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Using RS Analysis to Avoid Losers

After a rally in early 2011, the financial stocks have been much weaker than the S&P 500, and the relative performance analysis identified this weakness. The RS analysis can do a very good job of highlighting those stocks that you should avoid—or those you should consider for bearish strategies.

Figure 4

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For most, it will be another filter that can eliminate stocks from a buy list, no matter how compelling the fundamentals may seem. On May 13, I highlighted “The 4 Worst Bank Stocks,” as I had been sharing my negative outlooks for Bank of America (BAC) and Citigroup (C) for several months prior.

JPMorgan Chase (JPM) had violated RS support, line c, on April 15 when the stock closed at $43.90. The RS has continued to decline since, with JPM reaching a recent low of $40.10.

During this time period, JPM has declined almost twice as much as the S&P 500. The well-defined downtrend in the RS and the weak OBV gives no indication that JPM is ready to turn around.

Goldman Sachs (GS) was also featured in that May article, and the RS analysis showed that it had broken the RS support, line f, on January 23 when the stock closed at $166.30.

The uptrend on the price chart, line e, was not broken until almost two months later, on March 16. I have frequently seen similar signals where a breakdown in the RS will precede a breakdown in price by several weeks, if not longer. So far, the June low for GS is $130.50, as it has dropped 21.5% since the RS broke support.

Figure 5

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This type of analysis will work on any sector or stock. On April 13, just before Google (GOOG) was set to release earnings, I pointed out the potential head-and-shoulders (H&S) top formation. I then noted that the RS had already broken support on February 22 (point 1) with the close at $610.21, and the RS had since formed a series of lower lows, line c.

The break of RS support and its clear downtrend made it more likely that an H&S top would be completed and that the reaction to Google’s earnings would be negative. Two days later, the earnings were released and GOOG gapped through the neckline (line b) on heavy volume (point 2), completing the H&S top formation.

To calculate the measured target from the H&S top formation, you take the high price when the head was being formed ($642.96) and calculate the difference between it and the neckline ($553.31). This gives you (646.96 - 553.31) 93.65. This number is then subtracted from the neckline to give the downside target at (553.31- 93.65) $459.66.

With GOOG now trading around $500, it has the potential to decline another $40 from here. Though the daily RS analysis has moved sideways for several weeks, the weekly and daily on-balance volume (OBV) readings remain negative, suggesting that the stock has not yet bottomed.

Figure 6

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With the overall stock market correcting and despite the increasing bearish sentiment, now is the time to be looking for those stocks that are doing better than the S&P 500. One of the stocks I talked about early this week is an excellent example of what I am looking for…even though it is a utility stock.

Southern Company (SO) overcame seven-month resistance in April, line a, which was confirmed by the volume analysis. It is now retesting the breakout levels and the uptrend.

Even more important is the RS analysis: The downtrend from September (line c) indicated that SO was underperforming the S&P 500. The break of this downtrend in March was the first sign of a change. The move through resistance at line d completed the bottom formation (lines d and e) and signaled a new uptrend in the RS.

This was a sign that SO should outperform the S&P 500, which it has done. Therefore, the current pullback should be a good buying opportunity.

Investors can do similar analysis to what I have discussed for free online, as most Web sites that provide stock charting will also allow you to compare a stock’s performance to a major average like the S&P 500 or an appropriate sector or industry group.

To draw the trend lines, you may have to do it on a printed copy, but I think your efforts will be rewarded.