Relative Strength Line Leads Way Through A Choppy Stock Market
There are bull markets and bear markets. But in the world of stocks, the cruelest beast of all is a choppy market.
In a bull or bear market, there is a well-defined trend. The attentive investor can avoid the worst of the bear by quickly standing aside, watching from the sidelines as the market falls.
But a choppy market offers no trend. It first feigns a seductive rally, then just when it appears money is to be made, pulls back. Stocks break out, then sputter, falling back near the proper buy point or below it. The overly aggressive investor dies a death by a thousand cuts as trade after trade frustratingly ends with a small loss.
Once you recognize you're in such a market, it's often best to keep your investments small. Don't get fully invested. Take profits quickly. Cut losses even more quickly.
One tool that can help the investor in this circumstance is a stock's relative strength line. It should be holding up and moving higher. That tells you your stock is outperforming the broad market.
IBD's RS line is a simple but powerful concept. The closing price of a stock each day is divided by the S&P 500. That fraction is plotted on both the daily and weekly chart.
It's the trend that counts. If the RS line is rising, that means your stock is outperforming the S&P 500 — even if your stock was down for the day. If the line is falling, your stock is underperforming.
After the market has been in decline for a time, a new batch of leading stocks should emerge. Those are the ones to focus on.
Potential market leaders will firm up and begin rising even while the market is still in decline. This is because the smart money realizes the company has great fundamentals and potential for further growth. The top fund managers use the correction in the general market as an opportunity to accumulate shares.
Typically, in the early stages of a new bull market — just when you want to be buying — the RS line will often go to a new high before the stock does and sometimes shoot up almost vertically.
IBD readers get an added bonus from the relative strength concept: the Relative Price Strength Rating.
Using a proprietary formula, each stock is ranked by its relative performance over the past year, with extra emphasis given to the past three months.
Then, each stock is ranked on a 1 to 99 scale. A stock with a Relative Price Strength Rating of 90 or higher is in the top 10% of stocks in overall market performance. In general, investors should limit themselves to stocks with 80 Relative Strength Ratings or above.
Look at F5 Networks (FFIV) in 2009. Even as the market was in free fall in the early part of the year, F5's RS line was holding its own. Then, starting in March, the RS line went nearly vertical (1) as the stock climbed sharply for five straight weeks.
March 12 was a Day 5 follow-through day by the S&P 500. Its 4.1% blast higher in heavier trade signaled the beginning of a big bull market.
On May 20, F5 broke out past a 29.63 handle buy point within a deep cup. F5's Composite Rating was 97; the EPS Rating was 95 and the RS was 77.
The market grew choppy in May through July, but F5's RS line kept an upward slope. By year's end the stock rose 81%.
