Technical analysis used to be a secret sin in the investment world. Now, it is out in the open, often providing useful information. In particular, this kind of analysis can steer you and your clients toward successful investments or warn you away from weak situations.

Technical analysis reveals something about the Canadian stock market that fundamental analysis may or may not reveal: after a decade of outperforming Wall Street, Bay Street is now lagging. (See left-hand chart, above.)

Relative strength is the most basic form of technical analysis. Most often, it is shown on a chart as the ratio between a stock or an industry index and a broad market index. In the case being discussed, it compares Canada’s national index with the U.S.’s dominant index: the S&P/TSX composite index (the former) traded at more than 11 times the S&P 500 composite index (the latter) in August 2010. By yearend 2011, that ratio had dropped to 9.5 times.

Index prices went up and down for both markets in the interval, but the key fact is plain: Wall Street is again the better place to look for investment prospects.

Such analysis identifies a basic aspect of the Canadian market: relative to the S&P/TSX composite index, small-cap stocks have dropped and mid-cap stocks have remained steady. The S&P/TSX small-cap subindex and the S&P/TSX completion subindex provide the comparisons. (See right-hand chart.)

Separating the weak from the strong and the rising from the lagging has long been used by investors to narrow their focus.

Another way of viewing relative strength permits you to rank degrees of strength. Robert A. Levy, an American academic, began measuring the relative strength of stocks by comparing their current prices to their 26-week average prices. (No chart is needed.) The resulting ratios revealed that stocks with the highest ratios (highest relative to the price average) outperformed the rest over the next 26 weeks. Levy’s work confirms the value of relative strength analysis in choosing stocks to buy or sell.

Here is one example of how Levy’s method — adapted to using six-month average prices — had worked among the 22 industry groups in the S&P/TSX composite index in December 2010:

> Highest relative strength ranks were held by autos/components, materials, diversified financials, capital goods, consumer services and pharmaceuticals/biotechnology.

> Over the next six months, all but one of these six industries outperformed the S&P/TSX composite index. (Materials was the exception.) Autos gained only 1%; but diversified financials gained 13%; capital goods, 12%; consumer services, 10%; and pharmaceuticals/biotechnology, 70%.

> As 2012 begins, a similar ranking places retailing, transportation, pharmaceuticals/biotechnology and food/staples retailing at the top among the S&P/TSX industry groups.

> On Wall Street, of the 114 industries in the S&P 500 composite index, those ranking highest in relative strength are restaurants, tobacco, pharmaceuticals and integrated oil and gas. Following closely in rank are biotechnology, data processing/outsourcing and hypermarkets.

Although no method of investment analysis guarantees success, technical analysis says these industries should be considered in making new investment decisions.  IE