We’ve written before about using relative strength and sector rotation as our way to find the best Fidelity funds. One simple example is shown in this article about a simple Fidelity Select sector rotation system using just one Select fund at a time. That simple example uses just the one month percentage change in price as the strength metric, and it has done quite well over the years. But it is fairly volatile.

When you are looking at relative strength, it is important to have some idea of the minimum holding period that you expect for your fund selections. For example, for the Fidelity Select System, the Select Funds have a minimum holding period of 30 days, so we need to pick a period for measuring relative strength that is the most predictive for a 30 day holding period. We may come up with a perfect indicator for which way the fund will move tomorrow, but if it doesn’t do a good job of predicting the price movement over our holding period, then it’s of little value.

By the way, when I say “predicting” price movement, we actually don’t do that at all. What we do it try to improve the odds that we will have a better than average change in the price over the next 30 days. We aren’t predicting it will go up, we are simply choosing those funds that have a better than average chance of going up. DO NOT expect that this system will be right much more than half the time. A losing system is a bad system, but losing trades do not necessarily mean you have a bad fund trading system. You have to look at the trades in aggregate.

So, of the Fidelity Select System we looked at a variety of periods to maximize the probablity that we would outperform the market over the next 30 days. As it turns out, the more recent performance is more predictive than the price changes farther back in time, so we settled on an exponentially weighted moving average of the daily percentage price changes. The Fidelity Select trading system looks at the price changes a little over a month back.

Next we will take a look at volatility, and it’s role in selecting funds.