AUTHOR

Since I was introduced to Relative Rotation Graphs, I have been constantly playing
with them and trying to see how they can give me insights into what is happening in
the market. I love looking at different Asset Classes, Currencies and Portfolios. My
favourite group however will always be the SP500 GICS Level 1 sectors with the
SP500 as the benchmark, because I know that the total of the ten sectors must be
fully encompassed by the benchmark. The ten sectors embody all the elements that
can contribute to the SP500 itself. When I look at the RRG, which measures trends in
relative performance of each Sector against the Index, there has to be balance in
each of the axis.

SP500 GICS Level 1

Sectors verses SP500 -
Data from Bloomberg

Consider Figure 1; we can see the ten sectors based on their relative strength
against the SP500. An immediate stand out is the Utilities (S5UTIL) way out on its
own on the right (the tail shows us where it has been) while there is a group of

Mathew Verdouw, CMT,CFTe 24th February 2014 2

sectors clustering on the left. Based on what I was saying before, if these ten embody
all that contributes to the Index, and we consider the Index to be the very centre of
the chart, we can theorise that all the sectors have to be balanced around that point.
If that is true, it has to follow mathematical rules as we are dealing with what can
only be described as a closed universe (no other stocks are contributing to the
index).

We can see that there is a group of six sectors on the left side of the vertical 100 line,
that’s like a group of children on one side of a seesaw while less are sitting on the
right side. Figure 2 shows that to have balance it is only possible if the bigger group
of children is closer to the apex than the lone child (L2 is smaller than Lend). If we are
to have balance in the RRG, then we should see something similar.

As an exercise to check that we have balance, we can sum up all the negative
distances from the apex (100) and the positive distances and we would expect them
to be equal if it is a balanced universe. I’ve done this in a Watchlist in Figure 3. We
list the RRG Ratio and then the distance that ratio is from 100. By adding groups to
the Watchlist based on the Sign of the “From 100” column, the totals we get for the
left side (negative numbers) is 4.1 and on the right side (positive numbers) 4.4!
Hang on, that’s not balanced, we have a 7.3% discrepancy between the left and the
right sides!

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 SP500 Sectors with
RRG Ratio and
distance from 100

There is another aspect to the seesaw example that I have not been considering and
I believe that it is a fundamental oversight in some Intermarket Analysis theories
based on sectors (I’ll come back to that later on). The missing element may be
obvious to you, but it took me a little bit of thinking to work out why the two sides
were not matching. The issue was that I had always considered the ten sectors to be
equal weighted, but obviously that is not the case.

Again in our seesaw example, have a look at Figure 2, you can see that the one child
on his own is bigger than the 2, so not only do we need to factor in the distance from
the apex but also the weight of each child (sector).

How do we do that? Fortunately, if you are using a data source like Bloomberg, we
can fuse in the fundamental Market Cap of each Sector as an External Data Field and
then put that into a formula to get the weight of each. Here is the formula I used to
work out the sector weight as a percentage of the Sector Market Cap verses the total
SP500 Market Cap.

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 MC1=DATAFIELD(FIELD=CUR_MKT_CAP);
MCBM1 = DATAFIELD(GETDATA(CODE=SPX:BLMB), FIELD=CUR_MKT_CAP);

(MC1 / MCBM1) * 100

Let’s have a look at this on the RRG Chart by setting our script to define the size of
the Bubbles on the RRG. See Figure 4, bigger bubbles means bigger weight.

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We can see that Utilities is a featherweight, making up just 2.9% of the total index. It
can get a long way from the origin since it is so light. This chart also shows that
Financials (S5FINL in the cluster on the left) and Information Technology (S5INFT)
are the 300 pound gorillas of the SP500.

Now we need to include the weights in all of our calculations. All we need to do is
simply add up the product of the weight with the distance to get a variable that we
will call “Force”. Let’s do that in the Watchlist.

SP500 Sectors with

weight and force.

In Figure 5, you can see the weights of each sector. The last column in Figure 5 is
Force which is the product of the Weight of the Sector with the distance of the RRG
Ratio from the 100 apex. The sums for this become 32.05 on the left side and 32.11
on the right. Now that’s more like it! That’s a variance of 0.18% compared to 7.3% in
the unweighted case.

The script for the Force column is:

MC1=DATAFIELD(FIELD=CUR_MKT_CAP);
MCBM1 = DATAFIELD(GETDATA(CODE=SPX:BLMB), FIELD=CUR_MKT_CAP);
RRG1 = JDKRS(INDEX=SPX:BLMB) – 100;

((MC1 / MCBM1) * 100) * RRG1

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The result of this is that we have been able to show that the GICS Level 1 sectors are
balanced in a RRG but only when we consider their relative weights. Yahoo, high 5’s
all around! That’s great from a theoretical point of view, but how can we use that
information? For the most part there are a couple of key lessons that we can take
away from this:

First, when we do Intermarket Analysis based on sectors, we cannot consider all the
sectors to be equal because clearly they are not. The heavier sectors will exert more
torque the further away from the apex they are (now that will make an interesting
study). In fact, examining historical sector rotations and extrapolating to today can
actually be dangerous because the environment is so different. It’s like believing that
you can throw your twenty-two year old son in the air because you did it when he
was two! Let’s look at the situation twenty years ago as an example.

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In Figure 6 we can see that Industrials and Consumer Discretionary are the biggest
at 15% and 16% respectively. In fact, the spread between all the sectors is more
evenly spread, with the smallest sector being Utilities at 6%. So at that time, with a
smaller difference between Sectors, we could almost ignore the weights and treat
them as equals and apply all the theories and see them hold. Today I don’t think we
have that luxury. Am I saying that Intermarket Analysis should be thrown out? Not
at all! It is still extremely important, in particular in determining when a sector will
cease to be the outperformer. I am simply suggesting that there is another
dimension that needs to be considered as part of the analysis. There is more
research that will need to be undertaken in this area.

The other big take away that impacts Portfolio Selection is that if my goal is to gain
alpha over the Index, then I simply must consider the weights as part of my
selections. Back to the seesaw, by virtue of his weight, to have balance the largest
child cannot move too far away from the apex of the seesaw. In the same way, the
largest sector (or equity in a portfolio) cannot move far from an Index (average of
the portfolio) that it is contributing to. The further it moves away, the more it effects
the value of the Index, dragging the Index with it. The only exception to this is when
one large sector is moving in one direction and there is another large sector moving
the opposite direction, maintaining the balance across the chart. That in itself
presents a fantastic pairs trading opportunity, but I digress. If I want to achieve
alpha, I need a base of the heaviest sectors at weight, and then layer in the lighter
sectors that are improving by going overweight on them.

Since securities in the RRG tend to rotate in a clockwise fashion, when we are
looking for Long-only opportunities, we are looking for securities in the chart that
are moving from the negative quadrants with enough velocity to break through
(watch for another Optuma Whitepaper on the Physics parallels of RRG).

Now that we are considering weight too, we can make some decisions on position
sizing by going overweight on the lighter sectors since we know that they have the
greatest capacity to move a long way from the index without dragging the index
along. Obviously that can happen in both positive and negative directions, so they do
present the greatest risk too.

On the 16th Jan 2014, Utilities (The only item showing the arrow in the RRG chart)
was in one of the “perfect” RRG positions. At this point the trend of its relative
performance is improving and the trajectory is showing a lot of promise. The space

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between the observations (the dots) being wide shows good velocity which gives
confidence that it will continue on that path. The chart on the right of Figure 7 has a
vertical black line corresponding to the selected date of the RRG chart (January
16th).

We have identified the sector that we are

interested in, the next step is to drill into the
Utilities to see what selections we can make from
the sector. When we do this we need to make a
choice if we are going to keep SP500 as the
benchmark, or now look at each of the stocks
compared to the Utilities sector Index. I prefer the
latter as I am still interested in the weights of each
stock as a percentage of that sector’s index and to
take that same selection philosophy into the
Sector. By doing this I can look for low weighted
stocks that have the greatest ability to give me
significant gains over the index.

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Figure 9 shows the results with weights of each stock compared to the weight of the
Sector.

Utilities Sector
Members

When I look at Figure 9, the best opportunity that I see is PEG, it is in the top left
quadrant, and even though there was a bit of a wobble, it is heading in the right
direction and has low weight (3.3%). It is at this point that I would be opening up
the chart of PEG and confirming with my other analysis techniques if I am satisfied.
Figure 10 shows the performance of the stock since the 16th (Black Line).

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If we fast forward to today (21st Feb 2014) and then remove all the other securities
from the RRG, let’s have a look at PEG in Figure 11. I have also increased the tail
length of PEG so I can see the path that it took through the RRG.

PEG out-performed as expected and even though the trend is starting to weaken, it
is still very positive compared to S5UTIL Index. The little hook tells me that there
may be more in store. The RRG successfully assisted me in finding a great trade. It is
always interesting to bring this back to the SP500 and see how the performance has
been against the Index (particularly if the SP500 is my Benchmark). Remember in
Figure 1 that Utilities was out on its own? Let’s contrast that to PEG by adding PEG
to that same RRG in Figure 12.

We can see that PEG outperformed the SP500 by more than the Utilities Sector but it
has the same general shape as the Utilities. This makes sense since PEG was the best
relative trending stock in the best relative trending Sector. The ability to drill in and
make these selections is a powerful advantage for anyone who needs to make
selections like these. We need to see how this performed on an absolute basis, so
let’s open the three (SPX, S5UTIL & PEG) in a Relative Comparison Chart (see Figure
13).

Mathew Verdouw, CMT,CFTe 24th February 2014 11

Mathew Verdouw, CMT,CFTe 24th February 2014 12
We can see in absolute terms that PEG out performed S5UTIL which in turn out
performed the SPX. All of this was anticipated by finding the sector with the highest
probability of outperforming and then within that sector finding the stock that has
the highest probability of outperforming.

As with all strategies in the market, you need to test these for yourself to have
confidence in them. No technique is a guarantee of success and standard trade
management rules must be employed. This paper is merely presenting that RRG
coupled with weights can give a different perspective in understanding both
Intermarket Analysis and Portfolio Selection. If you do not have access to these
charts and would like to try them for yourself, contact one of our Optuma offices and
we’d be happy to help you set up a trial account so you can experiment with these
charts.

About Optuma
We are passionate about financial analysis using all techniques and models. Optuma
has been designed to be the ultimate analysis solution for anyone who wants to gain
insights into financial markets. RRGs in Optuma have capabilities not found
anywhere else including real time RRG, FX RRG and the ability to link price charts to
RRGs. More Information at http://www.optuma.com

Mathew Verdouw, CMT,CFTe 24th February 2014 13