Relative Strength

• The Bottom Line: Relative Strength tells you what's popular in the stock market, not what's valuable, making it a tool for understanding market mood rather than a reliable guide for buying great businesses.
• Key Takeaways:
• What it is: A simple comparison of one stock's price performance against another, an index (like the S&P 500), or its industry group.
• Why it matters: For a value investor, it's a powerful gauge of market sentiment. Extreme strength can signal over-hyped stocks, while extreme weakness can point toward unloved and potentially undervalued companies, a core principle of contrarian_investing.
• How to use it: By tracking if a stock's price is rising or falling faster than a chosen benchmark over a specific period. ¹⁾

Imagine you're watching a marathon. The most obvious metric is each runner's absolute speed—how many miles per hour they are running. This is like a stock's price going up or down. But what if you wanted to know who was actually winning the race? To do that, you'd compare each runner's performance relative to the others. A runner might be slowing down slightly, but if everyone else is slowing down even more, she is gaining relative strength and pulling ahead of the pack. In the investing world, Relative Strength (often abbreviated as RS) does exactly this. It's not a complex formula locked in a vault on Wall Street; it's a straightforward comparison. It measures how a stock's price has performed against a benchmark, which could be:

• The broader market: How is Ford performing compared to the S&P 500?
• Its industry sector: How is Coca-Cola performing compared to the consumer staples sector?
• A direct competitor: How is Home Depot performing compared to Lowe's?

A stock with high or improving relative strength is “pulling ahead of the pack.” Its price is rising faster (or falling slower) than the benchmark. A stock with low or worsening relative strength is falling behind. It’s essential to understand that Relative Strength is a cornerstone of a completely different investment philosophy called technical_analysis. Technical analysts focus on charts, patterns, and price momentum, believing that all known information is already reflected in the stock's price. For them, high relative strength is often a “buy” signal. For a value investor, who focuses on a business's underlying worth, it's a very different kind of signal, as we'll see.

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” - Benjamin Graham

This timeless quote perfectly captures the essence of Relative Strength for a value investor. RS is a printout from the “voting machine”—it tells you which stocks are winning the popularity contest right now. Our job, however, is to use the “weighing machine”—to determine the company's actual substance and intrinsic_value.

If Relative Strength is a tool for market technicians and momentum chasers, why should a disciplined value investor even bother with it? Because understanding the “voting machine” is crucial for finding opportunities the crowd has overlooked. For us, Relative Strength is not a tool for buying, but a tool for thinking. Here’s how it fits into a value investing framework:

• A Thermometer for Market Fever: Relative Strength is one of the best ways to measure market psychology—specifically, the emotions of fear and greed. A stock with skyrocketing relative strength is often basking in the glow of extreme optimism and greed. The story is exciting, the news is good, and everyone wants in. This is precisely the environment where valuations become detached from reality and a margin_of_safety vanishes. High RS acts as a warning sign: “Caution, market fever may be present.”
• A Hunting Ground for Contrarian Ideas: The real magic for a value investor happens at the other end of the spectrum: low relative strength. When a stock is deeply out of favor and consistently underperforming the market, it often means the “voting machine” is casting a resounding “no.” The narrative is pessimistic, fear is the dominant emotion, and investors are selling. This is the hunting ground for a value investor. It's in these neglected corners of the market that we can find wonderful businesses trading for far less than they are worth. Low RS doesn't guarantee a bargain, but it tells you where to start digging for one.
• A Warning System for Value Traps: While low RS can signal opportunity, it can also signal danger. A value_trap is a stock that appears cheap but continues to get cheaper because its underlying business is fundamentally broken. If a company's stock shows persistent, long-term relative weakness and your fundamental analysis reveals deteriorating sales, shrinking margins, and a crumbling economic_moat, then the market's pessimism is likely justified. In this case, low RS is a red flag confirming that you're looking at a melting ice cube, not a coiled spring.

In short, a value investor uses Relative Strength in the opposite way of a momentum investor. They see strength and get skeptical; we see weakness and get curious.

While sophisticated charting software can plot a Relative Strength line automatically, the concept itself is very simple.

The most common way to visualize Relative Strength is to create a ratio and plot it on a chart. The Formula: `Relative Strength = Stock Price / Benchmark Price` Let's say you want to compare the performance of a fictional company, “Innovate Corp” (ticker: INOV), to the S&P 500 (represented by the ETF, SPY).

1. Step 1: On January 1st, INOV is trading at $120 and SPY is at $400.

The RS Ratio is `$120 / $400 = 0.30`.

1. Step 2: Three months later, INOV has surged to $165, and SPY has risen to $440.

The new RS Ratio is `$165 / $440 = 0.375`.

1. Step 3: By plotting this ratio over time, you get a Relative Strength Line. Since the ratio increased from 0.30 to 0.375, the RS line would be trending upwards, showing that INOV is outperforming the S&P 500.

For those who prefer simple arithmetic over charts, an even easier method is to compare percentage changes over a set period (e.g., the last year):

1. INOV annual return: +37.5%
2. S&P 500 annual return: +10%
3. Conclusion: INOV has shown strong relative strength.

The interpretation depends entirely on your investment philosophy.

The cardinal sin for an investor is to see a rising RS line and conclude “it must be a good company” or see a falling line and think “it must be a bad company.” The RS line reflects market opinion, not business quality. Your job as a value investor is to find the situations where the two dramatically disagree.

Let's compare two hypothetical companies over one year, during which the S&P 500 rose by 15%.

• Flashy AI Solutions (ticker: AIZ): A darling of the tech world. Every news outlet is praising its groundbreaking AI technology.
• Dependable Bolt & Nut Co. (ticker: DBN): A 75-year-old industrial company that makes essential fasteners for heavy machinery. It's a boring but consistently profitable business.

^ Metric ^ Flashy AI Solutions (AIZ) ^ Dependable Bolt & Nut (DBN) ^ S&P 500 Benchmark ^

The Momentum Investor's View: The momentum investor sees AIZ's chart and is thrilled. The stock is up 120%, crushing the market's 15% return. Its relative strength is off the charts. This is a clear “buy” signal, based on the assumption that this powerful trend will continue. They wouldn't even look at DBN; its 4% return makes it a “laggard” to be avoided at all costs. The Value Investor's View: The value investor looks at this data and a completely different set of questions arise:

• For Flashy AI (AIZ): “A 120% rise is a sign of extreme optimism. How much of the company's future success is already priced into the stock? Is it trading at 100 times earnings while its competitors trade at 20? The risk of overpaying here seems immense. The margin_of_safety is likely non-existent or negative.” High relative strength serves as a signal to be deeply skeptical.
• For Dependable Bolt & Nut (DBN): “The market has completely ignored this stock. Why? Is there a temporary industry headwind that has scared away short-term traders? Is the business still generating solid cash flow and maintaining its market share?” The weak relative strength is an invitation to pop the hood and inspect the engine. If the analysis reveals that DBN is still a great business and is now trading for, say, 60 cents for every dollar of real value, then this is a classic value opportunity.

The value investor uses Relative Strength not to make a decision, but to decide where to focus their research efforts—typically on the unloved and unpopular.

• Quickly Gauges Market Sentiment: It's an efficient tool for taking the market's temperature and identifying the “hot” and “cold” areas without getting bogged down in complex calculations.
• Provides Performance Context: Knowing a stock is up 10% is useful. Knowing it's up 10% while its industry is up 50% provides critical context about its market perception.
• Simplicity and Accessibility: The core concept of comparing one asset's performance to another is intuitive and easy for any investor to understand and apply.

• Completely Price-Based, Ignores Value: This is its greatest weakness from a value perspective. Relative Strength is 100% about price movement and 0% about a company's balance sheet, income statement, cash flow, or competitive advantages. A stock on its way to bankruptcy can have brief periods of high relative strength.
• It Is a Rear-View Mirror: RS tells you what has happened. It provides no inherent predictive power about the future of the business. Chasing past winners based on high RS is a classic recipe for buying high and selling low.
• Can Encourage Herd Mentality: Following stocks with high relative strength means you are, by definition, following the crowd. Value investing success is often built on the courage to stand apart from the herd, buying what others are pessimistically selling.
• Confusion with the RSI: It bears repeating. Investors constantly confuse Relative Strength (a comparative measure) with the Relative Strength Index (RSI), a popular momentum indicator that measures the speed and change of price movements to identify “overbought” or “oversold” conditions for a single stock. They are entirely different concepts.

• technical_analysis: The school of thought where Relative Strength is a primary tool.
• momentum_investing: An investment strategy that actively buys assets with high relative strength.
• contrarian_investing: The strategy of going against prevailing market sentiment, often by investigating stocks with low relative strength.
• intrinsic_value: The true underlying worth of a business, which Relative Strength completely ignores.
• margin_of_safety: The bedrock principle of buying a security for significantly less than its intrinsic value, a concept that protects you from paying the high prices often associated with high RS.
• market_psychology: The study of how emotional and cognitive biases affect financial markets; Relative Strength is a direct reflection of this.
• value_trap: The primary risk when investigating low RS stocks; a company that is cheap for a very good reason (i.e., it's a failing business).