The traditional focus of the relative-strength indicator is the comparison of a stock to an underlying index, like the S&P 500 Index (SPX), creating a single line showing relative performance. This comparison is usually the performance of a key stock versus the entire market or a sector that the stock is a part of. We think of relative strength like a funnel of money flow. As the stock is outperforming a particular index, money is flowing more heavily toward that equity than that of the broader market. Likewise, if the stock is underperforming in comparison to an index, the equity has money flowing at a slower rate into the equity versus the general market.

A stock that displays improving relative strength versus the market or a corresponding sector index may be on the verge of an aggressive move to the upside. Conversely, a stock that begins to show weakness relative to the market or its peers may be poised for a breakdown. Consider the following examples.

Shop Inc. (SHOP) began showing a notable increase in relative strength versus the S&P Retail Index (RLX). In fact, the weekly relative-strength measure of SHOP versus the RLX moved higher in this period to break above a series of lower highs.

Although SHOP continued to consolidate over the ensuing months, the relative-strength breakout of SHOP was a precursor for a sustained move to the upside for the retailer. Eventually, the stock had moved to a new all-time high.

On the other hand, biotech company Medco (MEDC) saw its daily relative-strength measure versus the AMEX Biotechnology Index (BTK) begin to decline substantially in April after a prolonged period of outperformance.

While the shares continued to consolidate for the next 2 months, the relative-strength breakdown ultimately preceded disappointing fundamental news that sent the stock lower in June.