Relative Strength

Relative Strength (RS) is used to compare a stock or industry group with a measure of the market. It is an invaluable concept for trading and investing because it tells us which securities are likely to out perform others. In other words, it tells us what to buy and what to avoid.

The RS is calculated by dividing one security by another. The result is then plotted on a chart, creating a continuous line as multiple dates are calculated. Just like price, it moves in trends and can be analyzed with moving averages, trendlines, oscillators of relative action, and so forth.

Relative strength has two valuable applications. First, it makes it possible to compare the performance of a sector of the stock market to the market itself. This handy tool identifies sectors with rising RS lines; i.e., sectors that are out performing the market. Once you have isolated a favorable sector, the next step is to search for stocks within the sector that have an attractive technical position.

The RS’ second use is that it compares one market or asset class with another; e.g., stocks with commodities, gold with bonds, etc. This is an invaluable tool because it reveals the best performing asset classes. Also, since certain sectors do well at different points in the primary trend cycle, their relative action can be used as a crosscheck to give your analysis greater accuracy. For example, basic materials should be out performing the market at mature stages in the stock and business cycle when capacity constraints are greatest and interest rates are rising. This example is comparing two financials that are interest-sensitive and normally under perform at this point in the cycle. If the RS line for financials is rising and the line for materials is falling, it clearly shows the cycle is not in a mature phase, but more likely in a relatively early stage of recovery.

Analyzing Relative Strength

Relative strength is typically plotted under the series it is monitoring, as shown in Figure 1. When the RS line is rising, it means that the stock or sector is out performing the market. When it’s falling, it’s under performing.

Quite often we see a situation where the price makes a new high but the RS does not. This indicates the price is being pulled ahead more by buoyancy in the general market, rather than the underlying upside momentum of the plotted security. This is often a subtle warning the price may be about to reverse trend, as well. When the market finally does turn, this particular entity will be more vulnerable than most, since its RS line has already begun to weaken.

Figure 1

A second principle is that relative price, like the absolute price, moves in trends. Relative trends can be analyzed the same way as absolute prices with moving averages, trendlines, momentum, etc. Having said that, relative action tends to be more volatile, which means that it is not as receptive as the absolute price to moving average crossovers. With absolute price, reliability tends to increase with time. The same is true for relative action. For example, 12-month MA crossovers of RS lines tend to be reasonably accurate, whereas 30-day crossovers are far more random in nature.

Figure 2

Figure 2 compares an RS line to the price in a downtrend. Prior to the price making a new low, the RS line experiences a series of rising bottoms. This tells us that the security in question is not as weak as the market itself is. In other words, while the price is falling, it is not falling as fast as the market. This means, that if the positive trend of relative action is extended, the security will rise faster than the market when the market finally turns. You will notice the emphasis on the relative trend “extending”. I’ve brought this to your attention as a warning because market turning points are occasionally flagged by changes in sector leadership, so there is no guarantee that when the market itself reverses, the positive RS trend will extend. Assume it will, but you still have to be on the look out for a possible reversal. Just as the negative RS divergence was a bearish factor in Figure 1, the positive divergence is a bullish factor in Figure 2. You’ll notice that the RS line broke out above a down trendline just after the final low in price. This indicated

Chart 1

that the trend in relative action was firmly in the bullish camp. It’s important to remember that a rising RS line does not mean the plotted security is advancing in price, only that it is out performing the market. If the market declines 20% and our security loses 10%, the RS line will still rise because the loss in the security is smaller than the overall markets’ loss. This is why it’s always important to make sure the absolute price action confirms what the RS line is telling you. In this example, it happened to be the trendline violation shown in Figure 2, where the arrow joins the positive RS to the absolute price trend break.

Practical Relative Action Uses

Chart 1 is a good example of how to use the RS concept to trade markets. The arrangement consists of the price and an oscillator together with the RS line and its oscillator. I have used the Daily KST but there’s no reason why another smoothed oscillator, such as the MACD, or Stochastic, could not be substituted because the principles of interpretation are the same. Look for situations where the iShare Semiconductor is oversold and momentum is beginning to bottom. An example develops in late April (green arrows). You can also see that RS momentum is bottoming around the same time. It’s a buy signal when both the price and RS confirm with trendline breaks. Then, both oscillators peak out in early June, and again in July. Each situation is followed by a correction, but there is no corresponding trend break in either the price or the RS line. The peaking of the oscillators is a sign that you should be considering some level of profit taking, but don’t forget that a full-fledged sell signal requires a confirmation in the price and RS line. The confirmation finally comes in September, when the oscillators peak out at a lower level and a trendline can be drawn for each series that is ultimately violated.

Chart 2 shows a classic example of why positive RS action needs to be confirmed by the price. You can see that the false October 2005 break in the RS line was not confirmed by the price, or by the absolute KST. However, in December it’s a completely different story since all four indicators confirm each other in the bullish camp and the French iShare moves to the upside. Not only do they signal that the iShare will likely to go up in price, but that it is also likely to out perform the S&P Composite.

Chart 2

Remember, the power of relative strength is that it directs you to what you should be buying. But since you can’t buy and sell relative strength, it is vital to wait for a trend reversal signal in the price prior to taking action.