Using real market examples, see how relative performance, or RS analysis, can be used to pinpoint the market’s strongest (and weakest) sectors and individual stocks at any time.

Of all the technical tools that are available today, there is one that I think can help you find not only the strongest sectors, but also the strongest stocks within those sectors or industry groups.

It is a method that I use frequently in my daily Charts in Play feature, although I don’t always show it in graphical form. It is the relative performance, or RS analysis, which compares one market to another by plotting a ratio of the two markets.

Most analysts just use it to compare the percentage change of a market average—like the S&P 500—to a particular sector or stock.

Since the 1980’s, I have always analyzed indicators like the price charts. I often use moving averages on the indicator, as well using trend lines to identify support and resistance levels. I have found this can be a very useful way to identify the winning sectors and stocks, while at the same time avoiding the losers.

Relative Performance (RS Analysis)

Figure 1

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Most investors would likely pick Apple (AAPL) as the top stock of the past few years. Therefore, I thought it would be interesting to see how the RS analysis performed on this key tech stock.

This daily chart goes back to late 2007. On the bottom is the relative performance, or RS analysis. In the latter part of 2008, the RS was in a downtrend (line d), as major resistance at the 2008 highs (line c) was evident. This downtrend was broken in late-January 2009 after the RS had formed higher lows.

On January 22, 2009, I noted the basing action in AAPL and felt that a breakout above $97-$100 on heavy volume should complete the bottom formation.

Apple made higher lows (line b) in March with the RS in a well-defined uptrend at that time. On March 18, AAPL closed above $100, and on April 6, the major bear market resistance in the RS, line c, was finally overcome. The OBV also completed its bottom formation.

For the rest of 2009, the RS was in a solid uptrend, line e. While the overall market was topping in April and May, the RS continued to move higher. The first sign of weakness was in March 2011, when the uptrend (line e) was broken. A drop in the RS below the April lows will start a pattern of lower highs and lower lows.

NEXT: How to Find Which Stocks Are Leading the Market


Identify When Small, Mid, and Large Caps Are Leading

Figure 2

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Before selecting a stock in a particular sector, I generally have to decide what size company in a sector is likely to do the best. Therefore, I keep a close eye on how the small- and mid-cap stocks are doing relative to the S&P 500 (large caps).

The trend line analysis on the RS can often give some early insight as to whether the small- or mid-cap stocks are acting stronger or weaker than large caps. I often use the S&P 400 (mid caps) and S&P 600 (small caps) indices, but also analyze the iShares Russell 2000 Index (IWM), which tracks the small-cap stocks and is a very liquid ETF.

By May 2009, the relative performance, or RS line, for IWM was in a solid uptrend (line e) that stayed intact until it was broken on October 17 (line 1). This break coincided with the high made in IWM.

The small caps underperformed for the next nine weeks before the downtrend in the RS, line d, was broken the week of December 19 (line 2)

The RS was able to stay in its uptrend (line c) until June 12 before being broken (line 3). During the summer’s choppy market action, the RS formed a clear downtrend, line d, which was finally overcome in September (line 4). This was discussed on September 29 (see “Can Small Caps Break Out?”).

The small caps acted well until May 7, 2011 (line 5) when the uptrend in the RS, line e, was broken. The RS is now testing its longer-term uptrend, line e.

The A/D line on the Russell 2000 also failed to confirm the early-May highs. Taken together, this was a stronger warning signal than I recognized at the time.

Using RS Analysis to Pick Winners

As part of my regular sector analysis, I use not only the RS analysis, but also the actual performance numbers to find which of the sectors looks best. Though I have been favoring the health care sector since early this year, it came to the forefront in April, when I discussed the bullish RS analysis for both the Select Sector SPDR - Health Care (XLV) and the Select Sector SPDR - Consumer Staples (XLP). To see those charts, click here.

Once you have identified the strongest sectors, you can take it a step further by looking for the strongest industry groups within that sector.

Figure 3

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When you look at the industry groups that make up health care, one sub-group that stands out are the health care providers, which through June 13 were up 19.6% for the year versus 10.4% for the health care sector and just a 1.1% gain for the S&P 500.

The Health Care Providers have rallied sharply from the September 2010 lows, as there have only been shallow pullbacks. The RS analysis versus the S&P broke out to the upside on January 10 (point 1), as it overcame the resistance and prior highs at line c.

Ideally, you would like to pick stocks that are in the strongest industry groups in the strongest sectors. On the bottom of the chart, I have also plotted (in green) a comparison of the health care providers to the overall health care sector. In October, the health care providers broke through RS resistance (line f), indicating that this group was starting to outperform the broader sector.

By March, the providers were clearly outperforming the S&P 500, as the RS had formed a solid uptrend, line e. The RS consolidated during March and April before breaking through the resistance at line d (point 2). The RS has since surged to the upside.

One stock in the health care provider group is WellCare Health Care Plans (WCG), and the daily chart shows a nine-month trading range (line h) that was resolved to the upside in early January 2011. WCG then rallied from a low of $27.64 to a high of $32.75 before pulling back at the end of January. The correction retraced 57% of the prior rally, holding above the 61.8% retracement support.

By February 11, the RS had surpassed major resistance at line i and the OBV had also broken through the resistance at line j. These were very positive signs, and the weekly analysis confirmed the breakout.

The daily chart show a powerful rally over the past few months, as WCG is up by more than 60% in 2011, over three times greater than the health care providers Group (up 19.6%), and 59% better than the S&P 500.

NEXT: Using RS Analysis to Avoid Losers


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.