One of the most popular indicators of strong stocks is Relative Strength (RS), which measures a stocks performance against the market or selected index. Sometimes it is confused with Relative Strength Index (RSI) which is a momentum indicator/oscillator made popular by J. Welles Wilder. I first learned about RS through reading Investors Business Daily when I first got interested and trading in stocks in the summer of 2007.
I am a big fan of RS and if you see charts I post through Twitter/Stocktwits you will see the RS indicator with RS Average of 21-periods (roughly a month) in a pane with volume below it. Example shown below is a 9-month Google (GOOG) chart with RS pane enlarged. The green line is the RS and the purple line is the RS average:
While most platforms will use the S&P 500 to measure the individual stock performance against, I choose to use the Russell 3000. I like to use the Russell 3000 (RUA) as it compromises of 98% of the market while leaving out that 2% that can display extreme volatility everyday. I just find this as a perfect metric of the overall market to incorporate all pertinent stocks instead of using the S&P 500, Nasdaq, or Dow. If I see a stock making a higher RS vs. the previous day then I know it is outperforming the true market (or market of stocks) that is not limited to the the top market cap companies or those specific to an industry.
Now the problem with Relative Strength:
I like to think of RS as a double-edged sword. Before I get bashed, remember that it is a top indicator of mine. The problem where traders may rely too much on it is if the market stalls or regains its footing, then it is valuable. The other side of the sword comes in if the market continues to drop. I am a believer in a rising tide lifts all boats. With this, if a stock is holding up against the market firmly (showing strong RS) then that stock may be the most susceptible to a sell-off that hasn’t been displayed yet such as in other stocks. In other words, if it is a sellers market then these are the stocks to look at and sell for some hopeful big gains. I am a bull and think it is easier to trade as a bull, but when the market is being liquidated then it is your job to seek these stocks that have high RS or just go to cash altogether. I have learned that it is difficult to short outside of a swing and I don’t play short trades much and have opted to go to cash instead. But that is just me.
If you are looking for some examples just look at December 2008 and July 2011 when we saw liquidation and nothing else in the market. Off the top of my head stocks like JNJ, PG, KMB or those other stocks in the Consumer Staples or Healthcare industries that are deemed to be “safe” also saw selling that was enough to trigger stop losses. It is important to remember that mutual/hedge funds are supporting those stocks but when they are ready to sell it then no indicator, not even Relative Strength, holds a meaning….liquidation is I want out now and nothing else.