This column was originally published on RealMoney on Oct. 26 at 9:47 a.m. EDT. It's being republished as a bonus for TheStreet.com readers.

Because my market bias has changed from bearish to bullish over the past couple of weeks, I wanted to get a feel for what sectors could outperform the market in the current conditions. That seems like a tall order -- after all, isn't that what every long-side investor wants to know? But I believe that using one key measure and a good selection of exchange-traded funds to represent the market will yield the sectors that will prove to be good bets in an up market.

Considering the comparative relative strength of 14 ETFs in some carefully selected trading systems leads me to believe that biotech, broadband, Internet and oil service stocks should be winners. Let me explain how I arrived at that conclusion.

The Key Concept

Comparative relative strength is determined by comparing an equity's price either to its historical prices or another data series. For example, comparing the price of an equity to a popular index, such as the S&P 500, is a form of measuring the equity's relative strength. Relative strength is just a method of identifying strong sectors or stocks.

Not a new concept, its utility as a stock selection tool has been explored and validated in academic and trading journals going back to the 1960s. The basic idea behind its use is that the strong -- current outperformers -- get stronger, regardless of the market environment. In up markets, the strongest equities should outperform, and in down markets, they should underperform to a lesser degree than the general market.

Comparative relative strength has been used in market-timing models, with varying degrees of success. Most models involve rebalancing the portfolio at some predetermined interval, say, every month or every six months, so that it always holds the strongest-performing sectors or stocks.

The Methodology

Again, the recent shift in my market bias from bearish to bullish has me interested in finding those areas of the market that are poised to outperform. I chose to consider how 14 exchange-traded funds have performed during periods of bullish bias. I worked with these 14 ETFs because they represent most of the major segments of the equities market.
  • Biotech HOLDRs ( BBH)
  • Broadband HOLDRs ( BDH)
  • Internet HOLDRs ( HHH)
  • Oil Service HOLDRs ( OIH)
  • Pharmaceutical HOLDRs ( PPH)
  • Regional Bank HOLDRs ( RKH)
  • Retail HOLDRs ( RTH)
  • Semiconductor HOLDRs ( SMH)
  • Software HOLDRs ( SWH)
  • Utilities HOLDRs ( UTH)
  • Wireless HOLDRs ( WMH)
  • Energy Select SPDRs ( XLE)
  • Health Care Select SPDRs ( XLV)
  • Industrial Select SPDRs ( XLI)

For this purpose, I will be comparing the current price to the average price over the past 131 trading days. Why that interval? Because in Robert Levy's work on relative strength from the late '60s, considered to be the most authoritative on the topic, this was the value used to measure relative strength.

Using my market-timing models, I identified the periods of a bullish market bias from the past five years. (Due to limitations of the ETF data, the study period was from July 2000 until the present.) When the market bias changed from bearish to bullish, I "bought" the four ETFs with the highest relative strength and held them until the market bias changed back to bearish. No other factors, such as stops or P/E ratios, were considered in the analysis.

The Results

Before we get to the analysis of how the relative-strength market-timing strategy performed, we should examine how the stock-timing model performed over the past five years, because it's the filter that overlays the strategy. If you had bought the Nasdaq market only when the market bias was bullish, your capital would have compounded at a 16.75% annual rate. To achieve these returns, you would have had to suffer through two drawdown periods in which you lost 20% (2001) and 30% (2002) of your capital. As is well known, the Nasdaq has lost about 50% of its value since July 2000.

But if instead of buying the market you had bought the four sectors with the highest relative strength when the market bias changed from bearish to bullish since July 2000, your capital would have compounded at an 11% annual rate. Under this strategy, one drawdown period would have resulted in a loss of 25% of your capital (2002) and another that would've given a loss of 15% of your capital (2001). Compared to just buying the Nasdaq outright, buying the four strongest relative-strength performers did not improve reward relative to the risk. In other words, with the relative-strength strategy, the reward and the risk both decreased. I was hoping to see returns increase while risk decreased. This did not happen.

While the results were not what I had hoped, they don't negate the value of the strategy. Looking at the equity curves of both the stock-timing model and our relative strength strategy in a little more detail shows that since July 2002, which many would consider the bottom of the bear market, the relative-strength strategy returned approximately 133% on capital. This compares with a 100% return for the market-timing model, and about 60% return on capital for a Nasdaq buy-and-holder since July 2002. So over the past three years of the bull market, the relative-strength strategy has been a significant outperformer.

Another benefit to the relative-strength strategy is exposure to different sectors of the market. Concentrating all your eggs in one basket, such as in the Nasdaq 100 Unit Trust ( QQQQ), is an inherently weak strategy even though it may have been the most successful at a given time. The market can be too unpredictable, and relying on your ability to pick that one right sector or stock for your entire nest egg is not a good practice. The relative-strength strategy is more diversified in its approach and is likely to more consistently capture the best-performing sectors. After all, you have four chances to do so as opposed to one.

Last, let's compare this strategy to one in which we buy the four weakest relative-strength sectors at a time when the market bias becomes bullish. Since July 2000, this strategy compounded at an 8.79% annual return. There were two maximum drawdowns, of 25% (2001) and 35% (2002). There were also three other periods with drawdowns greater than 10%. These were not present under the other strategies.

The Winners

Although the data are limited, buying the highest relative-strength exchange-traded fund did outperform a strategy of buying the losing sectors. Strength does beget strength, and concentrating your efforts in the strongest sectors is a winning strategy. However, this strategy did not outperform a basic market-timing strategy, because a market-timing strategy based on the speculative Nasdaq is highly concentrated. Risk and, consequently, reward are likely to be higher as opposed to a strategy spread out across different sectors.

Buying out-of-favor sectors at a time of market bullishness leads to underperformance and excessive drawdowns. This is very clear from the data.

The current leading ETFs (from weakest to strongest) are Internet HOLDRs, Biotech HOLDRs, Broadband HOLDRs and Oil Service HOLDRs. Focusing your efforts in the sectors these ETFs represent -- or even just buying these ETFs outright -- should prove to be a winning strategy during the up market period that I believe is starting now.


Please note that due to factors including low market capitalization and/or insufficient public float, we consider Broadband HOLDRs, Internet HOLDRs, Regional Bank HOLDRs, Retail HOLDRs, Software HOLDRs and Wireless HOLDRs to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

P.S. from TheStreet.com Editor-in-Chief, Dave Morrow:
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At the time of publication, Lerner was long the Internet HOLDRs and Nasdaq 100 Unit Trust, although holdings can change at any time.

Guy M. Lerner, M.D., is an anesthesiologist and a freelance writer who trades for his own account. He blends technical and fundamental analysis to determine those factors that lead to sustainable moves in the markets. Lerner's approach is research-driven and focuses on supply-demand issues, investor sentiment, intermarket relationships and monetary liquidity. He is a member of the Market Technicians Association and is the founder of TheTechnicalTake.com, a Web site that offers content, commentary and strategies for investors and traders. Under no circumstances does the information in this commentary represent a recommendation to buy or sell stocks. He appreciates your feedback and invites you to send your comments by clicking here.

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