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Separating the Wheat From the Chaff Using Relative Strength

by Richard Evans

Separating The Wheat From The Chaff Using Relative Strength Splash image

There is a multitude of factors that enter into investors’ decisions to buy or sell a stock, other than fundamental analysis. Thus, keeping at least a partial watch on how a stock is acting, regardless of the fundamentals, can often save investors some headaches. One technical tool that allows you to do this is relative strength.

Relative strength is one of the oldest and most important tools in all technical analysis. While in recent years there have been various nuances of relative strength measurements which have been introduced, the basic concept of relative strength—comparing the relative price performance of X vs. Y over some time period in order to make future price projections—really remains the only simple measure an investor requires.

To illustrate the use of relative strength, we’ll examine one stock that showed declining relative strength relative to its industry group and the market as a whole before more fundamental problems began to appear.

The Semiconductors

The one group of stocks in particular that will be analyzed is the semiconductor stocks, in large part because they tend to be very volatile.

As a group the semiconductor stocks, as represented by the Philadelphia Semiconductor Index shown in Figure 1, had already started to top out in August. Initially, the index bounced off support at 370 frequently, but by mid-October, the index had broken support at 370 and declined to the next support level at 350, as represented by the rising trendline.

On October 23, the index broke below its rising trendline. By the time October 27 rolled around, the semiconductors were ripe for a selling panic, and down they went.

Leading the Downturn

Motorola, however, led the downturn by several months. Motorola’s price trend is shown in Figure 2. In June and July, Wall Street could not get enough of this stock. The stock was trading at a premium price-earnings multiple, around 50, amid projections of annual earnings increases of 30% or better. Stocks look most bullish at the top, and analysts’ stories are the most bullish at the top. Motorola was no exception.

However, while analysts were busy turning out a bullish case for the stock, Motorola was entering a typical distribution pattern. First, note the volume on the exhaustion gap on July 9 when the stock opened at a much higher price than its prior close, swelling to its highest level in six months.

When a stock is trending up, volume should expand. However, if the stock has already been in the mark-up stage for several months or longer, and volume swells to an inexorably high level relative to the average of prior months, it is usually the end of a move. Motorola would make one more minor move higher, past 90, the following week, but the stock was spent. Two days later the stock plunged 7 points.

Given the thinness of trading between 80 and 90 on the way up—thinness being defined by the lack of trades, a gap being the ultimate representation of lack of trading—little support can be expected and investors should expect a quick, sharp pullback. On July 18, Motorola just about negated all of its prior two weeks’ advance when the stock dropped sharply on high volume. The stock dropped to support, at 77, as represented by an intermediate up trendline.

Buyers on dips entered and attempted to push the price back up. However, investors who had previously bought between 84 and 86 at the far side of the July 9 gap were quite anxious to sell. Since there were more investors, as measured by volume, who wanted to cut their losses short, the rally proved short-lived and the stock dropped back to support at 78. After some attempt to stabilize the stock, that support level gave way, and the stock declined to its next level of support at 75.

By now the intermediate trend in Motorola could be classified as down. From the July 16 top, Motorola had a clearly delineated zig-zag trend lower: a minor decline, followed by a minor rally, followed by another minor decline to new lows. The major trend in Motorola was still bullish, but the intermediate trend was bearish, in contrast to the overall semiconductor index, which was still bullish.

The stock subsequently rallied, but could not rise any higher than 78, which had originally been support and was now acting as resistance. Investors at 78, who originally had bought in anticipation of higher prices, were now set to cut their losses short on any rally.

As the intermediate trend was bearish, the correct assumption is lower prices. After the rally to 78, the stock buckled, falling right through the support at 75, to new lows, sharply. Again, the thinness of preceding trading will determine the quickness of any subsequent decline. In late June during the mark-up, the stock rose quickly from 70 to 75. Likewise, on the way back down, the stock would move quickly from 75 to 70.

As shown in Figure 2, support at 66–70 was major, as represented by reversal patterns the preceding January, at 70, and June of the year earlier, at 66. Motorola would rally, but the advance would stop at the resistance at 75.

In looking at the stock’s interplay with support/resistance levels, you can see how and when trendlines are formed at reversal points, which represent investors either looking to get in or get out.

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Following the stock’s rally to 75, Motorola began once again to give ground. On October 22, Motorola closed at 681/8. On October 23, the stock gapped lower, opening at 66, and the deluge was on. Volume mushroomed as the stock plunged. The selling climax occurred on October 27, the day of the market mini-panic .

Now, in a matter of just a few months, Motorola does not look so glamorous. Indeed, few of the semiconductor stocks are acting very well. At the top, analysts were churning out bullish story after bullish story; now, with the stock down a third, which qualifies as a bear market by some definition, the bulls have pulled in their horns.

Indeed, the early December release of the Semiconductor Industry Association technology “road map,” which predicts “technological hurdles that may curb growth,” aptly reflects the bearish mood of the semiconductor market. However, a bearish market mood is just about the time technicians should be watching Motorola closely in anticipation of the eventual break in the down trendline, the first indication that momentum is once again shifting to the bullish side.


Discussion

Vernon Roberts from FL posted 9 months ago:

Good article - reminded me of some things I've forgotten lately.


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