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New methodology: Performance Ranking Divergences

May 6, 2013

I have shown how breadth indicators on custom stock groups can be calculated using the Metastock software FIRE. Another capability of this software is to rank performance of a group of stocks.

The best performing stocks will show relative strength against the group benchmark, which could be a market index or a sector ETF. The performance rank (PR) can be charted over time, so I can compare the PR line with the relative strength line.

Example: Dow Jones Food Index

  • A set of 70 US sector indices were ranked on price performance
  • Performance is ranked over 100 days. The ranking is weighted towards the most recent data: 40-20-20-20 for each 25 day period
  • The relative strength line of the sector versus the S&P500 Index is plotted, along with the 14 week RSI of this relative line

DJ Food Index vs S&P500 Index and PR

DJ FOOD

  • At B (Jan 06), the bullish divergence of the RSI is matched by a bullish divergence on the PR. The sector relative line rallies
  • At C (Jul 06), the new relative high is not confirmed by the RSI or the PR. The RSI divergence is not a ‘proper’, as it remains below 70. The sector relative line declines
  • At D (Mar 09) and at F (Sep 11), the bearish divergence of the RSI is matched by a bearish divergence on the PR. The sector relative line falls

Also note that:

  • At A (May 04) and E (Feb 10), PR was high and the relative fell

Operating principles for performance rank analysis

The FIRE manual suggests buying stocks and sectors showing strength in their PR. This works at times but my observations showed me too many times when a high PR did not persist, times such as A and E on the chart above.

Instead, the PR is most reliably used to substantiate divergences on the RSI of relative strength lines, times such as B, C, D and F above.

Operating principles

  • Look for 14 week RSI divergences on relative strength that coincide with divergences on the PR
  • The more pronounced the divergence, the more reliable the set up as identifying a turning point
  • Use the RSI divergence entry criteria for entering the trade
    Where there is not quite a proper RSI divergence (e.g. at C), run stock scans for another side to the trade. Only take the trades with good commonality. Don’t trade a pair that is an aberration just because it fits the RSI divergence criteria

Further observations

  • The DJ Food Index had the best record of the 70 sectors of producing good PR divergence signals. This is perhaps because the sector has a consistent relative strength correlation to the market indices (a negative correlation)
  • Being defensive, some relative peaks have corresponded with market index lows (times C, D, F). At G (Apr 13), the sector relative also has bearish RSI divergence
  • The difference this time is that the PR has dropped but not formed a divergence over a long period. The market index is also not at a low. The set up is not as clear as at times B, C, D and F

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