The Relative Rotation Graph (RRG) below shows the rotations of major stock market indices on 12 May. The high concentration of indices inside the leading quadrant stands out.
A closer look reveals what’s going on. The key thing to understand is that an RRG is based on relative strength. The chart doesn’t tell us much about price trends; rather, it illustrates that stock markets in Hong Kong, Japan and Germany are performing significantly better than the MSCI world index, which we use as a benchmark, and are also outperforming US markets.
As the US makes up a large part of the MSCI world index, the S&P 500 (SPX) sits close to the benchmark at the centre of the chart. The most important takeaway from this RRG is the negative rotation of US markets.
The Nasdaq (NDX), the S&P 500, and the Dow Jones Industrial Average (INDU) are all travelling in a negative direction, moving south-west on the chart, while most other indices are in or heading towards the leading quadrant in the north-east of the plot.
The above chart takes the same group of indices and compares them to an annual rate of return of 0%, showing their relative strength against a flat line. This essentially represents price performance, allowing us to look at price trends. The chart illustrates the current weakness in stock markets around the world.
Nevertheless, the rotations can be used to help identify pair trades, potentially allowing us to benefit from differences in relative strength across markets while minimising our exposure to general market direction.
The above weekly chart for the S&P 500 shows a clear break, completing a topping formation. At the moment, the index is challenging an intermediate support level, but major support is only found near the 3,500 area.
The most important takeaway from this chart, in our view, is that upside potential is now very limited, most likely towards the 4,200 area, while downside risk is increasing.
Zooming in on the S&P 500, the above RRG breaks the index down into 11 sectors. This is a weekly RRG, so it features slightly longer-term rotations. You can see that the end-points on the tails are now “bubbles” of different sizes.
The size of the bubbles in this chart is driven by the market capitalization of the sector. This brings us to an interesting observation.
Inside the lagging quadrant we find three heavyweight sectors. Information technology (which accounts for 26.4% of the index’s market capitalization), consumer discretionary (11.3%), and financials (10.5%). Combined, these three sectors make up almost 50% of US market capitalization. And they are underperforming the S&P 500.
As a result, we find a higher concentration of sectors inside the leading quadrant as they have to offset the market cap on the other side.
The above price chart for the information technology sector looks a lot like the S&P 500 chart. Again, a major top formation was completed on the break of horizontal support. The sector is now on course to test the next major support level just below 2,200. But more importantly, the upside potential is now capped at the level of the breakout, while downside risk continues to increase.
Given this rotational picture – with heavyweight offensive sectors in relative downtrends against the S&P 500, and defensive but lightweight sectors (healthcare, consumer staples, and utilities) in relative uptrends – it will be difficult for the market as a whole to get back into an uptrend in the coming weeks.
Nevertheless, as we saw earlier with stock market indices, the sector breakdown highlights the potential for pair-trading opportunities, while minimising exposure to directional market risk.