THE RELATIVE STRENGTH CONCEPT APPLIED TO SECTOR INDICES

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1 THE RELATIVE STRENGTH CONCEPT APPLIED TO SECTOR INDICES An Illustration with the DJ Stoxx 600 Index Yann CORDIER, CFTe, MFTA AXA Investment Managers London, 10/03/2015

2 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 10/03/2015 Society of Technical Analysts 2

3 1. THE CONCEPT AND POWER OF RELATIVE STRENGTH 10/03/2015 Society of Technical Analysts 3

4 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) 10/03/2015 Society of Technical Analysts 4

5 Relative charting: The famous example of DJ Transport vs. DJ Industrials (1) Daily chart, /03/2015 Society of Technical Analysts 5

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

6 Relative charting: The famous example of DJ Transport vs. DJ Industrials (2) Weekly chart, RSI (14), 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 10/03/2015 Society of Technical Analysts 6

7 Small caps vs. Blue chips in Europe Weekly chart, RSI (14) and Fibonacci retracements 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 10/03/2015 Society of Technical Analysts 7

8 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 /03/2015 Society of Technical Analysts 8

9 Relative Strength: US Pharma (left) vs. US Consumer Staples (right) (1) Absolute daily charts , ADX/DMI (14) Quite the same picture, isnt it? 10/03/2015 Society of Technical Analysts 9

10 Relative Strength: US Pharma vs. US Consumer Staples (2) Relative daily chart The relative chart clearly enlightens consistent outperformance from Healthcare with no warning of reversal give preference to Pharmas! 10/03/2015 Society of Technical Analysts 10

used in L/S Equity portfolios Going long an equity / short another,

11 Pair trading GSK vs. AstraZeneca Daily chart, Ichimoku, 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 10/03/2015 Society of Technical Analysts 11

12 2. COMPARING A SECTOR VERSUS THE MARKET: AN OVERLOOKED APPROACH 10/03/2015 Society of Technical Analysts 12

13 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 10/03/2015 Society of Technical Analysts 13

14 Top-down vs. Bottom-up approaches Description Method Top down Bottom up Portfolio allocation based on asset class, geography, industry sector Stock / bond selection based on a company s fundamentals Underlying philosophy Markets don t behave independently Intermarket analysis, Relative strength Focus on "micro" knowledge (earnings releases, meetings with managements) Portfolio construction Ex ante Ex post 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 10/03/2015 Society of Technical Analysts 14

15 3. RELATIVE CHARTING OF SECTORS: ADVANTAGES AND LIMITS 10/03/2015 Society of Technical Analysts 15

16 Chartist analysis of Relative strength General 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 10/03/2015 Society of Technical Analysts 16

17 Chartist analysis of Relative strength Example of breakout with the US Energy index (1) Absolute daily chart, RSI (14), /03/2015 Society of Technical Analysts 17

the S&P 500 index, RSI (14), 2013-2015 No big absolute gain in cutting exposure 20

18 Chartist analysis of Relative strength Example of breakout with the US Energy index (2) Relative daily chart vs. the S&P 500 index, RSI (14), No big absolute gain in cutting exposure 20 days earlier (0.6%) BUT far more reactivity from portfolio managers using a relative approach 10/03/2015 Society of Technical Analysts 18

19 Chartist analysis of Relative strength Example of Ichimoku graph on US Banks (1) Absolute weekly chart, /03/2015 Society of Technical Analysts 19

20 Chartist analysis of Relative strength Example of Ichimoku graph on US Banks (2) Relative weekly chart vs. the S&P 500 index, It is hard to remain complacently bullish on US Banks if you look at their relative strength!! 10/03/2015 Society of Technical Analysts 20

21 Chartist analyst of Relative strength The 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) 10/03/2015 Society of Technical Analysts 21

22 4. HOW TO USE TECHNICAL INDICATORS ON RELATIVE CHARTS 10/03/2015 Society of Technical Analysts 22

23 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 10/03/2015 Society of Technical Analysts 23

24 Divergence on Stochastics US Materials vs. the S&P 500 Daily chart, slow stochastics, MACD (12,26,9), June Dec The sell signal given by Stochastics coincided with a long divergence made by MACD2 vs. MACD 10/03/2015 Society of Technical Analysts 24

25 Bollinger signals European Retail vs. the DJ Stoxx (SXXP) Weekly chart, Bollinger bands, /03/2015 Society of Technical Analysts 25

26 Head & Shoulders pattern on RSI Nokia vs. Euro Stoxx 50 Weekly chart, RSI (14), /03/2015 Society of Technical Analysts 26

27 Ideal situation #1 A MT trend resumes after a pullback without impact on the LT trend (1) European Utilities vs. SXXP, Weekly chart, RSI (14), /03/2015 Society of Technical Analysts 27

SXXP, Daily chart, ADX/DMI (14), 2013-2014 Trend following

28 Ideal situation #1 A MT trend resumes after a pullback without impact on the LT trend (2) European Utilities vs. SXXP, Daily chart, ADX/DMI (14), Trend following indicators showed the MT trend was not seriously jeopardized 10/03/2015 Society of Technical Analysts 28

29 Ideal situation #2 MT 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), /03/2015 Society of Technical Analysts 29

European utilities, Weekly chart with MACD (12,26,9), 2010-2015 In this

30 Ideal situation #2 MT reversal with good probability to carry the LT picture along (2) Iberdrola vs. European utilities, Weekly chart with MACD (12,26,9), In this case, bullish divergences occured simultaneously on weekly and daily charts! 10/03/2015 Society of Technical Analysts 30

31 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 10/03/2015 Society of Technical Analysts 31

32 5. A RELATIVE ANALYSIS OF DJ STOXX SECTORS AND PORTFOLIO CONSTRUCTION 10/03/2015 Society of Technical Analysts 32

33 Analysing the Stoxx index subsectors today 3 parameters should be taken into account: 1. Synchrony between different timeframes 2. Recent signals 3. Sector weightings in portfolios today Portfolio construction is then based on technical analysis with a contrarian bias 10/03/2015 Society of Technical Analysts 33

34 Food & Beverages Weekly Daily Bullish mood may be shifting soon (end of trend, big resistances) 10/03/2015 Society of Technical Analysts 34

35 Healthcare Weekly Daily Bearish MT outlook might trigger off reversal of the LT trend 10/03/2015 Society of Technical Analysts 35

36 Mining Weekly Daily Bullish inflexion is likely provided USD doesn t appreciate too much 10/03/2015 Society of Technical Analysts 36

37 Telcos Weekly Daily Bounce off meaningful support levels look for confirmation on the LT trend 10/03/2015 Society of Technical Analysts 37

38 Banks Weekly Daily Clear outperformance expected 10/03/2015 Society of Technical Analysts 38

39 Insurance Weekly Daily LT bullish trend not impacted yet, but cautious on MT sell on probable ST strength 10/03/2015 Society of Technical Analysts 39

40 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 10/03/2015 Society of Technical Analysts 40

41 How are investors positioned on European sectors today? (2) 10/03/2015 Society of Technical Analysts 41

42 How would we be positioned in terms of sectors today? Summary table Automotive Banks Basic Materials Capital Goods Energy * Food & Beverages Healthcare Insurance Media Retail Telcos * Utilities Weekly chart + (a correction wouldn't jeopardize uptrend) + (RSI left oversold area, wonderful Bollinger signal) + (inverted H&S pattern, bullish RSI divergence) (inflexion but resistance from Cloud and SMAs) + (inverted H&S, RSI using 30 as a support level) = (trend has been fading) (RSI crossed 50 from above) = (but could rapidly worsen) (caution: risk of Rising Wedge, high bandwidth) ++ (broke to the upside from a bullish flag) + = (bouce off trendline and middle band) (broke key support) Daily chart + (Buy on weakness) ++ (broke resistance, bullish consolidation) + (++ if Cloud is broken to the upside) + (as far as the support line holds) = (contradictory signals) = unless Cloud is broken to the upside (but thick!) (support line broken, then tested as a resistance) = (broke support, sell on probable ST strength) = (near a key resistance) + (bullish ascending triangle) ++ (bullish Bollinger signal) (too early to go back) NB: Rating scale goes from to +++ Underlined sector means that recommendations on both time horizons coincide An asterisk signals a change of recommendation 10/03/2015 Society of Technical Analysts 42

43 Portfolio construction A 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 its historical range of holding 200 Bp OW Slightly positive on Capital Goods: ST technicals are decent and holding levels are at historical lows 150 Bp OW Slightly negative on Food & Beverage: Not "overloved" yet but chart analysis commands caution 150 Bp UW Negative on Insurance: Holdings at historical highs, technicals could rapidly deteriorate 250 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 10/03/2015 Society of Technical Analysts 43

44 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) 10/03/2015 Society of Technical Analysts 44

Introduction. Technicians (also known as quantitative analysts or chartists) usually look at price, volume and psychological indicators over time.

Introduction. Technicians (also known as quantitative analysts or chartists) usually look at price, volume and psychological indicators over time. Technical Analysis Introduction Technical Analysis is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends. Technicians (also known as quantitative