Using Relative Rotation Graphs® (RRGs)

by | Nov 22, 2016

 

In this webinar on Relative Rotation Graphs® (RRGs). We’ll be focused on two main areas:

  • How we can monitor a portfolio using RRGs.
  • How to perform RRG-based Stock Selection.

We’ll also briefly explain the theory behind RRGs and what do to when you are working with multiple Asset Classes.

Using Relative Rotation Graphs® (RRGs)

by Mathew Verdouw, CMT, CFTe

Hi, everyone. Thanks for stopping by and checking out our webinar. This week what I want to talk about is Relative Rotation Graphs or RRGs. Now, RRGs are a fantastic way of being able to take a whole group of securities and view them all on one chart in a relative strength manner, or type of calculation.

If you’ve not been doing relative strength, let me just give you a quick introduction to that. If you’re managing a portfolio and you are being judged against a benchmark, what you’re wanting to do is you’re wanting to load up your portfolio with securities that are outperforming the benchmark, because then by extension your portfolio is going to outperform that benchmark.

Typically, if you’ve got clients and you’re investing their money, they’re sitting there every day, looking at returns that you’re getting for them or returns that you’re getting for your own portfolio and judging that against what’s happened to the S&P last night.

It’s very common, for instance, to be benchmarking your portfolio against the S&P 500. The RRGs are a great way of being able to do that. What I’m going to do is just a couple of quick slides. Some of you who may be watching this have seen a lot of the theory before, and I don’t want to take too long on this, but just so for those who may be new to this, I want to take five minutes explaining how the RRGs work and then what I want to do is talk about stock selection using RRG and also portfolio management using RRG. Then, we’ll talk about some of the other more wider concepts as well that we’ve been working on here at Optima. All right, let’s just get started with these slides here.

RRGs were developed by Julius de Kempenaer. At the time, he was a Sell Side Analyst in the Netherlands. He was explaining to me that what he had was often he’d been going to visit portfolio managers or his clients, and he’d be talking to them about different securities and they’d been saying, “Well, you should have been using Google or should I be buying Microsoft?” And you could look at them from a relative comparison. You could say, “Yes, Google’s outperforming the S&P,” or “Microsoft’s outperforming.”

But how much are they outperforming? Remember that a relative comparison calculation is taking the price of the security and dividing it by the index. And so you’ve got that number. But, that number is actually meaningless. It’s just a ratio, not even a proper ratio. It’s just a calculation between the stock and the index.

What Julius did, which was absolutely ground breaking in this industry, was that he went and found a way to normalise all of these calculations, but then also create the rotation graph. So that not only could we see from a relative strength point of view, but we could also view then relative momentum. And so, as he did this, he created this chart that we look at. And you can see the coloured chart here. And this is very typical, you’ll see on any RRG this type of setup.

As we go through all the different quadrants there. I’m sort of jumping ahead on my slides, so let me jump to this one. Let’s just say we got a security here up in the leading quadrant, and we’ve got our benchmark in the middle. This is the way I like to visualise it, is that the benchmark is in the centre of the chart, and I’m looking at my securities. Are they outperforming, are they underperforming?

By being in the green quadrant, this security is leading, or outperforming, the SPX. What that means, and again, another great analogy I like to use is imagine that the SPX is this great big truck driving down the highway. And the security is just a sedan driving next to it. What’s happening here, is that the speed of the car, or the sedan next to the truck, is a relative speed. They’re both doing, let’s say, 60 MPH down the highway. But the car is pulling away, because it has relatively more speed, or it’s outperforming or out speeding the truck. That’s what’s happening in the leading quadrant. There is an out performance.

When Julius talks about it, he talks about relative trend or positive relative trend, which is a form of out performance. That’s why we talk about that here. As we go around the quadrant, you can see now the securities and weakening. Again using our analogy of the truck and the car, this is a scenario where the car is out in front, it’s been outperforming, but what’s happening now is it’s starting to slow down, and the truck is starting to catch up. On a historical basis, it’s still outperforming the index, but it’s not quite as strong. It’s not pulling away anymore, and that index is starting to catch up.

As we keep going around, we have the lagging quadrant. As you can start to imagine, here is where the index is out in front, the security is falling behind, and getting further and further behind. So, again, the car’s being left behind on the truck on the highway there.

And then finally, the last quadrant here, is the improving quadrant. This is where we have our security way behind the index. But, what’s happening now is it’s showing relative strength. Its trend has improved, and so it’s starting to catch up again to that truck. So, again, on a historical basis, you may look at it and say, “That security is not outperforming the index, why would I put that in my portfolio?” But on a relative trend, and what it’s starting to tell you, is that, “Hang on, it’s starting to catch up.” I can get in early here, and add this to my portfolio before it is obvious that it’s outperforming the market.

That is where a lot of the usage of what we’re talking about with RRG and the charts. That’s a lot of where this centres on. So, if we have a look, as Julius did this work, what he found is that this very predominant obvious clockwise rotation that is going on in the RRGs. And we’ll show you that as well with some of the charts that we bring up.

This is obviously a webinar that I want to show you how you can use Optima to be able to take advantage of these types of strategies. How you can find stocks to add, or ETFs, or securities. This isn’t just limited to stocks, there’s a number of different things that you can do with your RRG charts, with all sorts of securities, et cetera.

What we’ll do, let’s just jump in. And we’ll get rid of those slides, we don’t need that anymore. And let’s go have a look at the software. The first thing that I want to really cover is this whole concept of stock selection. So, let’s just say that we’re going to deal with equities, but we could deal with anything. For this one, I’m using Bloomberg Data, and I’m talking about a lot of the more professional features that are available in RRG. If you don’t have all of these features in your copy of Optima, just talk to us, because they are available, and we can make those available to you. Just let us know about that.

First thing I’m going to do, I’m going to hit F3 on my keyboard to bring up security selector. The way I like to start with this one is I’m just going to go to Bloomberg, and I’m going to start out at the GICS Level 1 Sector. We’ve got a few of these groups here, if there’s a group that you’re looking for that’s not available, just, again, let us know. What I want to do, is I want to open this list, open the folder here as a RRG.

What we’ve got in front of us is that rotation graph that we talked about there, and we’ve got all of these arrows. Each of these arrows here, let me make these lines just a little bit … Tail style, I want to make the lines a little bit fatter for you, so that we can see those a little bit better there. And let’s make the labels a bit bigger, too. So, it’s all just a little bit clearer on your screen there. One last change I want to make is I want to change the colours of the labels to match the arrows.

With an RRG and with these arrows, what we’re looking at here is 10 data points. The arrow is the most recent position on the rotation graph. So, are we leading, are we lagging, et cetera. The tail is the history. And you’ll see as we look along, you’ll see these bumps or these dots at each point. That’s where that value was, let’s say 1 period back. In this case, I’m looking at a daily chart, so it’ll be 1 day back, or 2 days back, 3 days back, et cetera.

What I can see is, all right, Financial is outperforming the S&P and the rest of the SP 500 at this point, but where’s it been? Where’s it come from? And it’s really important to know where things have come from, because it really helps us get an idea of where we can make a prediction, if you like, about where it’s going to go.

We’re looking at this chart here, actually, let’s just go back, and I’m just going to show you. We’ll go back, this one goes back a year. And if we scroll through time, you’ll start to see that predominant clockwise rotation that happens on a relative rotation graph. It’s not a guarantee, you’re not going to get a perfect rotation every time. If we just look here now, at the Financial right here, you can see that it does a little bit of a wiggle up and down, it doesn’t know what it’s doing at this point. And that’s very indicative of some sort of news event that’s happened and causing a bit of a shop.

But, there’s a couple of things that I’ve noticed in looking at RRGs, and that is that when you’ve got those spaces far apart, for instance, if I’m looking here at this materials and the history, I would say that these dots are fairly far apart. When that happens, the likelihood of a U-turn or a hook-turn or something like that happening is very, very low. Typically, you could almost call it like relative momentum in some respects. The arrow has momentum and it’s going to continue going on. But as they slow down, let’s go back to where Financial did that hook. We’re coming in here, if you look at Financial over here, we’re coming in, I’ll just use the arrows on my keyboard, and you can see now that we’ve got very, very, little momentum. There’s little conviction about where that’s going. And that is typically when I’ve seen these types of things where the arrows go back and forth all over the place. Here the arrow’s turned around, and then turned around again, and went back. These are things to watch out for. I’m looking for very convincing moves. That whole time you can look at Material. Material was just so convincing in that same period of time there. We’ve got these arrows, you can see the rotation, et cetera.

Let’s just go in and jump right back to the end, I want to zoom out a little bit. The other great thing about this is if you’ve ever done any study on intermarket analysis, let me just quickly jump over here, John Murphy, with stockcharts.com, he’s done a lot of really great work on intermarket analysis. This book here is one that I would highly recommend. It’s one of the best that I’ve read on the topic, but what he talks about in his material, is this whole concept of you’ve got the stock market cycle in red here, and then you’ve got the green economic cycle, and there are all these sectors that perform better at different points in the whole market cycle, or the whole business cycle.

If we looked at this one here, and let’s just say we are at the point where the economic cycle is starting to lift, it’s starting to go into a new phase of economic expansion. I know, there’s a lot of people who disagree, but we’ll come back and explain why we think that might be the case. But, you’d look at Energy and say, “It doesn’t mean that Energy has been outperforming.” What John Murphy’s saying here, is that from this point on, “Energy, if this is where we are in the cycle, then we would expect Energy to outperform going forward.” And that’s why this is really great. The more that I’ve looked at this, of course, as with every theory, there’s always going to be cases where you can say, “Nope, didn’t work.” But this is one where I’ve seen it work time and time again. Why do I bring that up in the context of RRG?

Let me change from a daily RRG, where we’re looking at daily points, and go to a monthly RRG. I need to zoom out because this is all much, much bigger. Where we are right now, with the last almost year of history, what we can see is Energy has been outperforming really badly, been in the lagging, being left behind by all the other quadrants. But look where it’s now. It’s actually gone into the improving quadrant. What that tells me is that we’re in an environment, where Energy is starting to do better, and looks like it’s going to follow on and outperform the rest of the S&P there. Materials is doing well. What else have we got here? Consumer, Discretionary turned down, Utilities has turned down, Info-tech has turned down. So, again, if we come back to this diagram, Info-tech, or Technology, it had been outperforming, but now that’s over, and it’s turned down. Industrials, Healthcare, Finance, et cetera. This is just a great thing to study, taking an RRG on a monthly basis at a sector level, really makes this sort of stuff come alive. And it’s very, very powerful.

We’ve got this, and let’s just say, I’m going to jump back to a daily for this one. Let’s just say we’ve been looking at that, we like the look of Energy, and say, “Right, I want to know, what stocks can I add to my portfolio?” Well, with the Bloomberg 1 I can come along in here and I can say, “Let’s display the index members.” What we’ve got here is all the energy stocks that are part of the S&P 500 Energy Index. You can see here at the top that this one is already automatically, Optima has automatically set the S5 Energy Sector as the benchmark there. We can look at this and say, “Well, which ones are the best ones?” Because I want to add the best ones to my portfolio.

Again, it’s almost like this fractal nature that we see in so many areas of technical analysis, where what we’ve done at a macro level starts working as we go down and down into subsequent levels. What I’m going to do actually, is just shorten the tail length here, just to get rid of a little bit of the noise. Again, what I’m looking for is things heading into the improving quadrant, so that I can pickup on that relative strength earlier. So, there may be things here I can look at … I’m not even going to pronounce all these names. But there’s all these different resource companies that I could be looking at, and then doing further investigation.

So, from the stock selection point of view, I could’ve gone to sub levels if there were a number of industry groups. Maybe I wanted to look at the different industry groups. And say, “Well, which do I think is the best?” Or, in this case, as I said, we just went straight into all the equities, and had a look at those. The other thing we can do with this, is start to have a look at how far away are they from the centre of the chart. I can be looking at this and I can have a lot of these equities, and looking at their relative strength against the benchmark.

But, sometimes you get an industry like Telecoms, where you’ve got AT&T and Verizon, which are the absolute heavyweights. They just stay centred around, and there’s so little movement around the index, because they contribute so much to that index. But then, you’ve got other ones like T-Mobile and Sprint, which are way out on the periphery. What we’ve found is that the further stocks are away from the benchmark on the RRG chart, the more opportunity there is for alpha over the index. It makes sense when you think about it, because as the stock has such a big impact on the index, then as the stock goes up, the index is going up with it. But, if I’m dealing with a stock that has little impact on the index, that has a lower capitalisation, then as the stock starts outperforming, it has the opportunity to really outperform and give us a lot of alpha over the index.

When I look at this chart here, on the Energy stocks, I’m seeing the same things. So, any one of these stocks here, Exxon Mobil, of course it’s the second or third largest company on the S&P, you expect that to be near the middle, because it contributes so much to the energy sector and the sector index. Where as out here, Southwestern Energy, that would be one that I would be interested in, especially if I was looking for alpha. Maybe not so much now, it’s starting to get a little bit long in the tooth already, but these are the types of things that I’m looking for.

There’s actually a really nice feature here, we can actually put on a feature where we have a standard deviation circle. So, I could actually make that 2 standard deviations, and what we’ve done is we’ve taken the average of all of the data points, and said, “If we know what the average is of how far away they are from the origin, then let’s take a standard deviation of that, and let’s get rid of the first couple of standard deviations,” because we know that the most alpha is going to come out of those ones that are around on the periphery. So, we can just focus on those when we’re adding them or removing them from our portfolio.

A couple of things there which are beneficial. The other thing I want to talk about is how we actually manage the portfolio using RRG. Again, I can come along here, now last week, if you didn’t watch last week’s webinar, it should still be on the page there at proweb, optuma.com/proweb, you can have a look at that. But, what we can do now is we can open up a symbol list. I’m just going to hit F3 on my keyboard, and go to my symbol lists. We covered this last week, here is a list of about 100 securities that I have on using Bloomberg, works with it with anything that we have there.

I’m going to open this list, first of all I want to open it as a watch list. I just want to bring that through there just so you can see all the codes that we’ve got. Then, I’ve got this little feature at the top of a watch list where I can open these groups. Now I could group this by sector and have a look at the sectors individually, but in this case what I want to do, because I want to manage my whole portfolio, I just want to open the whole lot. So, let’s just go and open that as an RRG, and that will all come up there. Again, with 100 equities, showing 10 days of data, it’s a little bit long, so let’s just shorten all of that.

The software automatically creates these with random colours. So each arrow colour means nothing. Let me just get that label size back up again so we can see a little bit of that and make that a bit clearer for you. I’m going to change that to the tail colour so we can link them up with their arrows. We’ve got these on the charts, but from a portfolio perspective, this doesn’t help me. If I’m looking at my portfolio, I want to know are there any equities here, or is there anything in my portfolio that I need to take action on?

I don’t know if you remember from last time, but let’s just go back to this F3, I want to show you this. I want to open up this CSV file again from this list of securities, because what I did in here is I’ve got 2 extra columns. And now, look, these numbers are made up, but you could be working with this, again. You’re bringing a portfolio from Bloomberg, all of this stuff automatically comes in. But, what we can set up is we’ve got the weight, in let’s say my portfolio, and we’ve got the weight in the benchmark. So, that way, the software can actually calculate active weight for any one of these securities. You may just have, do I own it? Am I long? And have a value of 1. Am I short? Have a value of -1. And then you don’t even need a benchmark, because a benchmark is assumed to be 0. You can have like this 1, 0, -1 option as well, and it will give you exactly what we’re going to show. But this is where all this information’s coming from.

Because I’ve got that, what I can do with my RRG is I can come along and say, “Well, I don’t want a colour randomly here in colour style, I actually want to colour by fund weight.” Now, what’s happened, is anything that I have a long position in will be coloured green. Anything that I’m short on, or sorry, underweight, in this case I’m talking about active weight. If I’m overweight the benchmark, it’s green. If I’m underweight, it’s red. If I’m neutral or equal weight within a percent, then it’s going to be blue. What I’m trying to do here is just have that concept of as things are showing relative strength, I want to overweight them. I want to get in early.

One of the great things that I love about the work of Tom Dorsey at Dorseywrite, is he does this relative comparison with point and figure charts. So he takes point and figure charts and he basically says, “If I divide IBM by Microsoft and the point and figure of that value starts posting pluses, meaning that it’s going up, it gets a positive score in our ranking system.” A lot more complex than that, but essentially what he’s doing is he’s picking up really early that there is relative strength building. And so, he’s able to give that a positive score when most people who would be looking at it would be saying, “Oh, it’s under performing, it’s been under performing for 3 months, and it’s going to continue to under perform.”

I don’t know about you, but many times I’ve sat with financial professionals who have taken great joy at pointing out, “Here is a fund that is outperformed for the last year. I think we should be moving your money, or your investments, into that fund.” Really what all of this analysis is telling us is that usually by the time that happens, it is too late. That ship has already sailed, and all your doing is just getting in and buying off the smart money that’s starting to sell. In our website, at optuma.com/research, there’s a white paper that I wrote on that. If you’re very interested in this material, have a read of that. I think it’s titled something like Buying Outperformers Is Too Late. Do check that out for a little bit more on that whole theory.

What I’m trying to do with this chart here is I want to make sure that my portfolio is weighted towards that. Then what happens is as time goes on, and let’s just go back a little bit of time here. So, let’s just say that I’m looking at this type of scenario, this would be terrible for my portfolio management point of view, but nevertheless, I’m looking here, at let’s say this Range Resources company. What I’ve got is, I’m looking at it, it is negative, it’s pointing in the wrong direction. That’s a concept we haven’t talked about yet. There’s so many concepts dealing with RRGs.

The direction of the arrow is actually really important. When I first started working with RRGs, I was thinking that maybe it’s all to do with just where it is, because I wanted to systemize it and I wanted to test it. And that, again, is what that white paper goes a lot into. So, I was looking and saying, “Well, if I buy at this angle, and sell at that angle, maybe I’d get good results.” What we found is you get much better results when we pay attention to the heading of the arrows, not just where they are on the graph. Another great example of that is this one, FTI, right here. It’s starting to point back up again. It may not do a full rotation, but it’s starting to point back up again showing relative out performance and relative strength and the trend is becoming positive again, so we want to jump on that one as well. By doing that, we were able to get some really nice results. You can read about it in that paper.

I can look at this from a PM point of view and say, “What am I doing that’s green? Why am I long? RRC here, maybe I better go and action it.” The point is, I don’t have to go through all my equities, all my securities every day looking to see do I need to change a position? If I’m outperforming my benchmark and it’s heading in the northeast direction and everything’s looking great, I can just leave it. I don’t need to go and do a lot of analysis. All I need to focus on is those securities that are coloured, let’s say I’m overweight and now it’s starting to really point down towards the southwest, starting to lag behind, or weakening, they’re the ones I want to spend my time analysing. And so I’m looking at that and not spending a lot more time in other areas. From a portfolio management point of view that’s really, really helpful.

The other things that I can do, let me just show you a quick example here, we can come along and of course, as many of you know, Optima is heavily driven on the Optima scripting language. It’s a really simple excel-like, but very logical language for writing these things. The RRG components is JDKRS and I want to have a look at the angle, sorry, the heading. Let’s say the heading, and I want to know is the heading, actually I’m going to put that in a variable, and giving you a quick lesson on scripting. If you want to know more about scripting, head over to learn.optuma.com, because we have 3 courses which are available on scripting, all for free. You can get in there and have a look at how the scripting in Optima works, highly recommend them. In our office here, Darren Hawkins has done a fantastic job on that one.

Let’s just say here, what I’ve done is I’ve said I want that heading to be in J1. I’ll just give it a variable there. I’m going to now jump in here and say, “Right, let’s say, I want to know when J1 is greater,” so I’ve got to think about the compass angles here, let’s say J1’s greater than 270. So, I want it heading up from west. Let me do this the right way for you. So, it’s spun around, and I went to know that the heading is heading towards the northern hemisphere. Let’s just put parentheses around that one quickly. And finally, it’s got to be greater than 270, or I want to be, let’s say J1 is less than 90. So I just want everything which is pointed towards the northern hemisphere. I’ve done a mistake there. Let me save that, and now I can apply it.

Now I’ve got in my watch list this saved condition. So I can look at that and I maybe want to set this up and I can sort that column, let’s go there, and I can be working that way if that’s the easiest. There’s a lot of flexibility with the way you set that up.

What if you were dealing with a group of securities, let’s say a group of ETF’s, and it’s not immediately obvious what the benchmark would be? I get asked that quite often. There’s a point where if you are managing clients’ money, I’d be often suggesting to people still use the S&P 500 or in whatever country, the XJO in Australia, or the FTSE, or the Euro stocks, whatever makes sense for where you are, because your clients are going to be judging you against one of those indexes. I like the concept on an RRG, where every one of these elements is contained in the benchmark, and there’s not outside influences. Because otherwise, you can get this situation where maybe there’s something big that moved the index and all your securities are off in a different quadrant and it doesn’t give you this nice, balanced look.

Nevertheless, using a common benchmark is important, or you maybe used a fixed annual rate of return. For instance, on this chart, I could come along here and say, “Well instead of using Index File, I’m going to use an annual rate of return of 10%.” So now, instead of being benchmarked against this index, which is going up and down, I’m benchmarked against this straight line 10% return. Again, we can see that we still get rotation that’s happening. There’s times where everything’s outperforming, they’re all doing better than 10%, and there’s times where everything’s going to be under performing. You can see how all of that works. It depends on how you’re working.

Another way which is really important, particularly then if you’re dealing with different asset classes, et cetera. I want to open up another list that I have here. This one here is a group of about 100 ETF’s, all sorts of different, they’re bonds, they’re real estate, all sorts of things in there. And this, again, open that, I want to open it straight as an RRG this time. We’ve got, again, very long tails. I’m just going to shorten all of that, maybe a little bit more than that. What we’ve got is all of these ETFs which are running around. An actual fact, this is actually a quite balanced group. But one of the things that we can do in instances where you’re dealing with something which it’s not so obvious what should the benchmark be for this group of securities, and that is that we can either take the cap weighted average or the price weighted average.

What I’m going to do here is take the price weighted average. And so what the software’s done, it’s taken all of those data points and created an index that it can use as a benchmark. And it is amazing. We’ll go through this, it is amazing how, when you just take an average of a group of securities, that you’re going to have some which are outperforming, and some which are under performing. I guess it’s not that amazing, when you think about it. There’s always going to be ones that are outperforming the index or benchmark or average, and ones that under perform. But, it’s a great way of looking at that and saying, “Well, if this is my fixed, universal, securities that I can work with, then I have this way of being able to take an average of them.” And again, I can overweight, or maybe take long positions in the ones which are starting to outperform. And this rotation holds, that’s the amazing thing about all the work that we’ve done. I still don’t even think that Julius de Kempenaer really realises how amazing this chart is and the insights that it can give.

There’s a few things there that we’ve covered, talking about. I know we’ve gone very quickly over that, but what I really wanted to do was give you a taste of this, a bit of an understanding of this revolutionary, pardon the pun, chart style that we have here, and then just some of the different ways that you can use it and you can start looking at different types of things there. Do go check out those white papers at optuma.com/research. I think you’ll find them, there’s 2 there that I’ve written on RRGs, about weights and about buying out performers being too late. And of course, if you have any questions, you want to try this with your own portfolio, you want to interface with Bloomberg portfolios, CSV lists, or excel, or anything like that, please do let us know. We’re here to help, however we can.

Thank you so much for taking the time, and again, any questions, please let us know.

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