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Understanding Sector Rotation: Technical Analysis 101

Generally, bonds lead stocks, and stocks lead commodities. In other words, a typical investment cycle consists of a bond rally, which is followed by a stock rally, which is then followed by a commodity rally. The opposite is true as well: Weakness in bonds generally precedes weakness in stocks, which precedes weakness in commodities. Not surprisingly, these relationships are due in large part to the causality between these different markets. For instance, stocks might be in the middle of a declining phase as rallying commodities increase input costs and put the squeeze on companies' profit margins.

Even though these relationships are a good simplification of the investment cycle, they're not infallible. Just because they hold true now doesn't mean they'll hold true in perpetuity, so it's important to stay on top of market relationships if you're taking an active approach to asset rotation.

As useful as it may be to know how the investment cycle operates, the most crucial piece of the puzzle is still missing: How do you know when to rotate into or out of a particular sector or asset class?

Trading Signals for Your Asset Rotation Strategy

Must Read: How to Trade a Breakout: Technical Analysis 101

Traditionally, relative strength has been one of the most popular ways of determining which sectors are worth watching. Basically, relative strength is calculated by taking the ratio of one security’s price over another's. While the resulting number is fairly meaningless, its change over time is very significant -- and uptrending charts of this metric mean outperformance is occurring in the numerator security. By using a moving average crossover signal to determine when that uptrend is broken, it's possible to get solid, mechanical buy and sell signals.

The relative strength chart below of the S&P 500 Index vs. Gold is in a well-defined uptrend. That's a signal that investors should have been actively rotating out of gold and into equities. Until that uptrend breaks, that's the long-term trend in play.

The fact that (traditional) relative strength can only compare two securities at a time means that a number of charts have to be analyzed to find the “winning” asset class -- but the objective buy and sell signals are a huge benefit to anxious traders.

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