Sector Detector: Bulls under the gun to muster troops, while bears lie in wait

Two weeks ago, bulls seemed ready to push stocks higher as long-standing support reliably kicked in. But with just one full week to go before the Independence Day holiday week arrives, we will see if bulls can muster some reinforcements and make another run at the May highs. Small caps and NASDAQ are already there, but it is questionable whether those segments can drag along the broader market. To be sure, there is plenty of potential fuel floating around in the form of a friendly Fed and abundant global liquidity seeking the safety and strength of US stocks and bonds. While the technical picture has glimmers of strength, summer bears lie in wait.

In this weekly update, I give my view of the current market environment, offer a technical analysis of the S&P 500 chart, review our weekly fundamentals-based SectorCast rankings of the ten U.S. business sectors, and then offer up some actionable trading ideas, including a sector rotation strategy using ETFs and an enhanced version using top-ranked stocks from the top-ranked sectors.

Market overview:

Last week, the Fed sounded a predictably dovish tone while removing some of the uncertainty about their intentions on the fed funds rate, while investors seem to be coming to terms with the relatively low impact of any Greek outcome. As a result, stocks made another breakout attempt, led by the Healthcare sector and in particular biotech, with the iShares NASDAQ Biotechnology Index ETF (IBB) rising 3.1% on Thursday, as well as a tepid breakout in the small and mid caps. The 10-year Treasury yield closed Friday at 2.27%, as the Fed’s dovish tone brought back global investors.

Stocks have enjoyed the benefit of the double benefit of rising corporate earnings and falling interest rates (and rising liquidity). But if rising wages cut into profits, and interest rates start to creep up, the fear is that asset prices will be capped and stocks will suffer. But the fear is that raising rates high enough to make a difference to interest-hungry investors and retirees would cap (or even collapse) asset prices. Thus, any sign that the Fed will keep it slow with rate hikes is well received.

Fed watchers think we might see two 25 bps fed funds rate hikes this year, and perhaps another 100 bps total next year. However, although I now think it is likely that the Fed will make its first rate hike this year (probably in September), we might not see another one until mid-2016. The problem for the Fed is, how do you wean a fragile economy off of the fuel that is driving its tepid advance? After all, low rates have largely driven stock buyback programs and M&A, which have been the key drivers for stock prices while individual investors have been reluctant to jump in. A fed funds rate of 1% and a 10-year Treasury yield of 3.5% might be about all the economy can absorb, at least in the near term.

Yes, stock buybacks and M&A continue to pick up speed while debt is cheap. In particular, Healthcare, TMT, Energy, and Retail are seeing M&A momentum. We know that 95% of profits from S&P 500 stocks last year were used for stock buybacks or dividends, and recent monthly buyback totals have been setting records.

After hitting a 2015 low of about 12.11 just about a month ago, the CBOE Market Volatility Index (VIX), a.k.a. fear gauge, closed Friday at 13.96. The 15 threshold between fear and complacency now roughly corresponds to the 200-day simple moving average, and it continues to hold as resistance. Nevertheless, VIX has been notably higher than it was last year at this time, when it lingering in the 10-12 range.

In any case, the global economy depends upon the US to buy products, so the entire world (with the exception of ISIS) is really in this whole thing together -- so the US economy must advance for the rest of the world to rise. Therefore, the US stocks should continue to rise, albeit gradually.

SPY chart review:

Back in May the SPDR S&P 500 Trust (SPY) broke out above the 212 line of solid resistance and then returned to retest it as new support, but it ultimately failed after seven days of sideways floundering around the 212 level. Then last week, bulls made another attempt at a break out in the wake of the Fed announcement but it failed on Friday, closing the week at 210.81, which is right at its 50-day simple moving average. Although there is still solid support just below -- primarily in the form of the long-standing uptrend line (around 210) -- the picture is not quite as bullish as it appeared two weeks ago. Much like the last tepid breakout above resistance at 212, oscillators RSI, MACD, and Slow Stochastic had all flattened out to neutral and could go either way. Nevertheless, the chart seems to be forming a very large bullish ascending triangle, with the long-standing uptrend line rapidly converging toward the 212 level of stubborn resistance. Below, the uptrend line, next major support is at the 100-day SMA (just above 209), prior support near 208, and the critical 200-day SMA (near 205), followed by earlier-in-year support at 204, then round-number support at the 200 price level.

SPY chart

Small caps and NASDAQ hit new highs last week, but neither appears ready to lead the way for large caps, at least for the moment. Let’s see how this week progresses ahead of the doldrums surrounding Independence Day vacations.

Latest sector rankings:

Relative sector rankings are based on our proprietary SectorCast model, which builds a composite profile of each equity ETF based on bottom-up aggregate scoring of the constituent stocks. The Outlook Score employs a forward-looking, fundamentals-based multifactor algorithm considering forward valuation, historical and projected earnings growth, the dynamics of Wall Street analysts’ consensus earnings estimates and recent revisions (up or down), quality and sustainability of reported earnings (forensic accounting), and various return ratios. It helps us predict relative performance over the next 1-3 months.

In addition, SectorCast computes a Bull Score and Bear Score for each ETF based on recent price behavior of the constituent stocks on particularly strong and weak market days. High Bull score indicates that stocks within the ETF recently have tended toward relative outperformance when the market is strong, while a high Bear score indicates that stocks within the ETF have tended to hold up relatively well (i.e., safe havens) when the market is weak.

Outlook score is forward-looking while Bull and Bear are backward-looking. As a group, these three scores can be helpful for positioning a portfolio for a given set of anticipated market conditions. Of course, each ETF holds a unique portfolio of stocks and position weights, so the sectors represented will score differently depending upon which set of ETFs is used. We use the iShares that represent the ten major U.S. business sectors: Financial (IYF), Technology (IYW), Industrial (IYJ), Healthcare (IYH), Consumer Goods (IYK), Consumer Services (IYC), Energy (IYE), Basic Materials (IYM), Telecommunications (IYZ), and Utilities (IDU). Whereas the Select Sector SPDRs only contain stocks from the S&P 500, I prefer the iShares for their larger universe and broader diversity. Fidelity also offers a group of sector ETFs with an even larger number of constituents in each.

SectorCast ETF rankings
Here are some of my observations on this week’s scores:

1.  Financial again takes first place with a strong Outlook score of 93. Financial displays the lowest (i.e., best) forward P/E (just slightly better than Utilities), and strong sentiment among both Wall Street analysts (upward revisions to earnings estimates) and insiders (buying activity). Technology remains in second place with a score of 83, primarily due to solid Wall Street sentiment, the best return ratios, and a strong forward long-term growth rate. Utilities stays in third this week at 77 with a good forward valuation (but flat forward long-term growth rate).

2.  Telecom share the cellar with an Outlook score of 10. Telecom stocks display a good forward long-term growth rate, but the forward P/Es remain high, while Energy scores poorly across the board -- although Wall Street has eased up on its cuts to forward earnings estimates, the sector still reflects a flat-to-negative forward long-term growth rate, and the highest forward valuations (despite the big fall in stock prices).

3.  Looking at the Bull scores, Technology displays the top score of 63, followed by Healthcare and Financial above 60. Energy has the lowest Bull score of 44 and is the only one below 50. The top-bottom spread is 19 points, reflecting low sector correlations on particularly strong market days. It is generally desirable in a healthy market to see low correlations reflected in a top-bottom spread of at least 20 points, which indicates that investors have clear preferences in the stocks they want to hold.

4.  Looking at the Bear scores, Consumer Goods (Staples/Noncyclical) displays the top score of 51, followed by Telecom, Healthcare, and Consumer Services (Discretionary/Cyclical) which means that stocks within these sectors have been the preferred safe havens (relatively speaking) on weak market days. Technology scores the lowest at 37. The top-bottom spread has expanded to 14 points, which reflects lower sector correlations on particularly weak market days. This is good. Ideally, certain sectors will hold up relatively well while others are selling off, so it is generally desirable in a healthy market to see low correlations reflected in a top-bottom spread of at least 20 points.

5.  Financial displays the best all-around combination of Outlook/Bull/Bear scores, while Energy is the worst. Looking at just the Bull/Bear combination, Healthcare is the best, followed by Financial and Consumer Goods (Staples/Noncyclical), indicating superior relative performance (on average) in extreme market conditions (whether bullish or bearish), while Energy by far the worst.

6.  Overall, this week’s fundamentals-based Outlook rankings remain mostly neutral. After showing some bullish promise two weeks ago with solid showings from Financial, Technology, and Healthcare, they have kind of languished in this position ever since, with Utilities and Consumer Goods (Staples/Noncyclical) remaining in the top five, while Industrial, Basic Materials, and Consumer Services (Discretionary/Cyclical) sink further in the bottom five. Keep in mind, the Outlook Rank does not include timing or momentum factors, but rather is a reflection of the fundamental expectations of individual stocks aggregated by sector.

Stock and ETF Ideas:

Our Sector Rotation model, which appropriately weights Outlook, Bull, and Bear scores in accordance with the overall market’s prevailing trend (bullish, neutral, or defensive), retains its bullish bias and suggests holding Technology, Financial, and Healthcare, in that order. (Note: In this model, we consider the bias to be bullish from a rules-based trend-following standpoint when SPY is above both its 50-day and 200-day simple moving averages.) SPY continues to find reliable support nearby at the uptrend line.

Other highly-ranked ETFs in SectorCast from the Technology, Financial, and Healthcare sectors include iShares North American Tech-Multimedia Networking Fund (IGN), First Trust NASDAQ ABA Community Bank Index Fund (QABA), Market Vectors Pharmaceutical ETF (PPH).

For an enhanced sector portfolio that enlists some top-ranked stocks (instead of ETFs) from within the top-ranked sectors, some long ideas from Technology, Financial, and Healthcare sectors include Integrated Device Technology (IDTI), Zebra Technologies (ZBRA), Capital One Financial (COF), Ameriprise Financial (AMP), Gilead Sciences (GILD), and Molina Healthcare (MOH). All are highly ranked in the Sabrient Ratings Algorithm.

If you prefer to maintain a neutral bias, the Sector Rotation model suggests holding Financial, Technology, and Utilities, in that order. But if you prefer a defensive stance on the market, the model suggests holding Financial, Consumer Goods (Staples/Noncyclical), and Healthcare, in that order.

Note that Fidelity offers its own line of U.S. sector ETFs that can be used for sector rotation, including Fidelity MSCI Financial Index ETF (FNCL), Fidelity MSCI Health Care Index (FHLC), Fidelity MSCI Information Technology Index ETF (FTEC), Fidelity MSCI Utilities Index (FUTY), and Fidelity MSCI Consumer Staples Index (FSTA).

IMPORTANT NOTE:  I post this information each week as a free look inside some of our institutional research and as a source of some trading ideas for your own further investigation. It is not intended to be traded directly as a rules-based strategy in a real money portfolio. I am simply showing what a sector rotation model might suggest if a given portfolio was due for a rebalance, and I may or may not update the information each week. There are many ways for a client to trade such a strategy, including monthly or quarterly rebalancing, perhaps with interim adjustments to the bullish/neutral/defensive bias when warranted -- but not necessarily on the days that I happen to post this weekly article. The enhanced strategy seeks higher returns by employing individual stocks (or stock options) that are also highly ranked, but this introduces greater risks and volatility. I do not track performance of the ETF and stock ideas mentioned here as a managed portfolio.

Disclosure: Author has no positions in stocks or ETFs mentioned.
Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into account their personal financial circumstances in acting on any rankings or stock selections provided by Sabrient. Sabrient makes no representations that the techniques used in its rankings or selections will result in or guarantee profits in trading. Trading involves risk, including possible loss of principal and other losses, and past performance is no indication of future results.

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