Specifically, RP is calculated by dividing the Friday closing price of a stock by the Friday close of an index. (We use the broad Wilshire 5000.) The weekly changes are then plotted on a line graph, using a log scale. When an RP 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. Each issue of the Cabot Market Letter shows the RP lines of the stocks we’re recommending and following.
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 RP 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 8 weeks or longer. But there are other 
considerations. 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? RP analysis is extremely important, but it’s not done in a vacuum. There are other considerations.
Let’s look at a few examples. In figure 9, you can see a stock that’s been strongly outperforming the market for almost a year. In that time, it has more than doubled! If you used RP analysis as the basis for buying and holding this stock, you would have profited handsomely. Notice how brief the RP corrections have been, lasting only one to four weeks before new highs are reached.
Figure 10 shows a positive situation developing. For months, the stock was unable to penetrate its price resistance at around 10. In early February, the RP line broke out to a new peak. This RP breakout was a precursor to a price breakout above the resistance area. The stock quickly shot up to the high teens! Finally, notice how the stock moved sideways for many months, while the RP line headed higher. RP analysis again revealed a buildup in buying pressure before the stock surged.
Now consider figure 11. After a long uptrend, the stock hit a new price high in March. Accompanying the price high was an RP peak. All was well. But then in late April, as the stock ran up to the old high after a brief consolidation phase, the RP line, on a 5-week correction, failed to confirm the upmove. This is a warning sign that the stock was running out of steam. This negative divergence is a red flag that lower prices may be on the horizon.
Interpreting RP 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 selling 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.
More on Cabot Technical Analysis
Cabot Investing Advice
Cabot Home
Sign up for free Cabot Wealth Advisory e-newsletter