Today I am going to discuss a slight twist on an intermediate-term indicator that I’ve discussed before. The idea comes from Gerald Appel’s book “Technical Analysis – Power Tools For Active Investors”. In it he discusses a relative strength measure of the NYSE vs. the Nasdaq looked at on a weekly chart. The premise behind the indicator is that the market tends to perform better when the appetite for Nasdaq stocks is greater than the appetite for NYSE stocks.Part of this is due to the higher volatility of the Nasdaq, and part of it is due to investors willingness to speculate more aggressively when their outlook is positive. Critics of the indicator suggest the reason it works is largely due to the higher beta of the Nasdaq. That may be part of it, but it doesn’t mean the indicator is without value. In fact, whatever the reasons behind it, the indicator has been an excellent barometer over the years. In the book, Mr. Appel suggests using a 10-week relative strength indicator to measure this phenomenon.

Since I normally trade the S&P 500 and not the NYSE Composite, I applied the indicator to the S&P 500. Doing so, I found the results to be even better. The indicator is shown in the chart below.

The two lines on the bottom panel are the relative strength indicator. When the solid line closes above the dotted line that means the Nasdaq is leading the S&P. When it closes below the dotted line, that means it is lagging the S&P. To make it even easier to view I’ve made the line green when the Nasdaq is leading and red when the Nasdaq is lagging. As you can see, the Nasdaq is currently lagging.

The performance can be evaluated a number of ways. This first equity graph (courtesy of Tradestation) shows the points gained in the S&P 500 since June 30, 1972 – May 15, 2009.

As you can see, over the time period measured the S&P gained 1,341.27 points when the Nasdaq was leading. Meanwhile, the total points gained by the S&P over the period was 775.74. The Nasdaq held a leadership position just slightly more than ½ the time during the period. So almost twice the gains (points-wise) were achieved in nearly half the time. Not bad.

What if you started with a $100,000 portfolio and compared buy and hold to only holding when the Nasdaq led?

I decided to show these results in Excel.

These results represent returns from 4/19/1971 – 5/22/2009. They do not include dividends. The pink line is the growth of $100k in the S&P 500. The blue line shows the results of investing in the S&P only when the Nasdaq is in a leadership position and earning 0% interest otherwise. The yellow line shows results if instead of earning 0% interest, you managed to earn a steady 2.5% interest on your cash balance while not in the market. While 2.5% isn’t easily doable today, over most of the time period it was extremely low.

It appears the only period where the Nasdaq/S&P Relative Strength Indicator didn’t provide an edge was during the 1995-2000 boom market when you would have wanted to be invested basically the whole time.

The ending value differences are striking. By sitting out of the market when the Nasdaq is lagging and earning a minimal interest rate on your cash, returns more than tripled. Nearly $2,000,000 more would have been earned on an investment of $100,000.

The Nasdaq/S&P relative strength indicator is well worth keeping and eye on and is a useful tool for measuring the health of the market.