Relative performance (RP) measures how a stock is performing relative to a specific market or index. Momentum analysis of a stock’s RP 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.
Relative Performance Calculation
Specifically, Relative Performance 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 Growth Investor 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 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. 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 Relative Performance 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. Relative Performance 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 a Relative Performance 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 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 selling for a quick profit. It helps you identify the strongest growth stocks in both weak and strong markets. And it gives you advance notice that a stock is weakening.