So far in this series on Point and Figure charts we have discussed; P&F basics, P&F support and resistance, P&F formations and P&F price objectives This week I would like to continue on with the series and chat about a very important P&F tool used for evaluating stocks, Relative Strength. Please take note though the relative strength used in this discussion does not have anything to do with the Relative Strength Index used in most charting platforms. The RSI evaluates a stock's or index's strength to itself to see if it is getting stronger or weaker where as the RS used here is an evaluation of performance to another stock or index.
If you simply want to equal the performance of the broad averages then all you have to do is buy the Spiders, the Diamonds or an index mutual fund and passively sit back and wait. However, if you want more, if you want to outperform the averages, outperform the indexes then Relative Strength is the tool for you. And the only way to outperform the averages is to own stocks that are outperforming the averages and the best way to tell whether your stock is outperforming is to evaluate its performance relative to the average you want to outperform or measure its Relative Strength.
Relative Strength is a measure of the magnitude of the movement of a stock in relation to another stock or index rather than a way to determine price direction. A Relative Strength chart in a row of Xs does not mean the security has risen in price, it just means it is stronger than the index (or other equity) to which you are comparing it. And vice versa, a Relative Strength chart in a row of Os does not mean the security has fallen in price, it just means it is weaker than the index (or other equity) to which you are comparing it. A stock could be climbing but in a row of Os on a RS chart.
This is probably a good time to make sure you all realize that when I talk about outperform I dont mean only outperform to the upside, I also mean outperform to the downside as well. I have always believed you can make more money in a bear market than a bull market (with a few exceptions like 1999) because stocks fall in a more orderly manner than they rise.
The Formula for Relative Strength
The Relative Strength formula is simply the price of the stock divided by the Index and the result is multiplied by 100. Here is the equation: (Stock Price / Index Price) * 100 = Relative Strength
A RS chart uses a three-box reversal method just like the basic P&F charts. The decimal place is moved to yield a whole number, similar to a stock price then the ratio is plotted on a point and figure chart the way any stock would be. The buy and sell rules are the same as for any other point and figure chart. You use the basic formations I have talked about in previous articles and then lay over the support and resistance lines.
The patterns of interest are simple double top breaks and double bottom breaks because they are most prevalent but any P&F formation that generates a buy or sell signal will work. This identifies whether the RS charts is on a buy signal or on a sell signal. You also need to take note if the column is in Xs as this shows that the stock is outperforming the index in the short term or if the column is in Os then the stock is underperforming the index in the short term. When evaluating a RS chart the scale is not important, it is the chart formation of the RS chart that matters. As a matter of fact, when evaluating a RS chart you do not even need to see the scale and I will not be showing the scale on the examples that follow.
RS signals are long-term signals with some lasting more than a year so don't try to use them for short term trades.
The four different states a Relative Strength chart can be in are as follows:
Buy Signal in Xs - This is the strongest Relative Strength reading. The fact that the stock is in a column of Xs, shows that it is currently outperforming the index and the buy signal gives you the go ahead to position yourself long.
Buy signal but reversed to Os - This is the second strongest Relative Strength reading. The stock is outperforming on a longer term basis but is currently ebbing in the constant ebbs and tides of the market. As long as the chart does not give a sell signal and stays above the support line the buy signal is intact.
Sell signal in Os - This is the weakest Relative Strength reading. The fact that the stock is in a column of Os, shows that it is currently underperforming the index and the sell signal gives you the go ahead to position yourself short.
Sell signal but reversed to Xs - This is the second weakest Relative Strength reading. The stock is underperforming on a longer term basis but is currently ebbing in the constant ebbs and tides of the market. As long as the chart does not give a buy signal and stays below the resistance line the sell signal is intact.
No Signal - Flat - If the chart is on a buy and a column of Os breaches a support line before a sell signal is given the chart is on no signal. If the chart is on a sell and a column of Xs breaches a resistance line before a buy signal is given the chart is on no signal.
Now let's look at some examples. I have chosen to use the S&P Equal Dollar Weighted Index (Stockcharts symbol - $SPXEW) for comparison instead of the Capitalization Weighted S&P ($SPX) because the Equal Dollar Weighted gives a broader picture of how many stocks are rising or falling than does the Capitalization Weighted index where just a few of the largest stocks have a greater impact.
Let's start with a very simple sideways move that has given very clear buy and sell signals.
In March of this year AXP gave its first sell signal since the buy signal back in August of 2003. Of course we don't know if AXP was on a buy from before August 2003 because the chart does not go back that far, but even so, that was a long signal. Also take a look at the sell signal it was not a double bottom, not a triple bottom, not a quad bottom but a 5 time bottom. I would say that is a very good indication that you should be out of your long positions and positioning yourself short. You certainly don't need any trendlines on this chart to help you with your buy and sell signals.
Here is Boeing (BA) compared to SPXEW:
Boeing (BA) gave a buy way back in December 2003 and is still going strong. I would be in long positions as long as the chart stays above the red resistance line and does not give a sell signal.
In which would stock would you want to be long - AXP or BA?
Here is a RS chart of Walmart(WMT) compared to SPXEW.
I was not able to squeeze the chart small enough to take an image of the title.
WMT gave a sell signal in December of 2004 and is still on the sell and looking rather weak. This is not a candidate for long positions. Not much need for trendlines on this chart either to help you with your sell signals because the red resistance line is a long ways off.
This chart is getting a little more complicated now. In June of 2003 the RS chart broke a double top and INTC generated a buy signal, the strongest of all signals. The next column of Os was the second strongest Relative Strength reading and as long as INTC does not give a sell signal or break the blue support line you should stay long. Now see where the blue support line is breached by the column of Os, (right under the 4 on the 4th column of Os)? This is where you would be getting out of long positions but not yet into a short. In July of 2004 INTC did indeed give a sell signal and it now time to go short. You stay short until you get a buy signal or the red resistance line is breached.
Now this chart is getting even more complicated.
1. The first Buy signal on this chart came in March 2003 and it stayed until the sell signal in May 2003 but you would have been out of your long positions when the blue support line was breached sometime in April 2003.
Here is MSFT compared to SPXEW:
See if you can figure out where you would go short, long or flat before you look at the annotated chart below.
The first sell signal on this chart came in November of 2004 and it was below the red resistance line so you would have taken MSFT short and still short today.
When using the Relative Strength charts one has to remember the all important part of this analysis is the word "Relative." If the whole market is falling a relative strength chart will tell you the stocks that are strong relative to the broader index but they may be falling as well. So it would be wrong to use these charts to position yourself long. You should be using other tools to evaluate the state of the market and position yourself in stocks that reflect your bearishness or bullishness. In other words if you see the market bullish as a whole then look for bullish RS candidates to take long but if you see the market bearish as a whole then look for bearish RS candidates to take short.
Next week Bullish Percent charts - if I can get to a point of understanding them myself that is.