Relative Rotation Concept
If you’ve ever lived in South Florida, there’s one thing that stands out – traffic is horrendous.
This isn’t New York City where everything is within a few blocks. Everything is miles apart down here.
Yet every time I hop on a highway, there’s a traffic jam.
I am constantly using my navigation to notify me if there is an accident ahead, or if there is a better route.
But I also find myself competing against the navigation itself.
If, according to the navigation, it is supposed to take me 30 minutes to get home from work, I want to arrive in less than that amount of time.
I guess it’s just the competitive nature in me.
The navigation represents the average arrival time. But I am not an average person.
I always seek to outperform averages, just as I seek to do so in my investments – no one want’s average.
To outperform the average consistently, you have to have a good method of picking winners and losers… and I have one to share with you today.
Picking Winners and Losers
While everyone has their own unique investment tools, one of my favorite market indicators is the relative rotation of the sectors in the market.
To break that down a bit, relative rotation is a combination of a specific sectors relative performance compared with the index (S&P 500) and the sectors specific momentum, or price change of the sector itself.
In doing so, I can determine which stocks are leading, weakening, lagging or improving.
The relative rotation graph puts this into a visual concept easy to understand and comprehend, which I’ll show in a moment.
But first, let’s talk a little more about our attempt to beat the average.
Think of it like this, if all the sectors of the S&P 500 make up the average, it’s difficult when choosing out of that bunch to find the few that will outperform it at any given time.
Because one sector will not continuously outperform and one sector will not continuously underperform as this will influence the average and cause other sectors to then outperform and underperform.
This is what creates the rotation in a relative rotation graph – and it makes it visibly easy to pick winners and losers.
It’s All About Rotation
Now that you understand the concept behind it, let’s take a look at a weekly relative rotation graph:
(Please note, there is a lot going on here, so keep reading to understand all of it)
Assuming the animation works, this may look like a bunch of squiggly lines running around, but there should be a distinct clock-wise rotation that you can see is generally going on.
It is partly thrown off in November, as the sectors paused waiting on the election and then broke out afterwards. Now you can see those are already starting to rotate again.
The animation only takes about 30 seconds to complete its cycle, so watch it a couple of times to see what is going on. The blue bar at the top with the shaded area running across it indicates the date at which you are watching.
If you are having trouble with the visual, don’t worry, there is a lot going on in one graph so let me explain.
The center of the graph represents the S&P 500, or the average return of the sectors.
If a sector is at the top right area (shaded in green) it is leading the market, or outperforming.
If the sector is in the bottom right (shaded yellow) it is still leading, but has started to weaken.
If the sector is in the bottom left (shaded red) it is lagging the market, or underperforming.
And, if the sector is in the top left (shaded blue) it is lagging, but improving against the market.
A Clear View
The relative rotation concept was developed by Julius de Kempenaer of RRG Research (which owns the trademarks for it) back in 2004. He designed relative rotation graphs for one simple reason – to show institutional investors a clear view of leaders and laggards in the market.
I think he accomplished that.
And I’ll take it one step further, to give you an easy way to pick winners and losers.
Since there is the steady rotation, you can pick winners and losers by grabbing stocks as they enter the improving section (shaded blue), and sell them as they enter the weakening section (shaded yellow).
Using that template, you will want to have more exposure to sectors that are improving – real estate, utilities, consumer staples and healthcare. These sectors have been lagging and are starting to improve, that means momentum is picking up and relatively speaking it is not underperforming as much.
The sectors you want to limit your exposure to are the ones that are weakening – financials, energy and industrials. These are sectors that have been and still are leading the market. But their momentum is fading and they could soon fall and be lagging the market.
There are countless ways to trade based on this one simple graph, and it is something I continue to study and analyze, but this concept of counting on the rotation aspect to play out is helpful when it comes to asset allocation.
The graph is a weekly basis, so you can make these changes and look to ride it out for a few weeks.
Chad Shoop, CMT
Editor, Automatic Profits Alert