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Understanding Sector Rotation: Technical Analysis Primer

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 -- as a result, 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

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 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.

A more anecdotal method involves taking a look at the performance of different sectors and asset classes over a given period to determine where in the investment cycle we are. Based on the intermarket relationships we talked about earlier, a bond rally turning south coupled with increased buying in stocks could mean that equities are about to start a more sizable run. Within stocks, comparing sectors that are historical leaders or laggards can point investors in the right direction as to which sector to be heavy on and which to avoid. When a leading industry such as transportation starts to see an uptick, it may be a good indicator that it's time to take a position in later-stage industries like consumer staples.

(Note: Martin Pring's book Technical Analysis Explained provides an excellent table of industries grouped by their leading or lagging effects during cycles.)

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