How to Spot Stocks With the Biggest Rally Potential After a Sell-off

If you fancy yourself a momentum investor, you're likely intimately familiar with the concept of relative strength (RS) -- arguably one of the most important technical investing tools and one that has withstood the test of time. 

At its core, relative strength investing involves buying the best-performing stocks relative to the market and holding them until their momentum changes course.

In 1967, Robert Levy published the first scholarly paper on the subject, which was called "Relative Strength as a Criterion for Investment Selection." The groundbreaking work showed stocks that had outperformed over the past six months tended to do well in the following six months, while stocks that underperformed also tended to continue to do so. Put another way, he showed that strong price trends tend to persist.

Even before that, though, the legendary Jesse Livermore -- one of the world's greatest traders from the early 20th century -- was following the same concept to make money. According to the classic investment book "Reminiscences of a Stock Operator," which is based on his life, Livermore believed, "Prices are never too high to begin buying or too low to begin selling."

My own trading system, the Alpha Score, is based on relative strength, and it routinely leads to double- and triple-digit winners.

Today, I want to talk about how useful RS can be during times of market turbulence to find those stocks most likely to soar once the market turns back up. Considering the volatility we've seen recently thanks to international woes, it's an ideal time to broach the topic.

Since most stocks follow the market, general weakness provides a shake test that allows technicians to see the strongest stocks in stark relief. 

While I typically use RS to compare a stock against all others in the market as a means of ranking them from best to worst, we can also compare a stock's performance to the broader market using the S&P 500.

As I search for buy candidates during a market decline, I look for three things:

1. Stocks that are trading in line with the market;
2. Stocks that are holding up better than the market; and 
3. Stocks that outperform when the market begins to turn up. 

When the general selling pressure eases, stocks with at least two of these characteristics have higher odds of being the next market leaders. 

Now let me show you exactly how this works with three examples. 

Between mid-September and mid-October, we witnessed the closest thing to a market correction we have seen in nearly four years, sparked by fears of an Ebola outbreak.

SPX Chart

As the market took a beating, a select few stocks showed the positive RS characteristics mentioned above.

The first one we'll look at is Ulta Salon, Cosmetics & Fragrance (NASDAQ: ULTA). The bottom panel of the chart shows the performance of the S&P 500. The middle panel displays the performance of ULTA. And the top panel shows the relative performance of the two with a sideways line indicating ULTA is performing in line with the market and a rising line indicating ULTA is outperforming.

ULTA Chart

I've marked three important points on the chart. At Point 1, the market and ULTA began falling. Point 2 shows the relative performance line moving sideways, which indicates ULTA's decline was in line with the market. 

Now, notice how sharply the relative performance line turns up at Point 3. This is key. While ULTA still had a little further to fall from this point, it began acting much better than the market. 

This showed sellers getting shaken out of the stock, and once they were, ULTA zoomed back to its pre-correction highs. By the end of October, shares made a new closing high and haven't looked back. 

Despite the fact that ULTA was falling, its relative strength versus the S&P 500 was an indication that such an uptrend was likely once the market got its groove back.

The next example is Centene (NYSE: CNC).

CNC Chart

Once again, Point 1 shows the decline starting in the S&P 500 and then in CNC slightly later. Point 2 shows CNC's relative performance. As was the case with ULTA, the relative performance line was initially going sideways.  

Point 3 marks the beginning of a surge in relative performance. In fact, CNC's rally was so strong compared to the S&P 500 that the relative performance line made a new all-time high. Shortly thereafter, CNC made a new all-time high and a big uptrend ensued. 

Our third example in UnitedHealth Group (NYSE: UNH).

UNH Chart

Again, at Point 3 we see a sharp increase in the relative performance line, which made a new high, tipping us off to the subsequent price rally.

The lesson is that, while corrections are scary, looking at stocks' relative performance compared with the broader market during these times can help us spot those most likely to be market leaders during the next leg up.

Currently, all three of the above stocks are in my Alpha Trader portfolio and are up between 26% and 98% since purchasing them. I will be honest, though: Their relative performance during the late-2014 "near correction" was not what alerted me to these stocks initially -- although each would have been a successful buy signal.

Rather, for every trade I select, I use my own RS-based system, the Alpha Score, and align it with trend-following principles like we've discussed today. This gives me the ability to execute trades consistently, and it's been very successful at capturing stocks that undergo large price trends -- up to 242% so far. 

If you're interested in learning more about my system and how it uncovers stocks on the verge of huge rallies, I've put together a free report you can view here

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