Would you rather own stocks that outperform the stock market or trail it? That rhetorical question captures the essence of the simple but powerful relative strength line.
Relative strength is how investors compare a stock with the broader market. And the relative strength line is nothing more than a performance comparison of a stock or index against the S&P 500.
That day-to-day comparison is plotted with a blue line in IBD Charts and the premium IBD MarketSurge. That gives investors an easy way to visualize relative performance. A line trending higher means the stock is beating the S&P 500; a line trending lower is lagging the stock market.
Simple as it sounds, investors can study the relative strength line to detect important trading signals.
RS Line Helps Find Stock Market Leaders
One of the most useful applications is in evaluating breakouts. When a stock tops the buy point of a proper base, the relative strength line should be making new highs. It's even more bullish if the RS line goes into new highs before the stock does. The Blue Dot in MarketSurge charts shows stocks with bullish base and RS line combinations.
The line doesn't necessarily have to make an all-time high. As long as it's at the highest level during the base-forming period, you're OK. If the line is short of a new high at the breakout, at least make sure it's trending upward.
And if the line is sloping downward as the stock trades near highs, that's a bearish divergence. In fact, if you see a stock on the market that's rising or going sideways while the RS line is falling, that could well be a topping signal.
MarketSurge adds tools to supercharge the relative strength line. Users can add a moving average to the RS line to detect changes in price trends. A rule of thumb is to set the daily moving average at 21 and 50 days, and the weekly chart at eight and 21 weeks.
You can also add a second RS line to track performance vs. the stock's industry group, or even another stock. The RS line also can be changed to compare against an index other than the S&P 500.
When the stock market is weak, any stock that makes a new high while basing should be on your radar.
Amazon And Its Market Moves
In 2020, when the Covid-19 pandemic disrupted retailing, Amazon.com emerged as one of the sector's big winners. Consumers used online shopping to avoid the limited access to stores, and lockdowns caused Americans to splurge on home comforts.
The Covid shock caused the stock market to decline sharply in March 2020. In Amazon's case, the stock fell as much as 26% from a February 2020 peak (1). Amazon shares bounced back and broke out past a 2,185.95 buy point April 14 (2). The stock climbed more than 50% to its next base.
The relative strength line made a new high a few weeks before the stock broke out to new highs (3). Amazon's bases in August-October 2017, December 2017 and March-April 2018 also saw the RS line make new highs ahead of the breakouts. All three bases produced significant gains.
Compare that with Amazon's bases in July 2020 through July 2021. In all three patterns, the RS line was trending lower (4). All three bases failed as the stock market weakened.
