Sector rotation is a concept that has always got our attention. Even if it’s something you don’t specifically focus on, I’m sure we can agree that we tend to notice more opportunities than others in a few particular sectors at different points of time. Sector rotation aims to exploit this property by shifting our money to sectors which are doing better than others (or sectors that are more likely to do better than others). In this blog post, we give an introduction to Relative Rotation Graphs, a tool to visualize sector momentum and relative strength of sectors. We've also created our own Relative Rotation Graphs for the Indian markets on Excel, the link to which you can check out at the end of this post.
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Let’s start by understanding the term RRG literally. Relative Rotation Graphs. Relative refers to relative strength. Rotation refers to sector/asset class rotation. Graphs is self-explanatory. Thus, a Relative Rotation Graph shows us the relative strength of sectors, on a graph. It’s that simple. Here’s an image of how a Relative Rotation Graph looks on the Bloomberg Terminal:
We’ll start with what the x and y axis represent. The x-axis shows the Jdk RS ratio, and the y-axis shows the Jdk RS-Momentum ratio. If you haven’t guessed it by now, RS stands for Relative Strength. When we say relative strength, we mean relative to a certain index that we have chosen as a benchmark. For example, if we are looking at a RRG of all Nifty sectoral indices, the relative strength will be relative to the Nifty index. Thus, the relative strength of each sector on the chart is compared, after which it is normalized to the 100 level. This forms our x-axis.
The Jdk RS Momentum ratio is pretty much self-explanatory if you are familiar with momentum. For those who aren’t, momentum is basically the rate of change. That’s the reason we say that a stock is showing great momentum when we see that it’s up 5% or any arbitrary percentage. In the context of an RRG, the RS momentum ratio calculates the rate of change of the RS-ratio. This is our y-axis. Plot the x and y-axis points for a sector on a scatter plot, then do the same for all the sectors, and we have a Relative Rotation Graph.
You’ll notice that the graph has four sections, or quadrants as we call them. The 1st quadrant is the leading quadrant. Here, the RS and momentum values are both greater than 100, implying that if a sector lies on this quadrant, it is up more than the market index, and at a higher pace than the index. The 2nd quadrant is the weakening quadrant. Here, the x-value is greater than 100, while the y-value is less than 100. This implies that the sector is exhibiting relative strength, but not momentum, which is why we say that it’s weakening.
The 3rd quadrant is the lagging quadrant, where the relative strength and momentum is less than 100, implying that it is lagging the broader market. Lastly, the 4th quadrant is the improving quadrant, where the relative strength is less than 100 but the momentum is greater than 100, implying that the performance of the sector is indeed, improving.
Now, the theory is that sectors keep rotating amongst the four quadrants. Of course, with the stock markets being unpredictable as they are, you cannot expect to see a clean 1-2-3-4 movement, but that’s the general idea. Looking at the rotation trails for each sector and the quadrant in which they belong to currently gives us a good idea of where we should be taking momentum setups, and where we could make value plays.
To have a look at Indian sectors on a Relative Rotation Graph that we created, head over to our blog post and scroll to the end: https://marginstone.com/an-introduction-to-relative-rotation-graphs/ Be sure to subscribe for updates!
Do you think such a visualisation of sector rotation would be helpful to your trading? Let us know in the comments below!