Theories of relativity

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  By Guest Blogger Doug Rowat

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After Nvidia blew the doors off in 2023, advancing by about 240%, I jokingly asked a few of my colleagues around the office if they thought that the stock could repeat the feat in 2024. The answer was a resounding “no chance”. And on a certain level this skepticism made perfect sense—the stock’s massive 50% plunge in 2022 was still fresh in most investors’ minds, so Nvidia could giveth, but it could just as easily taketh away.

But momentum’s a funny thing. And here we are in late 2024 and Nvidia’s up another 190% y-t-d. I’m certainly not making predictions regarding what Nvidia might do in 2025 (God only knows), but as a general principal of investing, there’s much evidence to suggest that price momentum persists.

Theories as to why momentum investing is effective range from momentum strategies being predictive of stronger or weaker corporate earnings to new investors recognizing the trend and continuing to pile on (a strength-begets-strength thesis), but regardless, momentum shouldn’t be ignored.

We frequently utilize a particular type of momentum analysis: relative strength. Relative strength compares index or security pricing and looks for a continuation of either outperformance or underperformance, or, alternatively, looks for violations of the relative strength trendline. Put another way, relative strength analysis often seeks to identify inflection points.

A broken trendline may indicate an index or security now ready to outperform or underperform another for an extended period. Again, one of the tenets of relative strength is that momentum persists, so when momentum shifts, the new trend is expected to last. Relative strength analysis won’t tell you how a particular security or index will move directionally, but it can offer clues regarding which one is likely to perform the best.

The hypothetical example below shows ABC Index’s performance relative to DEF Index’s. Relative strength can be graphically illustrated by dividing one variable (e.g., an index value) by another. This relationship is then plotted and examined for trends, trend breakdowns and, ultimately, changes in momentum. Using the hypothetical example, ABC Index could now be set to outperform DEF Index:

ABC index vs DEF Index – an illustrative relative strength breakout

Source: Turner Investments

New momentum may not last (false signals do occur), but analysts look for breaks—either to the upside or the downside—in well-established trendlines to lend additional evidence to an already positive or negative investment thesis. A thesis that should be based on many other factors (e.g., valuations, growth rates, macro factors, potential catalysts and so on).

Encouragingly, we now seen such positive additional evidence for the Canadian market as the S&P/TSX Composite has reached a relative strength inflection point versus the broader US market:

S&P/TSX Composite vs Vanguard Total Stock Market ETF (top chart) – a positive relative strength inflection point for Canadian equities?

Source: StockCharts.com

The S&P/TSX Composite has already performed fantastically well this year, up roughly 17%. But REITs, Canadian banks and pipelines have a massive presence in our equity market. And these are all sectors that have benefitted strongly from lower interest rates and will likely continue to do so.

REITs benefit because lower interest rates reduce mortgage-financing obligations and, generally speaking, increase property values. Canadian banks benefit because lower interest rates will almost certainly reduce future loan-loss provisions, which have been an overhang for the sector in recent years. And pipelines have a predictable, utility-like business structure combined with high yields, making them, to some extent, a high-yield bond proxy. High-yield bonds (and their proxies) have been doing well in the past year as interest rates have come down. It should come as no surprise that REITs, Canadian banks and pipelines all have similar relative-strength breakout patterns versus the broader US equity market.

We’ve seen four rate cuts so far this year from the Bank of Canada, including the big 50 bp cut earlier this week, and many more cuts are expected in 2025. So, there’s reason to think that we may have indeed reached an inflection point for Canadian equities and that our market’s recent outperformance may persist.

Time will tell, of course, and a trendline break is no guarantee that the shift in relative performance will last.

But if momentum gathers—look out. Just ask Nvidia investors.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Investment Advisor, Private Client Group, Raymond James Ltd.

Source: https://www.greaterfool.ca/2024/10/26/theories-of-relativity/