Spotting Relative Strength

Ever notice what good – I mean, really good – traders are actually looking at on a stock chart? They have price and volume, of course, but at most, maybe 2 to 3 additional indicators on there. Nothing is particularly sophisticated about what they do. And they’ll admit as much.

It’s a point of pride for them, actually. Because instead of getting bogged down by hundreds of conflicting indicators, they’re evaluating just one thing: demand. And for this reason, the indicator of choice for most expert traders is Relative Strength.

Relative Strength (RS) separates leading stocks from laggards. The RS rates the price performance of a stock relative to the S&P 500 over the past 12 months and is assigned a rating from 1 (the lowest) to 99 (the highest). A stock with a 99 RS is outperforming 99% of all other companies in terms of price increase.

What’s more, RS can identify stocks in very early stages of their big move.

First discovered by William O’Neil at the Investor’s Business Daily, he noted that “the average RS rating of the best-performing stocks each year from the early 1950s through 2000 was 87 before their major run-ups.”

That’s significant.

In today’s world, we can see the power of RS playing out over and over again. Below is a chart of Coupa Sofware (COUP) which sported a superb RS rating in December 2019 prior to its +100% move over the next 6 months.

It’s very subtle, but note how the price of COUP “behaves” relative to the S&P 500, Dow Jones and Technology sector. In December, when these major indices (reflecting most stocks) were making new lows, COUP only went down as far as its prior low. Basically, the price of COUP was not going down as much as other stocks.

That’s relative strength.

Ultimately, what is happening here is a basic lesson in supply and demand. For traders who would rather study the VIX or MACD – indicators with cool-sounding names and confusing outcomes – it’s easy to start yawning here.

But when markets go down and enter “corrective periods,” financial institutions begin looking for names they’d like to own at reasonable valuations. As they begin to buy those stocks, those prices will begin to slow their descent – at least relative to other stocks. This creates the situation in COUP where the market is making new lows, but COUP isn’t. COUP is being accumulated. Demand is in effect.

The interesting part is when the market finally begins to rebound. What do you think will happen to COUP? The demand in COUP will be so great (from additional buyers now) that the price has no choice but to rise – often explosively.

And that it did. Shortly after 2019 began, COUP broke-out from $65 and cleared $130 by late June – 100% gain in 6 months.

Here is another stock, Zscaler (ZS) which about the same time as COUP was trending sideways between November and December of 2018. At the time, all major indices and the technology sector (of which ZS is a part) was making lower lows. But not ZS.

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Again, look at the prices of ZS between October and December. Those prices are moving sideways while markets continues to make fresh lows. ZS is being accumulated.

Remember, most traders seek out the most sophisticated indicators money can buy, thinking the more sophisticated the metric, the more profitable. The opposite is usually true. In fact, profitable traders depend on this very natural compulsion to exploit their own edge – evaluating boring ole’ supply and demand.

Bottom line: Begin training your eyes to spot anomalies in stock prices vs. similar sectors and the broader market. You may just find your next big winner.

Relative Strength separates leading stocks from laggards. #RS Click To Tweet
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Again, look at the prices of ZS between October and December. Those prices are moving sideways while markets continues to make fresh lows. ZS is being accumulated.

Remember, most traders seek out the most sophisticated indicators money can buy, thinking the more sophisticated the metric, the more profitable. The opposite is usually true. In fact, profitable traders depend on this very natural compulsion to exploit their own edge – evaluating boring ole’ supply and demand.

Bottom line: Begin training your eyes to spot anomalies in stock prices vs. similar sectors and the broader market. You may just find your next big winner.

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August 10, 2019

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Great blog Gabe!

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