Sector Detector: Both Fundamentals and Technicals at Odds with Rally
The market continues to try to suck in bears who are itching to short a rally that is long on optimism but short on volume and fundamental underpinnings. But each time it appears that a correction of significance is ready to start, a bid arrives with the slimmest of justification to sends the market to new heights. Despite market exuberance, my own technical analysis of the charts and Sabrient’s SectorCast-ETF fundamentals-based quantitative ranking of the ten U.S. sector iShares are both telling me that there is still much to worry about.
Tuesday’s bullish breakout of the ascending triangle chart pattern, led by the Materials sector, was impressive indeed – all the more so given that it came in the wake of yesterday’s head-fake bearish failure of the ascending triangle, in which Materials was the leader to the downside. Although final trading volume figures appeared to be robust today, it was actually fairly modest until late-day short covering kicked in.
In deviance of historical patterns, September turned out to be an extremely strong month, with only a couple of timid attempts to sell off. The market seems to be guided by forces that defy technical analysis.
Friday put in a hanging man candlestick, which is a bearish reversal pattern that can mark a top or resistance level – and 115 on the SPY has certainly provided formidable resistance. When it forms after an advance, the hanging man signals that selling pressure is increasing, and indeed the market showed weakness on Monday on low volume. But it actually closed the day above its lows, and then raced out of the gate on Tuesday – and never stopped.
Graham Summers of Phoenix Capital Research wrote an article last week about the Fed stoking the stock market: (http://seekingalpha.com/article/227487-the-only-reason-stocks-have-ralli...). He says that the "QE lite" program allows the Fed to take the interest on maturing securities to purchase Treasuries from Wall Street Primary Dealers via its Permanent Open Market Operations (POMO), and then the Primary Dealers take this fresh capital and plow it into stocks, forcing the sort of "ramp jobs" we've been seeing whenever the market looks ready to weaken. This just adds to my skepticism about whether there is "real" investor fuel for continued market strength without a more significant retest of support levels.
The VIX volatility index (measure of investor fear) has been hanging around near the bottom of its 21-28 trading range, closing today at 21.76. However, while the market is hitting 5-month highs, the VIX is showing a bit of a divergence by not hitting 5-month lows. And while the TED spread (i.e., indicator of credit risk measuring the difference between the 3-month T-bill and 3-month LIBOR interest rates) is still at the low end of its range, it has been increasing lately from around 13-14 to 17.5 today. Both of these indicators show a lack of fear in the markets, which is positive for the bulls, but they also have been showing divergences from the strongly bullish trend of the market.
Also, the major indices of course remain well above their 50 and 200-day moving averages. And then, there is the record level of corporate cash that is finding its way into picking up strong, well-positioned, undervalued companies.
Latest rankings: Sabrient’s SectorCast-ETF ranking of the ten U.S. business sector iShares continues to reflect a defensive bias, with only minor scoring changes from last week.
Scores overall have come down across the board. Technology (IYW) continues to score at the top, but this week it must share the top spot with Healthcare (IYH) – both scoring an 83. Financials (IYF) is holding onto third place with another 65 after jumping 16 points last week, and Consumer Goods (IYK) maintained fourth place with a score of 61, which is up 6 points from last week. Consumer Goods is a defensive sector, so bulls really don’t like to see it strengthen in the rankings at the expense of Technology and Consumer Services.
IYW remains strong across the board, scoring highly (on a composite basis across its constituent stocks) in the percentage of analysts increasing earnings estimates as well as in return on equity, return on sales, and projected year-over-year change in earnings. IYH is strong in return on equity, return on sales, and projected P/E.
Top ranked stocks in IYW and IYH include Ingram Micro (IM), Lexmark (LXK), Endo Pharmaceuticals (ENDP), and Humana (HUM).
At the bottom of the list, we continue to find Telecom (IYZ), with the highest PPE and the worst return on equity. This week it scores a rock-bottom 0, which caused me to do some checking. Out of 327 equity ETFs in our rankings, only three scored so low. Returning this week to the bottom two after a brief hiatus is Consumer Services (IYC), which falls to 34 while Basic Materials (IYM) gets a bump from 33 up to 39. Nevertheless, stocks within IYM and Energy (IYE) are still the ones getting hit the worst with analysts’ downward earnings revisions. Note that IYE dropped further from a 46 last week to 41.
Low ranked stocks in IYZ and IYC include American Tower (AMT), Sprint Nextel (S), MGM Resorts International (MGM), and Barnes & Noble (BKS).
These scores represent the view that the Technology and Healthcare sectors may be relatively undervalued overall, while Telecom and Consumer Services sectors may be relatively overvalued, based on our 1-3 month forward look.
Disclosure: Author has no positions in stocks or ETFs mentioned.
About SectorCast: Rankings are based on Sabrient’s SectorCast model, which builds a composite profile of each equity ETF based on bottom-up scoring of the constituent stocks. The model employs a fundamentals-based multi-factor approach considering forward valuation, earnings growth prospects, Wall Street analysts’ consensus revisions, accounting practices, and various return ratios.
SectorCast has tested to be highly predictive for identifying the best (most undervalued) and worst (most overvalued) sectors, with a one-month forward look. Of course, each ETF has a unique set of constituent stocks, so the sectors represented will score differently depending upon which set of ETFs is used. For Sector Detector, I use ten iShares ETFs representing the major U.S. business sectors.
About Trading Strategies: There are various ways to trade these rankings. First, you might run a sector rotation strategy in which you buy long the top 2-4 ETFs from SectorCast-ETF, rebalancing either on a fixed schedule (e.g., monthly or quarterly) or when the rankings change significantly. Another alternative is to enhance a position in the SPDR Trust exchange-traded fund (SPY) depending upon your market bias. If you are bullish on the broad market, you can go long the SPY and enhance it with additional long positions in the top-ranked sector ETFs. Conversely, if you are bearish and short (or buy puts on) the SPY, you could also consider shorting the two lowest-ranked sector ETFs to enhance your short bias
However, if you prefer not to bet on market direction, you could try a market-neutral, long/short trade—that is, go long (or buy call options on) the top-ranked ETFs and short (or buy put options on) the lowest-ranked ETFs. And here’s a more aggressive strategy to consider: You might trade some of the highest and lowest ranked stocks from within those top and bottom-ranked ETFs, such as the ones I identify above.