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I want to share a little-known but powerful indicator with you today. To paraphrase hockey legend Wayne Gretzky, this indicator helps us skate to where the puck is going to be, not where it has been. In other words, we can use it to identify and anticipate strength and weakness in markets and specific sectors.
This indicator is a graphical illustration of relative strength (RS). Regular readers know RS is a quantitative measure of trend strength and one of the most powerful tools available to traders. Study after study shows that outperforming stocks tend to continue to outperform, and we have used high RS to find stocks that returned up to 242% in a year.
Typically, most people compare performance between financial instruments by measuring percentage changes. The following graph shows the performance of a few of the major U.S. equity indices over the past 10 weeks:
Here you can see the tech-heavy Nasdaq is leading the fray with the broad-market NYSE Composite a close second. The natural resource-heavy AMEX is in third, and the blue-chip Dow industrials and small-cap Russell 2000 are bringing up the rear. That's all the information you can really get from this chart.
Now I'd like to introduce you to the relative rotation graph (RRG). The RRG measures the same relative performance, but does so graphically. And as you'll see, it goes well beyond what we can glean from the graph above.
The RRG shows all of these critical relationships:
-- What is leading/lagging
-- How much something is leading/lagging
-- Whether the leadership or "laggard-ship" is speeding up or slowing down
-- What direction something is headed
It may look a little daunting. It was the first time for me -- even as a Chartered Market Technician (CMT) -- but I will break it down to help you understand.
The center point is the financial instrument to which we are comparing all the other lines. In this case, it's the S&P 500. This is the "relative" portion of the relative rotation graph. The colored lines represent the different financial indices in the table above.
Each dot on the line represents one week. The dot next to the symbol is the present location. The rest of the dots show the past 10 weeks of performance history. The distance between the dots shows how fast or slow the index is moving, i.e., its rate of change. The farther apart they are, the faster the index is moving.
These lines rotate clockwise around the four quadrants:
-- Quadrant 1 shows which indices are underperforming.
-- Quadrant 2 shows which indices are underperforming but showing improvement.
-- Quadrant 3 shows which indices are outperforming.
-- Quadrant 4 shows which indices are outperforming but starting to weaken.
The distance between the lines and the center point shows by how much the indices are outperforming or underperforming the S&P 500. The farther from the center, the stronger or weaker the performance.
Notice the AMEX ($XAX in blue) is in Quadrant 2, meaning it is improving. While it has underperformed during much of the past year, it showed sharp improvement in the past 10 weeks as oil and natural resource stocks rebounded from very oversold conditions. Also note how far away it is from the center axis. This shows the AMEX is rallying strongly compared to the S&P 500.
The AMEX is closing in on Quadrant 3. If/when the line crosses into it, it should be the leading index.
The NYSE Composite ($NYA) is already in Quadrant 3 and outperforming the S&P 500. This index contains many financial issues, and strength in that sector has provided a tailwind that helped push the NYSE into leading territory.
Both the Nasdaq Composite ($COMPQ) and Russell 2000 ($RUT) have slipped into Quadrant 4, indicating they are weakening. They are still outperforming the S&P 500, but their rate of change has slowed compared to gains in the broader market index.
Finally, we see the Dow in Quadrant 1 is lagging the rest of the indices. Strength in the U.S. dollar has hurt foreign profits at the multinational behemoths that make up this index. Until the Dow crosses into Quadrant 2, its component stocks will have a tough time making headway.
The relative rotation graph is a powerful indicator that elegantly dovetails with my Alpha Score system, which is a relative strength-based system designed to spot stocks on the verge of a breakout.
The RRG has helped me overweight market capitalization areas beginning to outperform and underweight those whose performance is declining. When I use a RRG in combination with the Alpha Score, I am able to find top-performing stocks with outstanding fundamentals in the strongest sectors.
To that end, I just recommended a stock listed on the improving AMEX that has an Alpha Score of 160 out of a possible 200. That places it in the top 10th percentile of the 7,000-plus companies in my database.
I doubt you've heard of this company before. It's in the nut business. That's right -- nuts.
That may not sound exciting, but in its most recent quarter, sales grew at a 20% year-over-year pace and earnings were a whopping 76% higher than the year-ago period. Following the earnings release, the stock rocketed 7.2% higher on a 340% increase in volume. That shows outsized demand to own shares and a market of investors who aren't afraid to pay up to buy in.
Technically, the stock is emerging from a large cup-and-handle base that saw price correct deeply near the 200-day moving average. So far, the stock is constructively digesting its earnings-fueled gains.
Based on the improving climate for AMEX stocks, its outstanding Alpha Score and technical pattern, I think this stock could double.
The relative rotation graph is a cutting edge technical tool few people understand. Consider yourself now on that short list. If you'd like to be on an even shorter list of people who know about the Alpha Score, you can view this short presentation.
It details how I use the Alpha Score to find stocks on the verge of a breakout, like the potential money-doubling nut distributor that just signaled "buy." Follow this link to access it now.
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