Momentum analysis of a stock’s Relative Performance is one of our favorite ways to measure a stock’s health. A stock that holds its value during a declining market often soars once the market turns higher. In a strong bull market, most stocks will rise, even the stocks of weak companies!
But you should concentrate your efforts on the best companies with the strongest stocks, the market’s leaders. The way to find them is by analyzing RP lines.
Specifically, Relative Performance is calculated by dividing the Friday closing price of a stock by the Friday close of an index. (We use the S&P 500.) The weekly changes are then plotted on a line graph, using a log scale—this is called the RP line.
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When a Relative Performance line is moving upward, the stock is outperforming the market. When it’s moving downward, the stock is underperforming the market.
A flat RP line indicates the stock’s performance is equal to the market’s.
How We Use Relative Performance to Make Buy and Sell Decisions
In general, we like to see a minimum of 13 weeks of outperformance (an uptrending RP line) before we consider buying a stock. Once this condition has been met, we conclude the stock has positive momentum.
If a company has a compelling fundamental story and strong positive momentum, it’s a candidate for purchase.
What constitutes strong momentum?
When a stock has a powerful RP line, its corrections will be brief, lasting just a week or two. The longer the Relative Performance correction, the weaker the situation. There’s nothing more positive than an RP line that’s hitting new highs!
In general we’ll consider selling a stock if it underperforms the market for eight weeks or longer.
How deep (or shallow) has the correction been? Has the stock been declining on heavy trading volume (a big negative)? Is it holding up in an area of price support?
Relative Performance analysis is extremely important, but it’s not done in a vacuum. There are other considerations.
When deciding whether to buy (or sell) a stock, investors should also examine both the fundamentals of the company and the technical health of the stock. There are dozens of technical indicators you can look at, but many of them will confuse rather than enlighten. Keeping it simple by studying the price, volume and moving averages will capture the real picture of the stock’s supply and demand relationship.
Interpreting Relative Performance lines is as much an art as it is a science. But to any serious investor, it’s worth the effort. It gives you the conviction to stay with a stock rather than sell for a quick profit. It helps you identify the strongest stocks in both weak and strong markets. And it gives you advance notice that a stock is weakening.
To what extent do you use Relative Performance lines to determine whether or not to sell a stock? Let us know in the comments.
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*This post is periodically updated to reflect market conditions.