A REFRESHER ON RELATIVE STRENGTH -- USING MARKET CARPETS TO FIND MARKET LEADERS
RELATIVE TO WHAT?... Judging from some of the feedback I've gotten recently, I think I need to discuss the concept of relative strength a bit more. The type of questions I've received, for example, is what happened to the defensive qualities of biotechs and drugs -- not to mention consumer staples. It's there, but you have to know where to look for it and what it means. When we talk about relative strength, we're usually comparing a stock, industry group, or market sector to the S&P 500. Relative strength determines if an entity is doing better or worse than the S&P. Relative strength doesn't mean that something has to be going up. In a rising market, that's usually the case. In a falling market, however, relative strength may mean that something is falling less than the rest of the market. That's not great, but it's better than being in the things that are falling the fastest. Defensive stocks -- like consumer staples, healthcare, and utilities -- are called that because they're a better place to be in a weak market. Some groups like energy often move in the opposite direction of the market. That means they offer not only relative gains, but absolute gains as well. Many stocks in defensive categories also offer absolute gains.

Chart 1
CONSUMER STAPLES ARE SHOWING GOOD RS... Chart 1 shows the direction of the Consumer Staples Select Sector SPDR (XLP) for the last three months. Below it is its relative strength line versus the S&P 500. The price of the ETF has been basically flat since the middle of December with a slight upward bias. That doesn't look too exciting -- until you look at its relative strength line versus the S&P 500 since the start of the year. Consumer staples have done better than the rest of the market during January. That's what we mean by relative strength. And that's why consumer staples have been at the top of my list of defensive stocks.
RELATIVE STRENGTH RANKINGS FOR 2005... Only consumer staples and energy are in the black for January. That means that those two groups have shown "absolute" as well as "relative" gains this month. Let's see how the nine sectors did "relative" to the S&P 500 through Thursday in order of their January rankings. Consumer staples outperformed the S&P by 2.7%; energy bested the S&P by 2.3%; utilities topped the S&P by .94%; healthcare was .72% better than the S&P. The worst performer was technology. A ranking of industry groups shows a similar trend. Oil Service is the only industry group to show both absolute and relative gains. The two other industries that did "relatively" better than the S&P were drugs and biotechs (through Thursday). Both lost ground, but not as much as the rest of the market. In other words, their defensive qualities were evident as the market started the year on the downside. The worst group was semiconductors. Chart 2 shows the sideways action in the Biotech Index over the last month. Not very exciting. But its relative strength line shows biotechs doing better than the S&P 500 in the last month.

Chart 2

Chart 3
FINDING STOCKS WITH GOOD RELATIVE STRENGTH ... Which brings us to the next step in relative strength analysis. Choosing individual stocks. The goal is to pick the stocks with the best RS in groups with the best RS. I recently identified three relative strength leaders in the biotech group -- Amgen, Biogen, and Genzyme. All three have done better than the biotech group during January. Genzyme did the best. Chart 3 shows the biotech leader hitting a new 52-week high this week. It's relative strength line compares the stock to the Biotech Index. Notice the jump in the Genzyme/BTK ratio during January. Even though the group has stayed relatively flat, individual stocks in the group have done quite well. The same is true for consumer staples and drugs.
JANUARY DEFENSIVE LEADERS... Three of the top performers in the consumer staples and drug areas are plotted below. All three stocks gained in absolute and relative terms. Notice in particular the jump in their relative strength lines (vs. the S&P 500) during January. I've included a chart of Johnson & Johnson because it's an example of a big drug that's doing pretty well. Weakness in a couple of big drugs (Merck and Pfizer) is masking gains in other big pharmas. And since those two stocks are the biggest in most pharma indexes, their poor performance understates the strength in the rest of the drug group. That leaves the impression that big drugs stocks are doing worse than they really are.

Chart 4

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Chart 6
WHERE TO FIND RS RANKINGS... There are two places on Stockcharts.com where you can track relative strength changes. One is under the Performance Charts on the Stockcharts.com main menu. A second, and more useful, place is the Market Carpets. Click on S&P Sector Carpets and you'll see the nine AMEX Sector SPDRs. You can tell at a glance which are leading for any given day and which are lagging. You can move the slider along the bottom to look at the last week, the last month, or more. That way you can see which sectors have been strongest (if you're looking to go long) or the weakest (if you're looking to go short). By clicking on each sector, you'll also see the top five and the worst five stocks in that sector over a selected time span. By clicking on one of the boxes on the upper right of the carpet, you can see a chart of any stock you want. In my opinion, the Market Carpets may be the most useful tool on the stockcharts.com site. I'd suggest you familiarize yourself with their use. When you do, the concept of relative strength (or weakness) will make a lot more sense to you and will become a lot more useful. I use them all the time. You should too.