Relative strength is a way to measure the performance of a stock. Relative strength ratings compare a stock’s price change over the last 12 months to those of all other stocks or a specific group of stocks. Results are most often ranked one to 99. A rating of 99 is the highest possible and means the stock has out performed 99 percent of all other issues that it is being compared to. A relative strength of one means nearly all others have done better. Market leaders usually rank 80 or higher.
In short, relative strength is a measurement of how one investment is performing relative to another.
Behavior of the relative strength line is often an early tip-off to a major move in a stock. It will often lead a strong stock higher. If the stock’s price moves to new highs ahead of the relative strength line, the line should make a new high shortly thereafter to confirm the stock’s move. If it doesn’t, the breakout in the stock’s price is probably faulty and will fail.
In a long-term bull market, never assume that a stock that has gone up a lot is through going up. The odds are it will continue to do well. A reading of bull market history shows that strong stocks usually get stronger and weak ones usually get weaker. This is one of the hardest things investors must learn.
Many investors, both general and professional alike, do something known as “bottom fishing.” This means that they buy stocks that are down in price significantly thinking that they are a deal and are close to their lows in price. However, stocks that lag the market typically continue to be laggards. Conversely, leaders tend to move higher. In practice, what seems to be expensive and risky to many investors usually keeps moving higher and what seems inexpensive and safe tends to move even lower.
Over the last 60 years stocks that gain to a relative strength of approximately 87 then make their major market moves. In other words, the greatest stocks were already outperforming nearly nine of 10 others before they took off and doubled, tripled, quadrupled or more.
Indexes and averages can be compared to one another through relative strength as well. For instance, relative strength lines are plotted for the NASDAQ market compared to the New York Stock Exchange. In this way investors and analysts can determine how one market is performing against another or one average against another.
Relative strength is just one of the technical tools available to investors. However, like all other tools this column continually reminds its readers that no tool or, even using a combination of tools, are of no use if investors abandon them at the wrong time. Usually this happens when greed grips investors on the upside as rapidly rising prices pull investors into the market like “iron filings to a magnet.” The same happens when fear grips investors on the downside as rapidly falling prices push investors out of the market. It is often during these two times that investors, professional and general alike, abandon their tools as emotion takes over.
Quote of the week: “The world steps aside to let any man past, if he knows where he is going.” — unknown
Bart Ward is the chief executive officer of Ward & Co. Ltd., an Anoka-based registered investment adviser – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.