Periodically, equity markets will undergo sector rotation where money moves from one sector of the economy to another.
Since equity markets are forward-looking, the individuals managing large sums of money, like hedge funds, mutual funds, and institutions, will rebalance or change exposure levels to certain sectors in a fairly discernable manner in anticipation of new trends.
Below is a Relative Rotation Graph (RRG) which plots the relative strength ratio for a particular security versus its benchmark against the corresponding momentum of the relative strength ratio. In the RRG below each Exchange Traded Fund (ETF) is compared relative to the S&P 500 Index.
An RRG can be valuable in identifying strengthening sectors of the market where traders should be long as well as flagging sectors to underweight, cut exposure, or even short.
For example, over the past seven weeks money has left sectors that represent Technology (XLK) and Consumer Discretionary (XLY) stocks. Additionally, we can see the lagging price action in both these sectors, represented by their ETF’s, as XLK is just making a new high as of today and XLY has yet to make a new high.
Meanwhile, other areas of the equity markets have also made new highs.
Broadly speaking, the NYSE Composite (NYA), S&P 500 (SPX), Dow Jones Industrial Average (INDU), Dow Jones Transportation Index (TRAN), and the Russell 2000 (RUT) all made new highs last week while other indexes and sectors are just following through.
Taking a deeper look at the leading and lagging sectors that make up each of these indexes will be valuable in identifying new price trends.
For instance, we can observe from the RRG that Healthcare (XLV), Industrials (XLI), and Basic Materials (XLB) have led other sectors in relative strength as well as relative strength momentum. These positive developments are confirmed by each ETF posting new highs several weeks ago.
Elsewhere it is interesting to note the movement in Financials (XLF) and Energy (XLE) stocks. As of today, both sectors are improving relative to the S&P 500 and have picked up momentum in relative strength as well.
Typically, the big moves in equity markets take place in the outer regions of the RRG graphs. Both XLF and XLE have the potential to move from the improving quadrant into the leading quadrant and create some nice price advances in the process.
Despite the prolonged downtrend in XLE, the daily chart displays relative price improvement. Specifically, XLE is exhibiting positive divergence against its Relative Strength Index (RSI) as well as its Moving Average Convergence Divergence (MACD) indicator. Positive divergence can lead to improved price performance as the gradual improvement in the calculation of each indicator represents underlying price strength.
Additionally, as of the close today XLE is now above its 50-day simple moving average (50SMA). Previously, the 50SMA was a point of resistance for XLE and a demarcation line for strategic shorting opportunities. However, with continued buying above the 50SMA a new intermediate term uptrend or countertrend move may occur.
The existing long-term uptrend in equities is providing an opportunity to profit from multiple sectors. Or, to quote former President John F. Kennedy, “A rising tide lifts all ships.” However, identifying which ships, or in this case sectors, are rising first and fastest will help you as an investor align your portfolio with the strongest trends in place.
John DiRico is a trading and investment professional focused on technical analysis as well as alternative investment strategies. Additionally, he is the founder of the blog “A Discounted View” where he offers his observations on markets based on industry experience and topics covered in the Chartered Market Technician (CMT) curriculum. Please feel free to connect.