Stocks are like people -- and with people, as a general rule of thumb, you can really see what they are made of when they go through extreme adversity.

Do they crack?  Do they become belligerent, scared or angry?

I ask myself the same questions when it comes to stocks.  In a weak stock market, all sectors stand naked for the whole world to see.  The flabby and out-of-shape ones have no bull market under which to hide their jelly rolls.

If you really want to boost your overall annual returns, you must have a strategy for exploiting market weakness to your benefit.  You must develop a strategy for identifying the sectors that will lead the next new bull cycle.

Do You Have Such a Strategy in Place?

If not, I’d like to share one of mine with you. 

What I like to do during times like this is to compare the relative performance of multiple sectors over the recent down period.

My first sectors to investigate will be those sectors that are actually showing any gains for the period.

Now, in a broader market sell-off, typically all of the sectors will be showing losses.  What I will do, then, is look at those sectors that are showing the smallest losses.

What we are doing, of course, is analyzing sector relative strength.  We are continually determining which sectors are outperforming other sectors on a relative basis.

But How Do You Measure a Sector's Performance?

This is where Exchange-Traded Funds really help out in the analysis process.  You can use ETFs as sector trackers that will give you a "pulse" on just how each sector is doing versus another. 

You simply find a well-diversified ETF that represents a sector; you do this for all the major sectors.  Then you simply compare their percentage gain performance over a standard period of time.

But let's say that you’ve now found a sector that you want to buy, but the sector has 20 ETFs covering it.

Here’s what you do ...

First of all, you pick a specific time frame during which you want to compare the ETFs' performance.  I will generally use a 12-month period.  However, when we’ve had a big drop in stock prices (such as we do now), I like to use a shorter time frame, typically three months.

The shorter time frame will tell me how the ETF behaved up to and during the market weakness period, and that’s the most-effective way to get the information I need in order to find the real champion. 

Remember, in a bull phase, even a kitten can look like a tiger; it's in the bear phase when we find out who the real jungle cats are.

OK, so now let's assume we are using the three-month time frame to test relative performance.  I will then use a chart service (BigCharts.com is an excellent free resource) to find out where the ETF was trading three months ago and where it is trading today.  (When on Bigcharts.com, be sure to use the "interactive chart" feature.  This will allow you to see the day's open, high, low and close.  For this purpose, only the closing price is important.)

I’ll then pull out my trusty calculator and figure out the ETFs' percentage performance during the past three months.  I will do this for every ETF in the sector that I am interested in.

(Our automated trading service Sector Hunter does the legwork for us. But now you can see how to do some easy research to compare apples to apples, and to profit from the fruits of your labor, in turn.)

After you are done with this process, you will have the clearest picture possible of which ETF to buy.  You're going to buy the strongest.  This means you would want to buy the one that's up the most (or the one down the least) and short the worst performers of the bunch.

Make Off-the-'Charts' Returns

Congratulations!  You just performed your very first peer relative strength analysis!  Next thing we know, it's your face we are going to be seeing on CNBC!

Seriously, though, part of our mission here at Tycoon is to demystify the investment process.  My hope is that this article will prove to be of some worth in furthering that cause.