Dan Sullivan has been publishing The Chartist since 1969, and without a doubt, is of the best in this business. Over nearly four decades, he has been extremely successful in combining a market timing strategy with a relative strength stock selection process. If any one mantra reflects his approach it is buy high, sell higher.

Says Dan, “The real secret to achieving long lasting financial success is the development of an overall investment strategy. We have an ironclad discipline. Profits are allowed to run, while losses are cut quickly.”

This approach clearly has its merits; The Chartist consistently ranks among the top-performing newsletter monitored by The Hulbert Financial Digest.  A second newsletter, The Chartist Mutual Fund Letter, was launched in 1988 to apply similar principles to fund investing.

Dan takes a technical view towards the market and stock selection. Although he considers and reviews a stock’s fundamentals, his buying decisions are based on a stock’s recent performance.

He explains, “The basic idea behind relative strength is the belief that stocks which are stronger than its peers will appreciate to a much greater degree than the average issue. Relative strength is calculated by comparing a stock’s performance to the market as a whole. In every bull market a select group of stronger-than-market stocks (high relative strength) will invariably emerge as the leaders and outperform the averages by a wide margin.”

Unlike many newsletters that are continually seeking the best-positioned stocks, Dan combines his relative strength selections with a proprietary timing system, with the goal of being invested only during bull phases, while staying out of the market during bearish periods.

He notes, “We base our investment decisions on the price action of individual stocks and the status of our proprietary Consensus Model, which tells us if the market is in an uptrend or a downtrend.” This timing model is comprised of three sub-models – momentum, Monetary, and Trend. Let’s take a look at each:

The Momentum Model measures the velocity and thrust of the market. Says Dan, “Our experience and extensive research indicates that virtually all bull markets begin with an initial surge. During these periods, the market’s breadth readings (advancing versus declining stocks) will be exceptionally strong and the majority of stocks will be participating in the rally.”

The Monetary Model gauges the direction of interest rates. Dan explains, “There is a direct correlation between the movement of interest rates and stock prices. Favorable monetary conditions (declining rates) provide the catalyst for bull markets. Conversely, rising rates hinder the upward movement of stock prices as fixed-rate investments becomes more attractive to investors.”

The Trend Model identifies market moves that are not preceded by a strong initial surge, but ones that move at amore consistent pace. Dan notes, “Based on broad market averages, this model determines the internal strength of the market. A positive reading means the risk levels are low and the odds favor a continuation of the upward trend.”

In order for Dan’s system to issue a buy signal, two out of three of his indicators must be positive. Once this system suggests that stocks have entered a bullish phase, Dan then uses relative strength for his stock selection process. Convincing investors to buy at the early stage of a bull market is a difficult task.

He notes, “Most investors are afraid to move boldly into the market in the early stages of a bullish cycle. Their apprehension is understandable because they have just come through a bear market cycle and are not at all sure that a new bull market is actually underway. But it is imperative that you are invested in stocks very early in the cycle.”

Not only should investors buy at a time when it is psychologically difficult to do so, they must also invest counter to the traditional theory of buying low and selling high.

Says Dan, “At first glance, our methodology appears to be quite simple. Buy the stocks that have appreciated the most. Unfortunately, it is difficult to do this in practice because the methodology we use calls for purchasing stocks after they have already made significant gains. The average investor finds this psychologically difficult to do because it is just the opposite of conventional wisdom. “

Dan also notes that relative strength can be a double-edged sword. He says, “These stocks have the potential for outsized gains in bull markets, but will also be among the hardest hit during bear markets.” Indeed, cutting one’s losses is a critical factor in Dan’s approach and a main reason for his long-term success.

To help protect against loss, Dan advocates the use of stop losses. For those unfamiliar with a stop loss, they are an order to sell a given stock any time it drops below a specified price. One can place an actual stop loss, which will be executed automatically.

A mental stop is simply a point at which the investor decides in advance at which they will sell, and it is then up to that investor to execute the sale. Whether one uses an actual stop or a mental stop, Dan considers a stop loss of 10% to 15% below one’s purchase price as appropriate. Dan then raises this stop level as a stock rises.

He explains, “It is essential to cut your losses quickly, before they become unmanageable. I cannot stress the importance of this enough. Yes, threw ill be times when that stock turns around and goes up. But remember, your success lies in following an overall strategy. Over the years, I have seen far too many portfolios riddled with huge losses simply because an investor was unwilling to admits a mistake. Don’t let this happen to you.”

One note of caution is necessary. Dan uses margin to leverage his positions. He does this only at the outset of a long-term buy signal and under strict trading rules. Despite his strict adherence to these rules, investors need understand that margin entails additional risks and should only be considered by those investors fully aware of the potential losses that could be incurred from this strategy.

For both his stock market and fund services, Dan is cognizant that the greatest value of his approach is its strict adherence to a time-test and proven discipline. He notes, “We do not make predictions or pretend to have a crystal ball. Instead, we let the market be our guide. When we buy, we rely on the price action of the market to let us know if we are right or wrong. If we are wrong, we simply get out of the market and wait for a more a more opportune time.”

Dan continues, “The reason that thousands of intelligent people have had poor results in the market can be directly attributed to their ability to deploy a patient, disciplined strategy in which losses are cut short before they come unmanageable. Conversely, when they have a winning stock they are too quick to sell. We do it just the opposite in that we are quick to sell off our losers and we part with our winners very slowly. It only takes one stock with gains of 300% to more than make up for a host of small losses.”

I’ve always been incredibly impressed with Dan and his work. In particular, I like that he not only believes his advice is right for his subscribers, but for himself as well; he does buy and sell the same positions that he recommends to his readers. Overall, his relative strength approach has always struck me as a terrific  enhancement of the more common momentum–based advisory strategies.

And while many have copied his approach over the years, few if any have been as successful in putting the theory of relative strength into action. He remains committed to a strict discipline that has proven its mettle for 40 years. For those willing to overlook a strictly fundamental approach and focus rather on a stock’s already-proven strength, Dan’s The Chartist, by all measures, is the relative strength winner.