Stock pickers love ratios, but which is the most predictive ratio of all? Value investors often have a bias towards low PE ratios or high dividend yields, growth investors look for high EPS growth while those that prefer a blend often lean heavily on the so-called PEG. All of these ratios have some anchoring in one of the fundamentals of the underlying business - the earnings or dividends of the company. It seems smart to ensure that you are basing investment decisions on business fundamentals but the irony is that the most predictive ratio for future price returns is completely unrelated to the underlying business. It's based entirely on the recent movements in the company's share price and has come to be known as the Relative Strength Index or RSI.
The Relative Strength Index (RSI) was first developed by J Welles Wilder in a 1978 book called New Concepts in Technical Trading Systems. It is not to be confused with the better known plain vanilla Relative Strength which simply calculates the absolute price return of a share (using the starting and end prices over a time period) and compares it to the return on the market index. RSI is a little more complicated to calculate which is perhaps why it has traditionally been used more often by technical analysts and chartists than fundamentally oriented stock pickers. We think this is a shame as recent evidence shows that it may be much more predictive than plain vanilla Relative Strength.
How to calculate RSI
RSI uses all the price changes that occur over a given period in order to derive the average price change. Essential to the calculation is creating the ratio U/D calculated by dividing the moving average of the total price points gained on 'up' days (U) by the moving average of the total price points lost on 'down' days (D). This ratio is then 'indexed' to create a number that moves between zero and 100 as follows:
RSI = 100 - ( 100 / (1 + U/D) )
The reason technicians enjoy the RSI so much is that it can be used as an oscillator and graphically displayed underneath stock charts as depicted in the image below. Wilder believed that readings above 70 signalled an overbought stock whereas readings under 30 signalled an oversold one. RSI has generated a big following amongst day traders who use it over short time periods,…