The Dominant Chart Pattern of Early 2012
01/12/2012 5:00 pm EST
Learn how relative performance, or RS analysis, can be used over multiple time frames by investors and traders to identify the market’s strongest and weakest sectors.
Sector rotation has been a popular investment strategy for many years. Long-term data on the business cycle gave rise to the idea that certain sectors should do best during certain stages of the economic cycle, so being in the right sector could allow one to beat the market.
The economic cycle was divided into four stages: full recession, early recovery, late recovery, and early recession. Specific sectors were then associated with each stage. For example:
- During the full recession stage, cyclical and transport stocks, along with technology and industrials, were expected to do the best.
- During the early recovery, the industrials were favored in the beginning, followed later by basic materials and energy.
- During the late recovery, energy stocks should lead early, and then staples, along with the service sectors.
- For the early recession period, the service and utility stocks were expected to do well early, followed by the cyclicals and transports near the end.
For quite a few of the business cycles of the past 20 years, these have served as useful guidelines.
Of course, the recent recession/depression was much worse than the normal recession. This, combined with the urge to follow the “hot money,” in my opinion, has shortened the time cycles for the sectors. The sluggish nature of the recovery since 2009 has also made it difficult to determine where we are in the economic cycle.
If you can identify a sector when it is just starting to outperform the overall market, and then get out before it becomes a lagging sector, you can dramatically increase your portfolio’s performance.
For example, in the first quarter of 2011, energy was the top sector. The Select Sector SPDR Energy (XLE) was up 16.8%. Looking at some specific industry groups in the energy sector gave you a further advantage, as the SPDR S&P Oil & Gas Exploration & Production ETF (XOP) was up 22.1% during the same period.
The Percent Change chart above compares the performance of these two ETFs to the Spyder Trust (SPY) starting in October 2011. By the end of the first quarter, XOP was up 51.5%, XLE up 40.8%, and SPY up 16.2%. However, over the next two quarters it was a much different picture, as XLE was down 26.6% and XOP lost 33.5%.
One of the best tools I have found to identify the early stages of sector rotation is relative performance, or RS analysis. This is calculated by comparing the ratio of a sector, ETF, or stock to a benchmark index like the S&P 500. This allows you to determine whether the sector is acting stronger or weaker than the overall market.|pagebreak|
Once a strong sector has been identified, one can then examine industry groups within that sector to find the strongest. This allows you to zero in on the best stocks in the strongest industry groups of the market-leading sectors.
For investors, it is often the weekly RS analysis that will be the most important, though over the past few years I have been combining weekly and daily analysis. In this article, I will explain how I combine the analysis of these two time periods, and also show why traders should also consider using the hourly RS analysis in their trading.
Unlike most analysts who use this approach, I use moving averages and trend line analysis of the relative performance to help me identify turning points.
This weekly chart of the Select Sector SPDR Energy (XLE) covers the period from late 2009 through August 2012. From October 2009, the RS line had been in a downtrend, as it formed a series of lower highs (line a) and lower lows. It moved above and below its 21-period WMA during this time.
The breaking of long-term up- or downtrends in relative performance is generally quite significant, as the length of the trend line is important. Therefore the break in the yearlong downtrend in October 2011 (line 1) did suggest a change in trend.
By the end of the month, it had formed a bullish zig-zag formation consistent with a new uptrend. The RS line confirmed every new high until the end of April, when XLE closed at $80.47 but the RS made a lower high. The next week, XLE reversed sharply to the downside, and the RS line broke its support (line c).
The RS line did move above its WMA in July, but then reversed, dropping sharply below its WMA and the prior lows. This reaffirmed the downtrend.
From late December 2011 to the middle of February, XLE rallied sharply, hitting a high of $76.50. During this rally, the weekly RS line diverged from prices, as it formed lower lows (line f) and was only able to move slightly above its flat WMA.
The RS line violated its WMA in March, and continued to drop sharply in April, making a spike low in June. The RS line has now moved above its WMA, but is still well below the long-term resistance at line e.
The daily RS analysis shows that it also diverged from prices in April 2011, and completed a top in May, when it broke support (line c). The RS line also rebounded back to this resistance in July.
The daily RS line was negative from August to October, and did not form any divergences at the October lows like other sectors did. The relative performance did move quickly back above its WMA soon after the October lows, but peaked at the end of the month.
The daily RS was also not confirming the price action from November through February, as it also formed lower highs and lower lows, indicating that XLE was weaker than the S&P 500.|pagebreak|
Soon after XLE made its March 2012 high of $75, the RS line violated support (line e) and started to lead prices lower. I have often observed that the RS line will break support ahead of prices, and this action should not be ignored. In this instance, XLE lost over 10% in the next three weeks.
The RS line moved back above its WMA in late June, and by July 16 had clearly started a new uptrend. It is still well below both its short-term (line d) and longer-term (line b) downtrends. So a major turn has not yet been confirmed.
On the hourly chart, I have added the 54-period simple moving average (in blue). As XLE was rallying sharply in early 2012, the hourly RS line was forming lower highs (line a). It just reached this downtrend as XLE was peaking.
On February 24, XLE made its high, and by February 29 the hourly RS had started a new downtrend (line 2), with XLE closing at $74.92. The hourly RS made lower lows into late June, and the first sign it was bottoming came on July 3, as it moved above the June highs.
A hourly bottom in the RS analysis was confirmed on July 17 (line 3), as the relative performance overcame further resistance (line b), with XLE trading at $68.39. In either an uptrend or downtrend, the hourly relative performance line tends to respect its 54-period SMA.
The weekly RS analysis has done a good job over the past two years in keeping investors out of the big bank stocks like Bank of America (BAC).
In April 2010, BAC made a high of $19.86, which was well above the late 2009 high (line a). The weekly RS had been diverging from prices, having begun to form lower highs (line b). Three weeks after BAC made its high, the RS dropped below its WMA.
In July, the RS broke below support (line c), and BAC spent the rest of the year declining. In December, the RS line moved above its WMA but failed to move above the previous peak (line d). If the RS had been able to move above this level, it would have suggested that a new uptrend was underway.
The rally peaked in early 2011 and just reached the 50% Fibonacci retracement resistance from the 2010 high. By March, the RS was back below its WMA, and a month later had dropped below the December lows. BAC declined from the early 2011 high of $15.31 to a low in December of $4.92, a drop of 68%.
The rally in early 2012 was a bit stronger technically, as the RS moved above its WMA (line 1) as BAC closed at $6.61. The rally continued for ten more weeks, and the RS line was able to move above the October highs. BAC had a high of $10.10 in March, again reaching the 50% Fibonacci retracement resistance from the early 2011 highs.|pagebreak|
As BAC dropped to $8.25 (line 2), the RS line dropped back below its WMA. The RS line made marginal new lows in June, so there are no strong signs yet that a weekly low is in place. A move in the RS above the March highs (line g) would be a sign that a more important low was in place.
Looking at the daily RS analysis of BAC, the rally in early 2012 was tradable. At the end of December 2011, the downtrend that went back to the June 2011 highs (line a) was broken. The RS then moved above the prior high (line b), which indicated that a bottom was in place (line 1). BAC traded in a narrow range ($6.06 to $6.30) the following day.
BAC rallied until February, when it developed a three-week trading range. The breakout of the range was confirmed by the action of the RS, as BAC quickly surged to a March high of $10.10. For two weeks, BAC traded in a fairly narrow range before it closed below its 20-day EMA, and the RS line also dropped below its WMA.
I have found that when the daily RS analysis is topping and the weekly is not in a strong uptrend, it is a reason for caution. If instead, the weekly RS analysis for BAC had been moving higher for some time, the daily action would have suggested a period of consolidation, not a top.
The daily RS by April was below its WMA, and had begun a new downtrend. At this time, the weekly RS line was also below its WMA.
The hourly analysis may have helped you fine tune both your entry and exits in BAC. By the end of December, the hourly RS was already in a short-term uptrend, with the 21-period WMA above the 54-session SMA..
The RS had formed higher highs on January 3, and the test of the 20-hour EMA could have been a good entry. The bottom formation was completed during the first hour of trading on January 5, as the prior high (line d) was overcome. BAC was then trading at $6.
The flag or continuation pattern that BAC formed in February is easier to see on the hourly chart, and the tight range in the RS suggested a bullish setup. BAC rallied sharply for the next four days, hitting an intraday high of $10.10 before reversing to close the day lower.
The hourly RS analysis turned negative on March 29, starting a new downtrend, as both MAs were already trending lower (line 3). The longer-term uptrend in the RS line was broken on April 10, but by then BAC was almost 6% lower.
Apple (AAPL) has been a stellar performer for the past decade, and the stock is widely watched by investors as well as the general public. Because it makes up 18% of the Nasdaq-100 and Powershares QQQ Trust (QQQ), its price action often allows it to move the market.
In a prior article on relative performance, “Spot Leaders and Losers with RS Analysis,” I discussed how AAPL bottomed ahead of the overall market in early 2009. The RS analysis has been quite useful in identifying corrective periods in Apple’s stock, as well as spotting new entry points.
The weekly chart of Apple (AAPL) shows that in July 2011 (line 1), the relative performance completed a bottom formation by moving above eight-month resistance (line a). It kept moving higher for the next month while the major averages were dropping sharply.
The stock rose about 10% into the latter part of October, when the RS line formed a short-term negative divergence before dropping below its WMA at the end of the month. This began a three-month correction, as the RS line dropped back to long-term support (line c).|pagebreak|
In early January 2012, the relative performance moved back above its WMA . By the end of the month, the RS line was in a new uptrend (line 2), as AAPL closed well above the October high of $426.70.
Over the next 11 weeks, the stock gained another 44%, with the RS line confirming the high in early April. Even though it dropped almost 19% from its highs, the action of the relative performance was characteristic of a correction, not a top.
The RS line tested its WMA in May before again turning higher, as the WMA was clearly still rising. The recent trading range in the relative performance (lines f and g) looks like a continuation pattern that should be resolved by a further rally. It is a positive sign that the RS line has been forming higher highs.
The daily relative performance analysis of Apple (AAPL) provide several examples of how the RS line often forms continuation patterns that can help one identify the beginning of a new uptrend.
During the last quarter of 2011, AAPL was in a broad trading range that did not take the normal shape of a continuation pattern. The RS analysis shows a clear triangle pattern (lines a and b) that was completed in the latter part of January 2012 (line 1), when AAPL gapped to the upside. It traded in a narrow range in the $444 area for two days, before it again began to move higher.
The RS line stayed above its WMA until April 13, when AAPL closed at $605.23. For the next six weeks, the RS line stayed below its WMA, but did not make lower lows (line f). This formed the lower boundary of the recent trading range (lines e and f).
The price chart shows broad flag formations, which like the formation in the RS analysis, does favor an upward resolution. The 127.2% upside projection from the flag formation is $679.
The hourly RS analysis first broke out of its trading range (lines g and h) on January 6, when AAPL was trading in the $422 to $418 area. The support (line h) was tested a few days before prices exploded to the upside.
The 21-period WMA and 54-period SMA of the RS line continued to rise until April, as pullbacks in price were accompanied by the 21 WMA testing the 54 SMA. The uptrend (line i) was broken soon after the MAs turned negative. By April 17, when AAPL was rebounding back to the $620 area, the hourly RS line was already in a clear downtrend.
The current RS analysis (through August 7) shows that both the daily and hourly remain in their trading ranges, and are not yet signaling an imminent upside breakout.
These examples of the weekly, daily, and hourly RS analysis show that it can be quite useful whether you are an investor or trader. In my regular daily column, you can find many examples of my interpretation of the RS analysis, and this allows you to look back and see how well it has worked.
If you are going to use it in your investing or trading, it is important for you to convince yourself of its merits, as that is the only way you will have the necessary confidence to use it when it counts. Also, don’t forget the monthly RS analysis, as in this monthly Dow analysis, where it helped identify some winners.
I have found it to be a very valuable tool in my stock selection process. When I find a sector that is outperforming the overall market, the RS analysis will often help me choose between different stocks in that sector to find the one with the best performance.Of course, chart pattern analysis and OBV analysis also play a key role. When all are in agreement, the odds of success are the best.