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A Powerful Investing Tool: Know a Stock's Relative Strength
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A recent post of mine on social media about relative strength received a lot of interest, so I figured that I would write a commentary about it. In the post, I illustrated the power of relative strength, or what I call RS, saying, “I’ve studied hundreds of indicators, both technical and fundamental, and nothing comes remotely close to relative strength (raw, not RSI).”
What is Relative Strength?
Relative Strength (RS) is a price-based analysis used by market technicians and traders to evaluate a stock’s price performance versus the performance of a benchmark such as the S&P 500 Index, an industry group, or an underlying commodity.
Before I jump into the “nuts and bolts” of how I have successfully implemented relative strength in my investing career, there are three common misconceptions I want to debunk, including:
1. RS is NOT a Signal: Relative strength is a secondary indicator, which means that I use it in conjunction with other analysis and will never take a trade based solely on RS.
2. There are Many Ways to Use RS: Today, I will discuss how I use RS, but understand there are many methods and ways to utilize it. What works for me may not work for you. Nonetheless, perhaps by reading this article, you can grasp some “golden nuggets” and learn to use RS within your investment framework or use a hybrid version of my approach.
3. RS is Different From RSI: I implement what I call “raw RS,” which is different from the popular Relative Strength Index (RSI) that many traders use. RSI is an oscillator, which I think has value, but that’s for another time.
How RS is Like a Beach Ball Underwater
Think of a stock as a beach ball and a poor (down) market as someone holding the beach ball underwater. In a down market, a stock that continues to bounce surface or resist the market weakness is worth watching further. Another way to think about RS is to think of a tennis ball versus an egg. When an egg hits the ground, it breaks (weak stock), and when a tennis ball hits the ground, it bounces (strong stock).
Why is Relative Strength such a Powerful Indicator?
Historically, roughly 75% of a stock’s move is correlated with the S&P 500 Index. In other words, most stocks move up in bull markets and fall in bear markets. When a stock refuses to move lower in a downward market, the stock is sending out a big clue. What will happen when the market steadies if you can’t bring the stock down in a bearish market? In an overwhelming majority of instances, the stock that held up best during the market’s downtrend dramatically outperforms. For this reason, it’s best to look for relative strength when the market is weak because RS candidates will stick out like a sore thumb.
RS Examples
In my personal investing framework, I utilize RS in various situations and for various timeframes. Here are three real-world examples from my trading history.
Bear Markets Breed Opportunity: Super Micro Computer
The best time to look for long-term RS opportunities is within a bear market. New, inexperienced investors tend to get frustrated and give up during bear markets. Conversely, savvy investors understand that bear markets present easily identifiable extremes. Further, history proves that even the most bear markets eventually recover and can provide rich opportunities. The year 2022 was one such example. As inflation soared, interest rates rose, and war broke out in Europe, the Nasdaq 100 ETF ((QQQ - Free Report) ) suffered its worst bear market in years, falling more than 30%.
High-valuation, fast-moving, growth-oriented stocks such as Nvidia ((NVDA - Free Report) ) were slammed as investors went full “risk-off.” However, in Q4 2022, Super Micro Computer ((SMCI - Free Report) ), a high-octane growth stock, printed fresh 52-week highs while the S&P 500 and Nasdaq hit 52-week lows. Sure enough, after stocks bottomed, SMCI became a leading stock and has provided multi-bag gains since.
Image Source: Zacks Investment Research
The beauty of RS is that investors did not have to understand that “smart money” was betting SMCI would be a leader in the coming Artificial Intelligence (AI) revolution. Instead, investors merely had to notice that the stock was exhibiting standout relative strength.
Price Action Versus News
Another powerful way to use RS is to evaluate how a stock acts relative to how it “should” be acting. In June 2023, the Securities and Exchange Commission charged Coinbase Global ((COIN - Free Report) ) with operating its crypto asset trading platform as an unregistered exchange. As expected, shares dove on the news, losing 17% for the week. However, over the next two weeks, COIN recuperated 14% of those gain, which was a sign of relative strength. Over the next three weeks, the stock would rise 69%.
Image Source: TradingView
Relative Strength Versus a Commodity or Industry
My most recent windfall trade attributed to RS was in the crypto sector. When trading a stock based on RS, looking at the stock in a vacuum is not enough. Instead, one should evaluate how the stock acts in relation to its industry peers and an underlying commodity. Bitcoin fell 4.33% during the week of June 10th and 5.21% during the week of June 17th, dragging several Bitcoin proxies like MicroStrategy ((MSTR - Free Report) ) with it. However, Marathon Digital ((MARA - Free Report) ), a leading Bitcoin miner, rose 1.04% during the week of June 10th and lost a minuscule 1.34% the following week – exemplifying classic relative strength.
When Bitcoin finally bounced more than 5% on July 1st, MARA broke out of a picture-perfect bull flag pattern and gained more than 14% in a single session.
Image Source: TradingView
RS Tips & Tricks
Sort your watch list by % change on down days and focus on the stocks that hold up best.
Contrary to popular belief, down markets are far more valuable than up markets.
Observe the action in sister stocks and related commodities to understand your stock’s strength better.
Use RS to gain an edge and conviction, but also use it in concert with a full investing framework.
Observe how a stock reacts in the wake of poor news. Poor news is bullish if a stock rises in the face of it.
Bottom Line
Relative Strength, or RS, is the most powerful indicator I have studied throughout my investing career. Better yet, RS works off common sense, is easily observed, and will get you in the strongest stocks.
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A Powerful Investing Tool: Know a Stock's Relative Strength
A recent post of mine on social media about relative strength received a lot of interest, so I figured that I would write a commentary about it. In the post, I illustrated the power of relative strength, or what I call RS, saying, “I’ve studied hundreds of indicators, both technical and fundamental, and nothing comes remotely close to relative strength (raw, not RSI).”
What is Relative Strength?
Relative Strength (RS) is a price-based analysis used by market technicians and traders to evaluate a stock’s price performance versus the performance of a benchmark such as the S&P 500 Index, an industry group, or an underlying commodity.
Before I jump into the “nuts and bolts” of how I have successfully implemented relative strength in my investing career, there are three common misconceptions I want to debunk, including:
1. RS is NOT a Signal: Relative strength is a secondary indicator, which means that I use it in conjunction with other analysis and will never take a trade based solely on RS.
2. There are Many Ways to Use RS: Today, I will discuss how I use RS, but understand there are many methods and ways to utilize it. What works for me may not work for you. Nonetheless, perhaps by reading this article, you can grasp some “golden nuggets” and learn to use RS within your investment framework or use a hybrid version of my approach.
3. RS is Different From RSI: I implement what I call “raw RS,” which is different from the popular Relative Strength Index (RSI) that many traders use. RSI is an oscillator, which I think has value, but that’s for another time.
How RS is Like a Beach Ball Underwater
Think of a stock as a beach ball and a poor (down) market as someone holding the beach ball underwater. In a down market, a stock that continues to bounce surface or resist the market weakness is worth watching further. Another way to think about RS is to think of a tennis ball versus an egg. When an egg hits the ground, it breaks (weak stock), and when a tennis ball hits the ground, it bounces (strong stock).
Why is Relative Strength such a Powerful Indicator?
Historically, roughly 75% of a stock’s move is correlated with the S&P 500 Index. In other words, most stocks move up in bull markets and fall in bear markets. When a stock refuses to move lower in a downward market, the stock is sending out a big clue. What will happen when the market steadies if you can’t bring the stock down in a bearish market? In an overwhelming majority of instances, the stock that held up best during the market’s downtrend dramatically outperforms. For this reason, it’s best to look for relative strength when the market is weak because RS candidates will stick out like a sore thumb.
RS Examples
In my personal investing framework, I utilize RS in various situations and for various timeframes. Here are three real-world examples from my trading history.
Bear Markets Breed Opportunity: Super Micro Computer
The best time to look for long-term RS opportunities is within a bear market. New, inexperienced investors tend to get frustrated and give up during bear markets. Conversely, savvy investors understand that bear markets present easily identifiable extremes. Further, history proves that even the most bear markets eventually recover and can provide rich opportunities. The year 2022 was one such example. As inflation soared, interest rates rose, and war broke out in Europe, the Nasdaq 100 ETF ((QQQ - Free Report) ) suffered its worst bear market in years, falling more than 30%.
High-valuation, fast-moving, growth-oriented stocks such as Nvidia ((NVDA - Free Report) ) were slammed as investors went full “risk-off.” However, in Q4 2022, Super Micro Computer ((SMCI - Free Report) ), a high-octane growth stock, printed fresh 52-week highs while the S&P 500 and Nasdaq hit 52-week lows. Sure enough, after stocks bottomed, SMCI became a leading stock and has provided multi-bag gains since.
Image Source: Zacks Investment Research
The beauty of RS is that investors did not have to understand that “smart money” was betting SMCI would be a leader in the coming Artificial Intelligence (AI) revolution. Instead, investors merely had to notice that the stock was exhibiting standout relative strength.
Price Action Versus News
Another powerful way to use RS is to evaluate how a stock acts relative to how it “should” be acting. In June 2023, the Securities and Exchange Commission charged Coinbase Global ((COIN - Free Report) ) with operating its crypto asset trading platform as an unregistered exchange. As expected, shares dove on the news, losing 17% for the week. However, over the next two weeks, COIN recuperated 14% of those gain, which was a sign of relative strength. Over the next three weeks, the stock would rise 69%.
Image Source: TradingView
Relative Strength Versus a Commodity or Industry
My most recent windfall trade attributed to RS was in the crypto sector. When trading a stock based on RS, looking at the stock in a vacuum is not enough. Instead, one should evaluate how the stock acts in relation to its industry peers and an underlying commodity. Bitcoin fell 4.33% during the week of June 10th and 5.21% during the week of June 17th, dragging several Bitcoin proxies like MicroStrategy ((MSTR - Free Report) ) with it. However, Marathon Digital ((MARA - Free Report) ), a leading Bitcoin miner, rose 1.04% during the week of June 10th and lost a minuscule 1.34% the following week – exemplifying classic relative strength.
When Bitcoin finally bounced more than 5% on July 1st, MARA broke out of a picture-perfect bull flag pattern and gained more than 14% in a single session.
Image Source: TradingView
RS Tips & Tricks
Bottom Line
Relative Strength, or RS, is the most powerful indicator I have studied throughout my investing career. Better yet, RS works off common sense, is easily observed, and will get you in the strongest stocks.