Relative-Strength Divergence Scan
Compare price with benchmark-relative strength to spot leadership changes
- Difficulty
- Moderate
- Time to result
- ~months to results
- Steps
- 6
- Confidence
- 98%
Divide a sector or stock price by a relevant benchmark, then follow the direction of that ratio. A rising line means the asset is outperforming; a falling line means it is underperforming. Next, compare price extremes with relative-strength extremes. A negative divergence appears when price reaches a new high but relative strength does not, suggesting that leadership is fading. A positive divergence appears when price reaches a new low but relative strength holds a higher low, suggesting that the asset may be preparing to turn upward. Strengthen the reading by checking whether long-standing relative support breaks and by considering how long the divergence has developed. The mechanism reveals movement toward or away from an asset that its absolute price can temporarily conceal.
Origin
Louise Yamada explained this sector and stock comparison process on Masters in Business, including a six-year financial-sector divergence before 2008.
Core principles
- 01Investors do not enter a market intending to underperform
- 02Benchmark-relative direction reveals leadership
- 03Price highs without relative-strength highs warn of weakening demand
- 04Price lows without relative-strength lows can precede recovery
- 05Longer divergences carry greater significance
How to run it
- 1
Set the benchmark
Select the broad index against which the stock or sector should be judged.
Pro tip Yamada uses the S&P 500 for sector comparisons.
- 2
Plot the ratio
Create the asset-to-benchmark ratio and note whether its line is moving up or down.
Watch out Absolute price strength does not necessarily mean benchmark outperformance.
- 3
Compare the extremes
Check whether each new high or low in price is confirmed by a corresponding extreme in relative strength.
- 4
Classify the divergence
Mark a price high without a relative-strength high as negative, or a price low with a higher relative-strength low as positive.
Pro tip Use divergence as an indication of a possible change, not certainty.
- 5
Inspect structure and duration
Look for support breaks, higher lows, and the length of the developing divergence.
Pro tip Give a multi-year pattern more weight than a brief discrepancy.
- 6
Adjust attention
Focus research on emerging outperformers and scrutinize holdings whose relative leadership is deteriorating.
Watch out Do not ignore conflicting evidence from the broader trend.
In the wild
In 2007 the financial sector made a new price high, but its relative strength did not. The relative-strength line then broke support that had existed for six years, signalling an important change before the sector's severe decline.
→ Leaving financials after the signal would have preserved substantial value during the subsequent fall.
Common mistakes
Reading price in isolation
A new price high can hide weakening performance against the broader market.
Ignoring pattern duration
A long divergence contains more evidence of a possible reversal than a fleeting mismatch.
Is it for you?
Best for
It is best for comparing stocks or sectors with a broad index such as the S&P 500.
Not ideal for
It is not ideal when no meaningful benchmark exists or when the comparison period is too short to establish a pattern.
From the transcript
“when that line is going up, the health care sector is doing better than the Bruin index. And when that line is going down, right,…”
“if the price moves up to a new high and the relative strength fails to move to a new high, you have an indication that…”
“the bigger the top, the greater the length of price. Evidence that something is on the verge of reversing is very important.”
From the episode
Interview With Louise Yamada: Masters in Business (Audio)
Louise Yamada