Yesterday, I mentioned on Substack and X that momentum in the Communications sector is improving:
If we zoom in on the chart, we can see that the Communications sector has been stuck in a sideways trading pattern since late September of last year.
During this time, momentum declined, and the sector relatively underperformed VBINX (which I am using as a proxy for a 60/40 index).
Currently, the sector is still trading in this range bound, sideways pattern, but as momentum continues to improve, we may see the sector finally break out to new highs.
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Under the Hood of the Communications Sector
The XLC ETF is designed to mimic the Communications sector’s index. As of August 26th, the weighting of stocks within the ETF and the index are almost exactly the same.
This allows us to use XLC as a proxy for the sector and as a trading vehicle.
source: State Street Investment Management
Since last September, with the exception of Verizon, Warner Bros. Discovery, and Google (where it can be argued the price is rising due to the AI trade), the top 10 has underperformed the market.
Since these 10 companies represent nearly 70% of the index, let’s take a closer look to see if we can gather more information about the recent changes in momentum.
Relative Rotation Graphs (RRG) for the Communications Sector
I am a big fan of Relative Rotation Graphs (RRG), as they help visualize the rotation between strength and weakness of the market, or in this case, a sector.
Currently, the majority of the top 10 is located in the bottom left hand quadrant. This is known as the “lagging” quadrant and is where we will find the weakest momentum and relative strength.
Naturally, we want to avoid anything in this quadrant, right?
Not necessarily. My own studies, as well as those done by others, have shown that since RRGs typically rotate in a clockwise fashion, the “lagging” quadrant may actually provide the opportunity to do what we have all been taught to do: “buy low, sell high.”
As I highlighted in this post: “Using Relative Rotation Graphs for Sector Selection”, Matthew Verdouw, CMT, CFTe, examined the probabilities of gain and the average annual return of each quadrant.
His research shows that the best performance comes from the lagging quadrant.
source: Buying Outperformers Is Too Late
By animating the RRG during the period of negative momentum, you can see the rotation of the majority of the top ten holdings in the index move from strength to weakness:
So, Where Does this Leave Us?
The Communications sector is still stuck in the same trading range it has been in since last September, and the majority of its largest holdings are sitting in the lagging quadrant. On the surface, that is not a chart most investors would want to own.
But that is exactly the point.
Momentum tends to turn before price does, and RRGs tend to rotate in a clockwise fashion. If the top 10 holdings begin to rotate out of the lagging quadrant and into the improving quadrant, the “buy low” portion of the equation may already be in place.
From here, there are three things I am watching: continued improvement in momentum on the XLC chart, rotation of the top 10 holdings from the lagging quadrant into the improving quadrant, and a breakout above the sideways range that has contained the sector for almost a year.
Of course, none of this is guaranteed. Sectors can sit in the lagging quadrant longer than we expect, and breakouts can fail. But when momentum starts to improve while price is still range-bound, that is usually when I start paying closer attention, not less.
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I didn't know about Matthew Verdouw's research on the rotation graph, thanks for sharing