Spot High-Flyers with Relative Strength

03/24/2011 6:00 am EST

Focus: STOCKS

Joseph Fahmy

Managing Director, Zor Capital, LLC

Relative strength (RS) analysis is a proven method for finding stocks that outperform the market, and investment strategist Joe Fahmy explains how it can be applied to find your portfolio’s next big winner.

Taking a look at the relative strength indicator with Joe Fahmy. Hi Joe.

Hi Karen. How are you?

I’m good. Tell me what is the relative strength indicator?

Well the main way I use relative strength is to find big winners in the stock market, so I use it during market corrections. So whether it’s a one- or two-day correction in the market short term, or a medium-term, two- or three-month correction, or even a longer-term bear market. What I do is I want to pay attention to the stocks that are holding up well because the way I define relative strength is very, very simple: It’s stocks showing strength relative to the market. So what I’m doing is I’m looking at no matter what the time frame of the correction, I’m looking for stocks holding up well, usually on the new high list, and the way I look at it is the market’s like a spring holding them down, and the second the correction or the tension is relieved off the spring, those are the stocks that tend to move on and become big winners in the market.

Is this what they use when they tell me it’s a stock picker’s market where you have the broader market not moving but individual stocks showing opportunity?

Exactly, exactly. It’s a very good question. What I like to do is especially coming out of the bigger corrections is look for those individual stocks, and throughout history, I’ll give you a few examples, in 1998 we had a big correction where there was a Russian debt crisis and Long-Term Capital blew up and Yahoo (YHOO), Broadcom (BRCM), AOL (AOL), some of those stocks were barely budging, so the market’s going like this and these stocks were just holding up very, very well, and as soon as the correction was done, they went on to become big winners. In 2000, when the internet bubble fell apart and the Nasdaq dropped 2000 points in two weeks, Panera Bread (PNRA), a recent IPO was just rising and making new highs. In 2001, after 9/11 the market was going down and Whole Foods (WFMI) was making new highs and what you notice with all those stocks as recently if I fast forward to 2009 even Netflix (NFLX), Green Mountain Coffee (GMCR), same thing, coming out of big corrections they were making new highs and if you look back, they went on to become big winners.

Can it also be said for it’s like the financial collapse of 2008 where a lot of babies were thrown out with the bath water?

Yeah. Yeah, exactly. That’s those examples in March 2009 when we finally bottomed from the 2008-into-early-2009 financial collapse as recently as Green Mountain and Netflix were holding up and within a day or two of the early-March bottom in 2009, those two were on the new high list and went on to 200%, 300%, 400% gain since then.

And so you looked at this relative strength indicator, picked the ones that you want, and then watch them. Do you have any risk management strategies you can share?

Sure. There’s different ways you could trade them, different time frames, whether you trade them short, medium, or long term, at least I know I have a high probability that they’re going to move higher. So if people want to trade them for one or two days, at least you know that they’re most likely going to move higher when the market’s moving. I’d like to trade them over a few weeks, a few months, so medium term. However, if you’re a long-term holder, you can also use them. They usually turn out to be big winners even if you’re a long-term holder.

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