THE RELATIVE STRENGTH CONCEPT APPLIED TO SECTOR INDICES

An Illustration with the DJ Stoxx 600 Index

Yann CORDIER, CFTe, MFTAAXA Investment Managers

London, 10/03/2015

OUTLINE

The concept and power of Relative strength

Comparing a sector vs. the market: An overlooked approach

Relative charting of sectors: Advantages and limits

How to use technical indicators on relative charts

A relative analysis of DJ Stoxx sectors with top‐down portfolio construction

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1.  THE CONCEPT AND POWER OF RELATIVE STRENGTH

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The Relative Strength concept

A relative strength chart simply reflects the ratio between two securities in a homogenized unit (currency)

It enlightens the strength of an asset vs. another asset / market, giving precious additional information vs. an absolute chart alone

Technical analysis can and should add value to relative charts

Examples of relative charts:

Inter‐market analysis (corporate debt vs. equities  risk premium concept) A sector vs. the overall stock market A stock vs. its sector / the overall market Two stocks (for pair trading purposes)

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Relative charting:The famous example of DJ Transport vs. DJ Industrials (1)Daily chart, 2008-2009

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Relative charting:The famous example of DJ Transport vs. DJ Industrials (2)Weekly chart , RSI (14), 2010-2015

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Weekly RSI of the ratio crossed 50 from above watch out for possible bearish breakout of the trendline

Could be a forerunner of impending weakness for the overall US stock market

Small caps vs. Blue chips in EuropeWeekly chart, RSI (14) and Fibonacci retracements

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After years of outperformance, 2014 was poised to be a year of underperformance for small caps vs. blue chips Resistance from the 138.2% level of previous bullish cycle RSI leaving its overbought area

Relative Strength:Buy the strongest of two assets

Mostly, the best pick is the asset that performs most (Don’t fight the trend!)

Especially useful when comparing emerging currencies vs. $, £ or €, or sectors vs. the equity market

Example of US Healthcare and Consumer Staples vs. the S&P 500

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Relative Strength:US Pharma (left) vs. US Consumer Staples (right) (1)Absolute daily charts 2013-2015, ADX/DMI (14)

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… Quite the same picture, isnt’it?

Relative Strength:US Pharma vs. US Consumer Staples (2)Relative daily chart 2013-2015

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The relative chart clearly enlightens consistent outperformance from Healthcare with no warning  of reversal  give preference to Pharmas!

Pair tradingGSK vs. AstraZenecaDaily chart, Ichimoku, 2013-2015

The technique traditionally  used in L/S Equity portfolios Going long an equity / short another, preferably:

When they’re comparable When they tend to experience cycles of out/underperformance

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2.  COMPARING A SECTOR VERSUS THE MARKET:AN OVERLOOKED APPROACH

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The interest of analysing a sector vs. the overall stock market

Most equity portfolios are guided by hunt for alpha  Bottom‐up approach (stockpicking)

Overall portfolio construction is rarely an ex ante priority, hence the value of Top‐down approaches

The stock market is a succession of cycles of frenzy or disinterest vis‐à‐vis sectors, countries and/or styles (value, growth, yield…)

Relative strength approach is the least risky way to implement contrarian opinion principles

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Top-down vs. Bottom-up approaches

Relative strength analysis can make bottom‐up approach much more efficient by helping know when to put the cursor on the names you want to bet on

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Method Top‐down Bottom‐up

Description Portfolio allocation based on asset class, geography, 

industry sector…

Stock / bond selection basedon a company’sfundamentals

Underlying philosophy Markets don’t behaveindependently Inter‐market analysis, Relative 

strength

Focus on "micro" knowledge(earnings releases, meetings 

with managements)

Portfolio construction Ex ante Ex post

3.  RELATIVE CHARTING OF SECTORS:ADVANTAGES AND LIMITS

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Chartist analysis of Relative strengthGeneral principles

Relative charts have nothing particular except they’re pictured as line graphs (candlesticks are meaningless here)

Thus, they evolve in trends, reversals and experience congestion phases

Usual chart patterns are at least as significant as with absolute charts as breakouts are not "played" by traders

Double Tops/Bottoms, Head & Shoulders following strong trends are particularly meaningful

Trendline breakouts are serious – i.e. less false signals

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Chartist analysis of Relative strengthExample of breakout with the US Energy index (1)Absolute daily chart, RSI (14), 2013-2015

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Chartist analysis of Relative strengthExample of breakout with the US Energy index (2)Relative daily chart vs. the S&P 500 index, RSI (14), 2013-2015

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No big absolute gain in cutting exposure 20 days earlier (0.6%) BUT far more reactivity from portfolio managers using a relative approach

Chartist analysis of Relative strengthExample of Ichimoku graph on US Banks (1)Absolute weekly chart, 2010-2015

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Chartist analysis of Relative strengthExample of Ichimoku graph on US Banks (2)Relative weekly chart vs. the S&P 500 index, 2010-2015

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It is hard to remain complacently bullish on US Banks if you look at their relative strength!!

Chartist analyst of Relative strengthThe importance of multi-timeframe approach

As usual, it is important to make sure that a trade does not go in a way that is opposite to its primary trend

As regards sector indices, cycles are generally rather long (i.e. several months)

The most rewarding trades are made when LT, MT and ST display comparable patterns

Ideal situation #1: When a ST/MT trend resumes after a pullback while the LT trend was not impacted

Ideal situation #2: When a ST/MT trend starts to develop but the LT trend is not impacted yet (but with clues it could happen soon)

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4.  HOW TO USE TECHNICAL INDICATORS ON RELATIVE CHARTS

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Technical indicators, the RS’s best friends

Cycles on sectors vs. market tend to be long (longer than on pair trading with frequent reversions to the mean)

Trend indicators are well suited to take full benefit of this phenomenon (cf. Ichimoku charts)

Importance of catching turning points and not simply following trends

Divergences on momentum oscillators are particularly powerful

Bollinger bands provide extremely reliable signals

Oscillators very often make significant patterns by themselves

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Divergence on StochasticsUS Materials vs. the S&P 500Daily chart, slow stochastics, MACD (12,26,9), June – Dec. 2013

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The sell signal given by Stochastics coincided with a long divergence made by MACD2 vs. MACD

Bollinger signalsEuropean Retail vs. the DJ Stoxx (SXXP)Weekly chart, Bollinger bands, 2010-2015

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Head & Shoulders pattern on RSINokia vs. Euro Stoxx 50Weekly chart, RSI (14), 2004-2013

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Ideal situation #1A MT trend resumes after a pullback without impact on the LT trend (1)European Utilities vs. SXXP, Weekly chart, RSI (14), 2010-2015

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Ideal situation #1A MT trend resumes after a pullback without impact on the LT trend (2)European Utilities vs. SXXP, Daily chart, ADX/DMI (14), 2013-2014

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Trend‐following indicators showed the MT trend was not seriously jeopardized

Ideal situation #2MT reversal with good probability to carry the LT picture along (1)Iberdrola vs. European utilities, Daily chart, Bollinger bands, slow stochastics and MACD (12,26,9), 2011-2013

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Ideal situation #2MT reversal with good probability to carry the LT picture along (2)Iberdrola vs. European utilities, Weekly chart with MACD (12,26,9), 2010-2015

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In this case, bullish divergences occured simultaneously on weekly and daily charts!

Is there an optimal combination of technical indicators on relative charts?

RSI is generally more reliable on relative charts than on absolute ones, and is powerful on LT charts

MACD brings enormous value‐added:

Peak & trough divergences made by MACD2 Crossing the Signal 0 acting as a Support or Resistance

Bollinger bands are perhaps more helpful for pair traders, but Bollinger signals made by sectors vs. the market are very powerful and reliable

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5.  A RELATIVE ANALYSIS OF DJ STOXX SECTORSAND PORTFOLIO CONSTRUCTION

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Analysing the Stoxx index subsectors today

3 parameters should be taken into account:

1. Synchrony between different timeframes2. Recent signals3. Sector weightings in portfolios today

Portfolio construction is then based on technical analysiswith a contrarian bias

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Food & Beverages

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Weekly Daily

Bullish mood may be shifting soon (end of trend, big resistances)

Healthcare

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Weekly Daily

Bearish MT outlook might trigger off reversal of the LT trend

Mining

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DailyWeekly

Bullish inflexion is likely… provided USD doesn’t appreciate too much

Telcos

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Weekly Daily

Bounce off meaningful support levels  look for confirmation on the LT trend

Banks

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Weekly Daily

Clear outperformance expected

Insurance

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DailyWeekly

LT bullish trend not impacted yet, but cautious on MT  sell on probable STstrength

How are investors positioned on European sectors today? (1)

As most equity fund managers are bottom‐up, they tend to stick to their highest convictions

Inertia in their sector positioning is an interesting consequence of it (Portfolio shifts may take several months, cf. 3‐year UW on Banks)

Polls among the biggest managers give a key clue to risks to the up‐ or downside for sectors (extreme complacency or mistrust)

Recent examples:

Media ("overcomplacency" end‐2013 with 450 Bp OW overall; strong, repeated bearish divergences from RSI) Utilities Healthcare Telcos

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How are investors positioned on European sectors today? (2)

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How would we be positioned in terms of sectors today?Summary table

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NB: Rating scale goes from ‐‐‐ to +++ Underlined sector means that recommendations on both time horizons coincide An asterisk signals a change of recommendation 

Weeklychart

Dailychart

Automotive+

(a correction wouldn't jeopardize uptrend)+

(Buy on weakness)

Banks+

(RSI left oversold area, wonderful Bollinger signal)++

(broke resistance, bullish consolidation)

Basic Materials+

(inverted H&S pattern, bullish RSI divergence)+

(++ if Cloud is broken to the upside)

Capital Goods‐

(inflexion but resistance from Cloud and SMAs)+

(as far as the support line holds)

Energy  *+

(inverted H&S, RSI using 30 as a support level)‐ =

(contradictory signals)

Food & Beverages‐ =

(trend has been fading)‐ =

unless Cloud is broken to the upside (but thick!)

Healthcare‐ ‐

(RSI crossed 50 from above)‐ ‐

(support line broken, then tested as a resistance)

Insurance=

(but could rapidly worsen)= ‐

(broke support, sell on probable ST strength)

Media‐

(caution: risk of Rising Wedge, high bandwidth)=

(near a key resistance)

Retail++

(broke to the upside from a bullish flag)+

(bullish ascending triangle)

Telcos *+ =

(bouce off trendline and middle band)++

(bullish Bollinger signal)

Utilities‐ ‐

(broke key support)‐

(too early to go back)

Portfolio constructionA mix of relative analysis and contrarian opinion

Strongly positive on Banks: Still underweighted in portfolios and at historical average 500 Bp OW

Positive on Telcos, but not the strongest Overweight as the sector is at the high end of itshistorical range of holding   200 Bp OW

Slightly positive on Capital Goods: ST technicals are decent and holding levels are at historicallows 150 Bp OW

Slightly negative on Food & Beverage: Not "overloved" yet but chart analysis commandscaution  150 Bp UW

Negative on Insurance: Holdings at historical highs, technicals could rapidly deteriorate250 Bp UW

Negative on Healthcare: Technicals get ugly, the sector is far from "overhate"  300 Bp UW

Strongly negative on Utilities due to chart patterns and the fact they are decently owned on a historical basis in portfolios  200 Bp UW

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Conclusion

Relative strength charts add valuable information

A Top‐down approach based on relative momentum makes sense to build an equity portfolio

Big sector rotations are a rather inert process 

Nevertheless, identifying reversals is made easier with relative analysis

Combining chart analysis, oscillators and multiple timeframes may lead to nice, consistent results (ca. 80% win rate when LT and MT signals coincide)

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