A sharp market correction affords keen-eyed investors buying opportunities for suddenly undervalued stocks, as we found throughout January.

But what to do when the market starts to rebound? Shares of high-quality companies often bounce back beyond bargain levels before the rest of the pack. Is it truly too late to find short-term winners? After all, the market remains way below its recent highs. What’s the best way to identify those stocks likely to lead the averages in the coming weeks and months?

#-ad_banner-#One answer: relative strength.

Relative strength is an indicator of a stock’s performance relative to a benchmark, normally a broad stock index such as the S&P 500. If, say, Microsoft shares are up 10% over a two-week period and the S&P 500 is up 5% during that period, Microsoft’s Beta (a measure of relative strength) is 2.0 during that time. It’s a strong indication that — at least in the short run — investors are more enthusiastic about Microsoft than they are about the market as a whole. Why? For our purposes, that doesn’t matter. All we need to know is that Microsoft is exhibiting relative strength vs. the market.

What’s key here is that history shows that relative strength tends to be a good indicator of future performance. Stocks that outperform their benchmark are more likely to outperform in the near future than stocks underperforming their benchmark. Is that true 100% of the time? Of course not. By definition, what goes up must come down. No stock can continue to outperform forever. But when a stock’s performance begins to adjust, we can see that in the declining relative performance — leading eventually to a sell signal.

In other words, relative strength can be an effective system not for long-term investing, but for short-term trading. Stocks that are outperforming tend to continue to do so — until they don’t, at which time we sell them and move the proceeds into other stocks that are outperforming.

Always Bet On A Winner
My colleague Jimmy Butts uses a sports analogy to describe the effectiveness of relative strength. As he puts it, in any sporting event the winner almost always plays relatively better than the loser. Before a game starts, one team seems to be the stronger of the two based on their relative recent performances — as measured by win-loss record, scoring differential or other statistics.

Jimmy says when it comes to stocks, relative strength is an even better indicator than the sports teams’ performances before the game. Because we can compare how a stock has performed relative to its benchmark as recently as the previous day’s close, relative strength is more akin to picking the winner of  a sports event after the game is already underway — for example, three innings into a baseball game or one period into a hockey game. At that point, the winner is much easier to predict. It’s not a shoo-in, but it’s a really good bet.

One way that technical analysts use relative strength is to compare the performance of sectors of the market. Often, the relative strength of one sector versus another provides a clue as to the direction of the overall market. For example, analysts look at the performance of consumer staples stocks (for example, food and tobacco) versus more-cyclical consumer discretionary stocks (for example, large appliances and cars) to see whether investors are leaning toward or away from economically sensitive stocks.

In fact, consumer staples stocks were one of only two sectors with positive performance over the past month, as investors took refuge in companies whose earnings are less dependent on a strong economy.  (The other positive sector was utility stocks.) But as the market has rebounded in the past few days, energy and financial services have led the pack — a sign that investors have recognized serious bargains in these beaten-down areas and that the crowd believes the correction was overdone.

Make Relative Strength Part Of Your Investment Strategy
Going forward, we’ll keep a close eye on individual sectors and stocks that demonstrate relative strength as an indicator of the future leaders as the market attempts to stage a rebound.

Jimmy Butts is one of the best practitioners of relative strength investing in the country. Part of the reason is that he doesn’t rely solely on a relative strength as a single indicator. 

You see, he’s developed a system that combines relative strength with a more fundamental metric. Together the two indicators create what he calls a stock’s “Maximum Profit score.” This “score” tells him which stocks are outperforming the market and which of those overachievers has the best chance to deliver the biggest possible returns to investors. 

He got the idea for this strategy after reading about a group of amateur investors who used a similar method to earn $175 million. Recently his Maximum Profit system has helped investors earn as much as 89%… 127%… even 150% in as little as five months — and you can see which stocks it’s tagging as “buys” now by accessing Jimmy’s latest financial briefing here.