that's true. Single stocks often trade in directions that are divergent from the broad market; identifying those divergences is the domain of the successful trader.

But it's a huge mistake to underplay the importance of the stock market as a whole.

Clever sayings aside, the vast majority of stock movements are highly correlated with one another and with the collective market itself. That fact has become more evident than ever in the last few decades, as index funds became the most popular investment choice for Americans' retirement portfolios. With exposure to a diversified basket of stocks that's designed to track "the market," these funds are directly impacted by losses in the big indices they track.

Practically speaking, it makes a lot of sense that most stocks trade in tandem. It has more to do with the flow of funds into and out of the market than with the specifics of any particular stock. As investors tried to liquidate stock positions and free up cash in the recession of 2008, for instance, they were selling the good alongside the bad in order to stay solvent. In the process, even fundamentally sound stocks got pushed significantly lower as the broad market crashed.

Must Read: Does Technical Trading Really Work?

But you don't need to be beholden to the market. By measuring market strength, you can target asset classes that look to be the strongest performers when times are tough, and you can spot early signs of broad market reversals when times are good.

Today, we'll explore some popular measures of market strength.

Relative or Absolute Market Strength

Market strength is a broad term that can mean a lot of things depending on how we define it. Market strength can be either a measure of a market's power to perform on a relative basis (vs. other markets) or on an absolute basis (vs. its own historical levels of momentum and investor participation).

First, we'll take a look at the relative strength of a market. Relative strength is a technical analysis metric that's not relegated to intermarket analysis (in other words, it can be used for individual stocks just as effectively), but it's arguably at its most powerful when used to help select the strongest asset class.

Essentially, relative strength is just the ratio of one asset to another over a period of time. By taking the daily close of the S&P 500 divided by the daily spot price of gold, for example, you'll get the relative strength of the S&P (or more broadly, of stocks) vs. gold. Because relative strength is a ratio of two disparate items, you don't need to pay attention to the absolute level of the relative strength chart. Instead, it's the trend that matters.

By looking at relative strength of various asset classes over the long-term, technical traders can determine when it makes sense to rotate a portfolio from a relatively weaker asset to relatively stronger assets. Of course, it's crucial to monitor the instruments themselves at the same time. Using relative strength alone, it's possible to invest in the "least worst" of two declining assets.

The abundance of new, commodity, currency and foreign equity exchange-traded funds has made this method of trend trading especially popular in recent years.

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