Chart Smarts: Using Relative Strength to Find Winners

This was originally published in two parts on RealMoney (part one on Apr. 9, 2008 at 3:46 p.m. EDT, part two on Apr. 11, 2008 at 3:49 p.m. EDT). Both parts are being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

Before we go to the charts, I want to go over what I mean by "leading stocks."

The stocks that I buy always have a RS (relative strength to the S&P 500) rating of 70 or higher over the last 12 months. (These data points can be found in Investor's Business Daily.) That means that these stocks are the top 30% of all stocks in the market based on price performance.

Most of the time, if you check the charts I post here, you will notice a RS rating of 80 or higher. That means I am only dealing with the strongest 20% of the stock market.

I do this because 125 years of stock market research shows that the best and biggest "monster stocks" every year had a RS rating of at least 80. If my stock does not have at least a 70, I won't even take a second look at it.

Now, of course, the RS line alone does not make a stock a buy or a sell. Only a well-formed chart pattern, with the stock bouncing off the 50-day moving average on heavy volume or breaking out on heavy volume, makes it a buy or sell.

Not only that, but that base must be formed near the stock's previous 52-week highs. I prefer this, as it means that once the stock breaks out, there will be no overhead resistance and hence no sellers waiting to unload at higher levels.

IBD's 125 years of stock market research on the greatest stock winners -- I have confirmed the research -- has proved that buying stocks hitting fresh 52-week highs (this is the key here; not the 100th time on the list) outperform fresh 52-week lows. This is why I always focus on the best leading stocks that are within 20% of previous 52-week highs.

For me, when it comes to the fundamentals , it is all about annual EPS growth, quarterly EPS growth, quarterly sales growth, ROE , profit margin , debt, mutual fund ownership and cash flow .

But along with good fundamentals, I want the stock to be within 20% of a new 52-week high, under very heavy accumulation, and forming and breaking out of a base of at least five weeks long (and preferably seven weeks) before actually making the purchase.

When everything lines up fundamentally and technically , there is only one more test: Is the general stock market in an uptrend or downtrend? If it's in an uptrend, then it is safe to invest. If not, knowing that three out of four stocks follow the market, the long should probably not be taken. That is, unless it is in a leading industry group -- the top 20% of groups based on price performance from IBD. Let's get to the charts.

Titan Machinery

Click here for larger image.

Source: TeleChart Gold

If Titan Machinery (TITN Quote) can pull back to the 50-day moving average on light volume and then bounce on strong volume, I would love to add to my long position in this leading retail/wholesale-building products stock.

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Syniverse

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Source: TeleChart Gold

If Syniverse (SVR Quote) can bounce off the 50-day moving average one more time or move sideways for a few more weeks and then break out on strong volume, I would love to add to my existing long position in this leading telecom-wireless services stock.

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Telemig Celular Participacoes

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Source: TeleChart Gold

If Telemig Celular Participacoes (TMB Quote) can pull back to the pivot point of the breakout area or the 50-day moving average on low volume and bounce on higher volume, I would like to get long this leading telecom-wireless services stock.

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Bancolombia

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Source: TeleChart Gold

If Bancolombia (CIB Quote) can create one more cup-shaped base and break out to a new high on strong volume, I would like to get long this leading foreign bank stock.

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First Financial

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Source: TeleChart Gold

If First Financial (FFIN Quote) can continue to move sideways for a couple more weeks and then break out to a new 52-week high, I would like to get long this leading banks-West/Southwest stock.

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DRS Technologies

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Source: TeleChart Gold

If DRS (DRS Quote) can pull back on low volume to the pivot point area or 50-day moving average, I would like to get long this electronics-military systems stock on the next heavy-volume bounce off the 50-day moving average.