Inexperienced investors may simply see making gains in their portfolio as a sign they are reaching their goals. But to achieve true investing success it is essential to have positions in stocks that are outperforming the broader market. This is why the relative strength line is such an essential tool.
XSimply put, the relative strength line compares a stock's performance to that of the S&P 500. When the line is climbing, this means it is outperforming the benchmark index.
It is important not to confuse the RS line with the Relative Strength Rating. The RS Rating is a metric that measures a stock's price performance over the past 12 months.
One reason the RS line is such a crucial tool is that the RS line can rise even when a stock price is falling. This means its value is slipping at a slower rate compared to that of the overall S&P 500. Such stocks tend to make better gains when a market uptrend emerges from a slump.
The RS line is front and center on both daily and weekly IBD Charts, and should always be given careful consideration. It's also in MarketSmith, a premium service from IBD.
The RS line serves as a key gauge when looking at stocks that have the potential to break out, when they may be offering up follow-on buy points or when a stock is showing signs of a top after a long winning streak.
Relative Strength Line Hints At RH Breakout
A good example of a stock that enjoyed a successful breakout after showing signs of strength was RH (RH) in 2020. The upscale furniture chain is backed by Warren Buffett and was a market darling last September, when it boasted an A- Accumulation/Distribution Rating.
The stock broke out of a deep-cup base with a buy point of 256.27 on June 3 (1). The relative strength line was showing signs of strength even ahead of the breakout.
It was rising sharply as the stock formed the right hand side of the base (2), then hit a new high just before it passed its buy point (3). (It was not an all-time high, but the highest in the period spanning the base.) This is an extremely bullish sign that hints a stock is ready to go on a strong run. Indeed, the stock was strong enough to pull out of a post-breakout dip (4), because shares didn't get going until July.
Volume, a measure of supply and demand for a stock, also was good. It jumped the week of the breakout.
The signs all proved prescient, with the stock continuing to make progress right up until it reported earnings Sept. 10. Strong results caused the stock to gap up, reaching a new all-time high of 410.49. This was a 60% gain on the original buy point.
This article was originally published Sept. 17, 2020, and has been updated.
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