The Tycoon Report

Step-By-Step: Sector Rotation & Relative Strength

Putting together a sound plan of attack using sector rotation and relative strength in order to pick stocks is confusing, complicated, and sometime frustrating. It can become downright stressful when dealing with one's own money. What exactly should I look for? What order should I go in? How do I work in trends, moving averages, and other momentum indicators? Where can I find a concrete step-by-step plan?

I am going to give you one right now, clear and simple!

Below is a step-by-step process to picking the strongest stocks in the strongest sectors, with positive momentum.

Step 1: Sector Rotation

First, we need to see what sectors are in favor and if they are oversold or overbought. Below is the “industry bell curve.” The sectors in blue are in bull status, the red in bear. If the sector is below 32%, then it is usually oversold. Above 68% usually indicates overbought. I like sectors in the 35-45% range with significant room before hitting overbought territory. I am going to choose the health care sector showing a 48% bullish reading (48% of the stock in the health care sector are on P&F buy signals). 

TIP: All of these charts except the Industry Bell Curve, I accessed for free! I am sure you can get the bell curve somewhere for free as well. I use Investors Intelligence; CRISS members get a membership discount.

Step 1A: X’s & O’s

After finding a bull sector, we want to see if the sector is trading in an up column. Meaning, is the point & figure chart showing a column of X’s or a column of O’s? If the sector is showing a column of X’s, we know the short-term trend as well as the long-term trend is Bullish. If the column sits on O’s, there may be some short-term downward pressure which could eventually lead to a long-term down trend. On the other hand, the column of O’s may represent a buying opportunity. I personally would move on to a new sector if it sat on a column of O’s.

Is the sector on a column of X’s? Yes it is! Below is Rydex S&P Equal Weighted Healthcare ETF (RYX). You can see that the last column is sitting on X’s (below).

TIP: Always use equally-weighted sectors for the most accurate reading.

Step 2: Sector Relative Strength

What is the sector's relative strength against the market? Below I compared (RYH) with the S&P Equal Weighted ($SPXEW). Notice since mid July that the health care sector is significantly outperforming the S&P. If the S&P was outperforming health care, you would want to find a new sector. This would signal a market lagard, not a leader which is the purpose of relative strength.

So far we have a bullish sector, on a column of X’s, outperforming the S&P. Which takes us to the hardest part, picking the right stock!

Step 3: Find a breakout stock!

Not only is this the hardest step, it is also the most time consuming. As you get going, you will understand better how to filter the stocks you are looking for. You would need to go to the Rydex website and find the components of (RYH). Then you would start looking at them one by one. I have already done the work and in the health care sector I like Stryker (SYK). Below is the PNF chart for (SYK). You will notice (SYK) just broke through a triple top at $58 where twice before there was resistance (the red box).

TIP: Above the chart, right next to where it says, “P&F Pattern” (In Green) the chart says, “Triple Top Breakout on 22-Aug-2008.”

In other words the chart helps you spot these types of trends.

Step 3A: Momentum indicators

Does the stock show momentum? Yes.

First, on top, the RSI is below sixty. Significant because historically Stryker’s RSI has traded over 70, as it did in July.

Second (in the main chart), notice the high volume in the middle of August coincides with a slight downward movement (Circled). The Bulls and the Bears fought and the Bears barely won. Every other time there was heavy negative volume, large losses followed in July, May, and March. Also in the main chart notice how the 20 recently crossed the 50-day Exponential Moving Average, creating support.

Third, the bottom MACD indicator is also heading higher with newly found support.

TIP: You may use different indicators; nevertheless, the point is to find a stock with positive momentum.

Now that we have found a breakout stock in a bullish sector we have to see how that stock stacks up!

Step 4: Stocks Relative Strength

How is (SYK) fairing compared to the sector? Is it outperforming or just following along? As you can see, (SYK) is rising compared to (RYH). Just to recap; we now have a stock with positive momentum that is outperforming a sector, which is outperforming the market.

Step 4A: Double Check

Even though the health care sector is outperforming the market and (SYK) is outperforming health care; let's see how (SYK) is performing compared to the S&P (below). This step is pretty much repetitive but I like to double check and find as many positive indicators as I can. As we could have predicted, (SYK) is trading higher compared to the S&P.

TIP: Some like to look at the peer relative strength as well, the sector within the sector. Equally weighted peer groups are hard to find so I usually do not put in the time.

So there you have it. We have selected a bullish sector with more room for growth. The sector is on a column of X’s and outperforming the S&P. We have selected a stock that is outperforming the sector, the market, and showing considerable momentum on a P&F triple breakout. Now, all that has to happen is the stock trades higher as we reap huge rewards. Obviously, technical analysis is no guarantee. But when we buy stocks within these parameters, we give ourselves the best opportunity to succeed.

John Micheline