Every demanding craft — including the art of investing in growth stocks — presents its puzzles. Having a few specialty tools on hand and knowing how to use them can make all the difference in working through such occasional challenges with success.
XFor investors, IBD's relative strength line is just such a tool. At Investors.com and MarketSmith, it is the blue line usually scribed just below the stock's price bars.
It compares a stock's price action to that of the S&P 500. A rising line tells you the stock is outperforming the benchmark index. Even if a stock falls in price, if the S&P 500 falls harder, the stock's RS line still rises. The line is plotted on daily and weekly charts.
A falling RS line over a period of weeks or months says the stock is being passed up. RS lines near highs show a stock that is steadily outpacing the general market. RS lines near lows indicate a stock is struggling, and can't muster the strength to compete with its peers.
Why does that matter?
Growth Stock Investing: Putting The RS Line To Use
There are certain junctures in stock charts where a stock's strength relative to the overall market is telling.
- Breakouts: You'd like to see a relative strength line making new highs as a stock breaks out, or even before a breakout. That's ideal. Sometimes, such as when a stock makes a big move out of a deep base, the RS line is not actually seizing new highs at the breakout. But the direction — particularly before the breakout — can be an important indicator, corroborating the strength of a stock as you prepare to make an initial buy.
- Follow-on buy patterns: The RS line is also a good secondary reference when deciding whether and how much to buy as a stock enters buy zones in three-weeks tight or 10-week support situations. A lagging RS line counsels a more cautious approach.
- Topping behavior: After a lengthy rally, a stock may send some topping signals, such as a break below its 10-week moving average in heavy trade. These can be signals to lock in profits. How does the RS line look? Relative strength will often begin to break down before the actual stock price, or simply fall into a lull below its highs. If it is holding near highs, which shows the stock outperforming or holding its own against the market, you may want to wait for additional signals before trimming too much of your position.
The RS line acted as a helpful tool in gauging former IBD Sector Leader and ex-IBD 50 member Grubhub. (The company was acquired in 2020 by European food delivery company Just Eat Takeaway.com.)
The RS line had declined in the five months through March of 2017 as the stock consolidated. Nothing abnormal about that.
Hitting New Highs Before The Stock
But then the RS line began gaining strength at the end of March 2017, and was tilting sharply higher ahead of a breakout that occurred the week of April 28 (1). That was a positive signal from the RS line, even if it took a while for the stock to rally in earnest.
The RS line also prefaced the stock's breakout in October, turning up and running higher two weeks ahead of the move.
By the time Grubhub broke out past a 57.71 entry point in a six-week flat base on Oct. 26 (2), the RS line had already taken new highs. The stock rallied sharply.
Grubhub's next base also flashed the same bullish signal. When the stock broke out in late January 2018, the RS line made new highs as shares also made new highs. The stock climbed 50% from a 74.90 buy point to a March 2018 peak.
A version of this column was first published on Feb. 23, 2018, and has been updated. Follow Elliott on Twitter at @IBD_AElliott.
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