The Technical Indicator That Uncovers A Stock's True Strength

Jim Woods's picture

Tuesday, October 21, 2014 - 7:30am

by Jim Woods

What's the first rule of successful real estate investing? Of course, you just said to yourself, "location, location, location." Well, when it comes successful equity trading, the first rule that should come to your mind is "price, price, price."

More specifically, it is the share price performance of a stock or ETF relative to other stocks and ETFs traded in the market that is the most important metric to put in your favor. 

If a security you are looking to buy has a proven track record of outperforming others in the broad market, or within its specific industry group, then that tells you others on Wall Street think there is something special about it that makes it worth buying.

This "something special" could be a variety of things, including a proven track record of strong revenue and earnings growth, e.g., Walt Disney (NYSE: DIS); a breakout product or game-changing service, e.g., Netflix (NASDAQ: NFLX); a high-demand personal technology product, e.g., Apple (NASDAQ: AAPL); or a brilliant CEO, e.g., Elon Musk of Tesla Motors (NASDAQ: TSLA). 

Whatever the reason, or combination of reasons, the price performance relative to the rest of the market will tell you more about what the market thinks about that security than any other fundamental ratio or so-called "valuation" metric you will ever use. 

The chief way to assess share price performance relative to the rest of the market is an indicator called relative strength (RS). This indicator assigns a numerical score to a stock based on its price performance relative to other stocks in the market. 

The RS rank gives you a great sense of how strong a stock has performed compared to the rest of the market. And though past performance isn't a guarantee of future results, a stock or ETF with a strong RS rank is far more likely to continue outperforming the rest of the market than those with a low RS rank.

So, what is a "strong" RS rank? RS ranges from 0 (weakest) to 100 (strongest). When I look for stocks to trade, I want to see a RS rank of at least 70, meaning it has outperformed 70% of all other stocks in the market over the past six months. 

The 70 threshold here is the minimum level, and the reason why is because with so many stocks to choose from, why try to pick one that hasn't shown market-beating performance?

Think of it like trying to bet on professional sports. When you are looking to pick winning teams, do you look at the teams with losing records first and hope they pull off an upset? Or, do you look at teams with winning track records and bet on those to win based on their relatively better records?

Any successful sports gambler will tell you the odds of success are greater when you bet on teams with a winning record. Sure, you may be the victim of a big upset occasionally, but most of the time betting on the team with the better record (particularly over time) will net you the best results. Well, it's the same for equity trading, and in this sport, RS is the way to keep track of a winning record in the markets.

Now, over the past several decades, there have been numerous academic studies demonstrating the importance of relative strength when it comes to successful stock selection. The latest study is the work of Prof. Eugene F. Fama at the University of Chicago. In his Nobel Prize-winning research, Fama showed that relative strength was one of the three factors identified as the biggest drivers of stock prices. 

Before Prof. Fama, there was James P. O'Shaughnessy, who studied 46 years of market history and concluded that stocks with high relative strength significantly outperformed the overall stock market. 

Other high-profile research advocating for the use of relative strength includes market luminaries such as Investor's Business Daily chairman and founder William O'Neil, famed investor Jesse Livermore, and market pros H.M. Gartley and Robert Levy.

For traders looking to identify winning stocks, the most important thing is price, price, price. Once you've put that factor on your side via a strong RS rank, the rest of your undertaking becomes a whole lot easier.

Note: You've probably never heard of the Alpha Score. It's a proprietary stock market indicator based on RS, but it's never been revealed to the general public. In the past six months, it's flagged 71 stocks right before they shot up 10%... 33%... even 61% in just 14 days. Get the name of its latest "buy" here, free of charge.

Jim Woods does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.