Put New Muscle in Your Portfolio

Comparing stocks on the basis of their relative strength can lead you straight to the potential winners

Ever hear the one about the two guys camping in the woods and a bear appears? As one guy starts running, the other stops to put on his sneakers. "What are you doing?" the first guy yells out. "You'll never outrun the bear." His partner replies: "I don't have to. I just have to outrun you."

Well, that's the idea behind a savvy investing approach called relative strength. Popular with Wall Street pros, relative strength involves judging a stock's performance not in absolute terms but by how well it outruns its peers. History shows that stocks that sprint to the head of the pack tend to hold their leads for long periods. These winners notch the biggest price gains during rallies while suffering the smallest losses during downturns. "You want to own the strongest stocks, regardless of what the overall market is doing," says Bernadette Murphy, chief technical analyst at Kimmelman & Baird. "That means focusing on stocks with robust relative strength."

STAYING POWER. In this installment of Market Measures, we'll show you how to use relative strength to find and evaluate the stock market's up-and-comers and avoid stocks that are running out of steam.

As an investor, you can employ relative-strength measures in a variety of ways. Money managers often examine the relative strength of the dozens of industry groups within the broad stock market to unearth the strongest sectors, and then repeat the exercise to zero in on the leading stocks within those sectors. "It's impossible to learn the minutiae of every public company," says Jeffrey DeGraaf, chief technical strategist at Lehman Brothers. "But you can quickly home in on a few stocks with improving relative strength, and then do further research."

Checking a promising stock's relative strength can also help you gauge its staying power. "When a stock's share price makes a new high, you want to see the relative strength making a new high, too," says Edward Nicoski, technical strategist at U.S. Bancorp Piper Jaffray. If not, then the stock's buyers are losing interest, signaling that the share price may soon retreat. Notes Richard McCabe, chief market analyst at Merrill Lynch: "Changes in relative strength often precede changes in a stock's price direction."

A common way to measure relative strength is to divide the stock's closing price each day by a broad market index such as the Standard & Poor's 500-stock index. Say a stock ended the day at 51, and the S&P 500 at 890.81. The ratio is 0.057. The next day the stock rises to 54, but the index slips to 889.54. The ratio is now 0.061, and the stock's relative strength has improved.

To analyze the trend, you'll need a running tab of the daily ratios over 12 to 24 months. When the relative strength of a stock is consistently improving, that means it's outperforming the market by a wider and wider margin. You can plug these data points into a computer spreadsheet to do the calculations. If you would rather go to an outside source, many Web sites that provide stock quotes also offer accompanying relative-strength data. However, you often have to dig to find what you need. At YahooFinance (finance.yahoo.com), after you call up a particular stock, you must click on Chart, then Technical Analysis to obtain graphs of the stock compared with an index such as the S&P 500 or Dow Jones industrial average. BusinessWeek Online provides lists of stocks with strong relative strength, but you must look in the advanced stock screening section to find that out.

The most sophisticated relative-strength investing tools are on Web sites that focus on technical analysis. Unfortunately, these sites usually charge stiff subscription fees. One excellent site with a variety of relative-strength tools, Daily Graphs Online (www.dailygraphs.com), offers a one-week trial subscription for $19.95 but otherwise charges as much as $1,000 annually. A distinctive function is a proprietary relative-strength ranking that compares a stock's performance over the past 12 months with the approximately 8,000 stocks in Daily Graphs' database. Amazon.com recently had an "RS" ranking of 93, meaning that it had outperformed 93% of the stocks in the Daily Graphs universe during the past year. The site suggests seeking stocks with a rating of 85 or higher.

A BEAR ON THE RUN. Merrill's McCabe thinks that the three-year bear market has just about ended, so he is now employing relative-strength measures to hunt for stock sectors likely to lead the next bull market. Based on past patterns, McCabe looks at groups that were laggards during the prior bull market but have shown improving relative strength during the bear market. The three big industry sectors he believes best fit the bill are basic industrials, especially forest-products companies and those that mine copper and other nonferrous metals; capital-goods manufacturers, especially machinery and truck makers; and energy companies, especially oil and gas producers.

On the other hand, the consumer goods sector, one of the bear market's brightest performers, has begun to show signs of waning relative strength, McCabe says. The sector includes packaged-foods and soft-drink makers.

Once you've selected industries with robust relative strength, the next step is to seek out the strongest companies in those areas. In the energy sector, Lehman's DeGraaf is keen on Apache, an oil-and-gas exploration-and-production outfit. In February, 2002, the stock began to outperform the S&P 500 and has continued to do so by an increasingly plump margin. During that time, Apache's stock price jumped 22%, to $61.52 recently (charts).

Energy behemoth ChevronTexaco's relative-strength history tells a different story. Since July, ChevronTexaco's relative-strength line measured against the S&P 500 has sloped downward. During that period, its share price has slipped 14% -- to $64.68 recently (charts).

Evaluating a stock based on its relative strength can help you to determine the optimum time to buy and sell shares. With that valuable information at your fingertips, you might just outrun other investors.

This is the third in a series showing how various Market Measures can help you identify good opportunities and avoid traps

By Susan Scherreik

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