Relative strength is a concept used in investing and technical analysis to compare the performance of one asset or security against another over a given period of time. It measures the strength or weakness of an asset relative to its peers or a benchmark index.
According to the Global Industry Classification Standard (GICS) there are 11 sectors into which S&P has categorized all major public companies.
The charts above display the relative strength for each US stock market sector by comparing its price performance to the S&P 500, a widely used benchmark index. When the ratio rises, the sector outperformed the market - and when it falls, the sector underperformed.
Applying relative strength analysis to sectors is particularly valuable in facilitating sector rotation strategies. By identifying sectors demonstrating robust relative strength, investors can strategically allocate their investments, seeking to capitalize on sectors with positive momentum.
The chart above gives a different view of the same data from the ratios above. Presented below are brief sector descriptions along with some example companies.
The chart above shows a heat map depicting the correlation coefficients among various US stock market sectors. Each sector is represented on both the x and y axes, with intersections revealing the strength and direction of their correlation. A correlation coefficient of +1 indicates a perfect positive correlation, implying that two sectors moved in the same direction during the specified time window. Conversely, a coefficient of -1 signifies that the sectors moved in opposite directions. Colors range from deep blue, indicating a negative correlation, to bright red, signifying a strong positive correlation. The chart shows that over a long time frame the Energy sector exhibits the weakest correlation with the other sectors.
The correlation coefficient is important to consider for diversification because it helps investors assess the potential benefits of including different assets in their investment portfolios. Diversification is the practice of spreading investments across different asset classes to reduce risk. In his book Principles, Ray Dalio called diversification the “Holy Grail of Investing”. He realized that with fifteen to twenty uncorrelated return streams, he could dramatically reduce the risks without reducing the expected returns.
The minimum spanning tree (MST) simplifies the data from the correlation matrix above by retaining only the strongest correlations between the sectors. If two sectors are connected, it means that they are positively correlated and that they tend to move in tandem. By analyzing the structure of the MST, one can identify clusters of assets that move together. This visual tool is especially beneficial when considering portfolio diversification. In fact, Marti, Gautier, et al. (2017) found that the optimal Markowitz portfolio is found at the outskirts of the tree and that the tree shrinks during a stock crisis.
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