As Adam, my firm’s portfolio manager, can attest to – I like pair trades. I like the ability to find pairs that work in a mean-reversion type way that allows a short and long to work together. There appears to be one setting up between the iShares MSCI EAFE ETF ($EFA) and the iShares MSCI Emerging Market ETF ($EEM). The chart we will look at today shows the ratio between these two ETFs along with the Relative Strength Index. When the ratio is rising it tells us that $EFA is outperforming $EEM on a relative basis, with the opposite being true when the green line is falling.
I’ll often look at the momentum of a pair of ETF’s based on the Relative Strength Index (RSI) indicator. While simple overbought/oversold levels give us an interesting picture of the relationship between $EFA and $EEM, I prefer to seek out divergences.
For example, when the RSI indicator breaks above 70 and then creates a negative divergence with the ratio between the two region ETFs. This tells us that since momentum is unable to make a new high that relative performance between $EFA and $EEM may begin to turn. The same can be observed when the RSI breaks below 30 and is unable to make a lower low alongside the ratio.
Looking at the above chart we have the first part of the equation with RSI breaking above 70. Going forward I’ll be keeping an eye on the relationship between the EAFE and emerging markets ETFs to see if momentum starts to diverge.
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