Does it make sense to use (sector) weights when looking at RRGs?
When studying relative strength and sector rotation by using Relative Rotation Graphs it is usually clearly visible that all the elements on the plot are more or less evenly spread around the benchmark (positioned) in the centre. I say 'usually' because the real world' as we all know always throws curve balls at our models. In such an ideal world (for Relative Rotation Graphs) all securities on a RRG would be equal weighted AND they would move perfectly circular AND clockwise through all quadrants AND the benchmark would be positioned exactly in the middle..... That is NOT the case!
The Relative Rotation Graph below shows the sectors (GICS I) of the S&P 500 index.
As you can see there is a cluster of six sectors on the right hand (positive) side of the plot and three on the left hand (negative) side of the plot while financials is detached from both groups. So the universe is NOT evenly spread AND the ones on the left are much further to the left, much more negative, than the ones on the right.
One of the reasons that this is happening is because not all the sectors are weighted equally and relative moves in one or two heavy weights in the index can disproportionally influence the direction of the benchmark and thus the rotation on the RRG. When two heavy weights like Financials and Information Technology, together they make up approximately 1/3 of the S&P 500, are moving in one direction there is a fairly good chance that the S&P 500 index is moving more or less in the same direction.
Relative Rotation Graphs provide a perfect canvas to dive deeper into such forms of analysis and help investors and portfolio managers to get a better understanding of market structure and relative strength forces that dictate sector rotation.
Mathew Verdouw of Market Analyst International has written a great white paper on this subject which you can find and download in the Market Analyst area of the forum. Needless to say that the MA software carries all the tools to perform such analysis on any universe where weight data are available.
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