Relative Strength

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There are a myriad of ways to calculate relative strength. Many software packages have their own formulas for scanning through charts and assigning relative strength values to them. Investor's Business Daily (IBD, also short for inflammatory bowel disease) includes a figure for relative strength in its listings.

But you really are better off without all of the fancy formulas and calculations. Because we're honing in on just one or two hot sectors at a time, we find it far more reliable to just watch the top 5 stocks in the sector/s on a daily basis. This gives you a feel for the stocks, which you don't get by relying on relative strength figures.

Relative strength, in its purest form, is simply a comparison of a stock's performance relative to a baseline. The baseline should be diversified, so the indexes are used. A quick glance at a group of stock charts is all you need to pick the relative strength leader. Times of broad market weakness are not only the best times to compare relative strength, they're also the times when you'll do your buying. So while you may not like market corrections, they are an essential part of your success, and you should eagerly await them.

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We've posted 4 charts above. The first is our baseline, the Nasdaq. You could use any index for this, but we chose the Nasdaq because its moves have been textbook, from its nearly perfect S-curve to its nearly identical double bottom.

The S-curve started off this whole "Big Fat Greek and then some BP worst environmental disaster in U.S. history" correction. Once we were in it, we had no choice but to use it as a way to ferret out the highest relative strength LED issue.

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In chart #2, the chart of CREE, you'll see that CREE's bottoms roughly align with the bottoms of the Nasdaq. That is, they are all kind of in the same area. CREE's relative strength is flat. In other words, it is just mirroring the moves of the market, nothing less & nothing more. Of course it will move at a higher percentage than the index, but relative strength does not factor in percentages, it merely distinguishes between which stocks have buyers and which don't.

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The chart of VECO shows a stock with weak relative strength. Each low was lower than the last, despite the broader market being able to hold its bottom. Once our top holding, we sold VECO when its relative strength came into question. With Friday's performance, VECO is redeeming itself. We will only know in hindsight if VECO's severe correction was just a panic, or company-specific problems. Its fundamentals still appear strong, but we feel that we're better safe than sorry... where there's smoke there's fire. We may repurchase VECO at some point, but are still concerned that its weakness during the correction may be a window into some "behind the scenes" issues.

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The last chart is a chart of RBCN, which swept us off our feet during the correction. Each low was higher than the last. Charts that exhibit this kind of strength during periods of market weakness are the first to make new highs when the market turns around. They also most often do tremendously well during the subsequent bull run. The mechanics of it are simple... there are few sell orders during the months of the correction. For whatever reason, people want to hold this stock. So when buyers return to the market, the buy orders overwhelm what few sell orders exist, and the stock rallies strongly. The reason people don't want to sell this stock (or any other stock with high relative strength) is typically not known to the retail investor for several quarters. We are not privvy to the boardroom discussions, factory visits, wildly complex formulae, and other shenanigans that go into determining which companies are poised for explosive growth. Despite being left out of all of this, they do inadvertently give us a very valuable treasure map... the chart.