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By Frederic Palmliden, CMT
Senior Quantitative Analyst, TradeStation Labs
Sector rotation is based on the concept that different sectors of the equity markets perform differently during various phases of an economic cycle. Much technical and fundamental research has been conducted on intermarket analysis as the question nowadays is more where to invest than whether or not to be in the market. For instance, cyclicals may start to outperform consumer staples when the economy is experiencing an upswing reflecting improved consumer expectations and optimism about the direction of the business cycle.
While there are many approaches to monitoring sector underperformance and outperformance, this paper will focus on sector rotation using a proprietary relative strength methodology. Challenges associated with traditional relative strength analysis become apparent when several moving parts are involved, which is the case with sector rotation. This paper will discuss and address these challenges, while providing a preview of future TradeStation Labs products.
Figure 1 – S&P Sector ETFs with the NRSS Indicator for Industrials (XLI)
Different market sectors perform better at different stages of the business cycle. Sector rotation refers to capital flowing from one stock market sector to another as investors pursue the next best-performing sector during a given business cycle. The intermarket relationships behind sector rotation are extensive and go beyond this paper. For example, energy stocks may take over market leadership near the end of an economic expansion due to rising energy prices and the resulting buildup of inflation pressures. The turn from the end of an economic expansion to the beginning of an economic contraction may be marked by leadership switching from energy stocks to more defensive sectors, such as consumer staples. It is important to note that market trends usually anticipate economic trends by six to nine months. Factors that affect sector rotation are wide-ranging and include industrial production, consumer expectations, interest rate movements, the shape of the yield curve and trends in the currency market. To learn more about some of these factors, readers may want to refer to Intermarket Analysis – Profiting from Global Market Relationships by John J. Murphy (John Wiley & Sons, Inc., Hoboken, New Jersey, 2004). In his book, Murphy provides a visual look at sector rotation throughout the market cycle and economic cycle (represented in Table 1 below).
Table 1 – Murphy’s Sector Rotation Throughout the Market Cycle (Gray) and Economic Cycle (Blue)
In this paper, the nine Select Sector SPDRs will be used. These are exchange traded funds (ETFs) representing the nine sectors of the S&P 500 index (see Table 2 below).
The performance of the different sectors from a chosen starting point, such as the beginning of the year, can easily be charted on the TradeStation platform by inserting all the symbols into the same chart window. After inserting the symbols, right-click, select “Percent Change Chart” and then select “Enable.” See Figure 2 below. S&P Depositary Receipts (symbol: SPY) is included as a reference point representing a broad measure of stock prices (see light green line in Figure 2).
Figure 2 – S&P Sector ETFs Simple Returns Year to Date (as of 11/30/11)
Figure 3 – S&P Sector ETFs Simple Returns Year to Date as of 11/30/11 (using Excel)
A useful advancement in the analysis would be to include the performance of a benchmark into the calculations when comparing the performance of the market sectors. For example, the performance of the S&P 500 Index can be deducted from the raw performance of the sectors for an improved view of the underperformance and outperformance of the sectors (see Figure 4 below). The chart now reflects how much a given sector is returning on top of the benchmark, or how much it is trailing behind the benchmark. Here the data was also reorganized for an easier view of the best- to worst-performing sectors year to date. Notice that utilities have outperformed all other sectors year to date, whereas the financial sector has been the worst performer for the same period.
Figure 4 – S&P Sector ETFs Returns Versus SPY Return, Year to Date as of 11/30/11(using Excel)
The different methods described thus far are generally accepted and very useful tools for tracking purposes, but they do not necessarily help determine which sectors may be the next ones to underperform or outperform the broad market benchmark. This is where relative strength comes in.
At first glance, the concept of relative strength in technical analysis is rather straightforward. The price of a security is divided by the price of another security, usually a benchmark index such as the S&P 500, and the resulting ratio shows the relative strength of the first security. (An indicator supplied with the TradeStation platform named “Spread – Ratio” makes it easy to graph the relative strength.) This can be a great help in spotting points when a particular sector is transitioning from a period of underperformance to a period of outperformance. Ideally, in that particular scenario, the relative strength line would be breaking a downtrend and starting a new uptrend, possibly signaling a period of outperformance.
Sector rotation using relative strength becomes rather complicated, however, when multiple sectors are compared at the same time. Directly comparing the relative strength ratios as described above is impossible, since the ratios by themselves do not mean anything. A simple example is shown in Figure 5 below to illustrate this point. From the price chart, the security in orange (XLP) is outperforming the security in dark green (XLE) year to date (8.84% YTD versus 3.84% YTD as of 11/30/11). However, the relative strength value for XLP is lower than the relative strength value for XLE (see sub-graph 2 in Figure 5), simply because XLP is at a lower price than XLE, resulting in a lower relative strength ratio. This example highlights the scaling issue when dealing with more than one relative strength ratio. Imagine how confusing it is when trying to compare all nine sectors using traditional relative strength wherein each ratio is using a separate scale due to price differences.
Other issues related to traditional relative strength analysis include historical look back and future projection. If the relative strength line is turning, does it signal a new trend? Is it a minor setback? Where does the last signal fit in relation to the overall cycle of the sector and the business cycle? In other words, the analytical context around traditional relative strength may be ambiguous.
Figure 5 – Traditional Relative Strength Example (XLE and XLP vs. SPY as of 11/30/11)
It is the trends of the different relative strength ratios that carry meaning, not the ratios themselves. Therefore, extensive hands-on charting is required to interpret sector rotation using traditional relative strength, but even then there is a lack of context due to the price differentials. This is where the NRSS indicator comes in.
The Normalized Relative Strength Score (NRSS) indicator is a proprietary indicator developed to address the challenges associated with the traditional relative strength analysis. The indicator normalizes the different relative strength ratios so that the different sectors can be compared at any one time during the business cycle. Moreover, the sinusoidal wave shapes that soon become visible give context to the different sector rotation turns. In other words, if a particular sector turns up (outperformance) in the upper portion of the cycle after initiating a down wave (underperformance), the current turn may well prove to be temporary and additional downside (underperformance) can be expected (see the temporary uptick for industrials, XLI, in the first quarter of 2011 on the far right side of the chart in Figure 1).
Figure 6 – NRSS Indicator (11/10/00 to 11/30/11)
In the time period covered in Figure 6 above (2001 through 2011), the NRSS indicator reflects fairly closely the order of the sector rotation outlined in Table 1, supporting Murphy’s research. This is particularly noteworthy in the period from 2007 to 2010, during which the chart shows sector leadership peaking and shifting in the order outlined in Table 3 below.
*It should be pointed out that due to some degree of smoothing, the dates in Table 3 do not reflect the precise dates when sectors turned. In other words, there is a small lag involved. Also, remember that the NRSS is not showing simple price performances; rather, it is displaying relative strength. In other words, a particular line from the NRRS could be trending lower, while that sector is appreciating in price. In that case, the sector would be underperforming the benchmark while appreciating in price.
The NRSS also reveals when different sectors move in tandem and when they do not. Knowing the theoretical order of sector rotation may help confirm when different relationships may be only temporary or when they are likely to persist.
Please note that the NRSS indicator is not currently available for download. Instead, the analysis generated by the NRSS indicator is slated to be made available on the TradeStation Labs pages of the TradeStation website, along with other proprietary market indicators.
Third-party 3-D imagery software developers may also be utilized to view the NRSS indicator, such as AlphaVision® from Aqumin® (see Figure 7 below).
Figure 7 – NRSS Indicator with AlphaVision from Aqumin*
Additional information, such as hidden patterns and relationships, can be more easily identified with this interactive 3-D visualization. The larger field of vision provides market professionals a unique advantage in viewing and analyzing large amounts of data. Regarding the NRSS indicator, the zoom feature as well as the ability to rotate the landscape can be very useful for historical studies and for real-time analysis.
*Note: For further information on Aqumin and its products, please visit http://www.aqumin.com.
Figure 8 below shows the NRSS year to date for 2011. A general reading of the indicator suggests that the current underperformance of the Energy sector (XLE) may have further to go. The underperformance in the Consumer Discretionary sector (XLY) for most of this year may also continue despite a recent uptick in the last few months.
Moreover, the dramatic underperformance seen in the Financial sector (XLF) since the beginning of 2010 may be showing limited downside. As emphasized above, this is not to say that Financials will gain in value, but rather that the underperformance may be nearing an end.
The outperformance of Utilities (XLU), Consumer Staples (XLP), and Health Care (XLV) may have some additional upside according to the NRSS indicator.
Figure 8 – NRSS Indicator (Year-to-Date)
The NRSS indicator builds on the traditional relative strength concept and provides a clearer picture for spotting sector rotation turns. Context for comparison is added to the picture, something that has long been an issue with the traditional relative strength methodology applied to sector rotation. Individual scores from the NRSS indicator for the different sectors can be directly compared through the market and economic cycles, an all-but-impossible task with traditional relative strength analysis. The NRSS indicator, along with other proprietary indicators for market analysis, is expected to reside on the TradeStation Labs web pages, providing updates on the different sectors.
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