16
Nov
2011

Sector Detector: Financials and Materials take the heat

U.S. stocks are raring to rally. Earnings reports have been quite good. Consumers are spending despite stubbornly high unemployment. Interest rates are at rock bottom, which is good for borrowing and also makes stock yields relatively attractive. So what’s the problem? Oh, just the usual—fear of a European debt meltdown triggering a global recession.

The fear is that the freeloaders like Greece and Italy may bring down the kingpins like Germany and France. But big-time investors like Warren Buffett remain undaunted. In fact, during 3Q11, Berkshire Hathaway (BRK.A) made its largest quarterly allocation of cash to equities since the mid-90s, including a 5.5% stake in IBM Corp (IBM)—a rare investment in Technology for the “Sage of Omaha” who normally sticks with non-cyclicals like Consumer Staples and Financials.

Notably, while the Financials and Materials sectors have been hit hardest this week, Technology and Consumer Staples have held up the best. If you look at the Sabrient SectorCast ETF rankings show that Financials and Materials sector iShares (IYF and IYM) indeed have been the leaders on strong market days and the laggards on weak market days.

Despite good overall earnings reports this season, suspect earnings quality nevertheless has been the downfall of a number of stocks. Forensic accounting firm and recent Sabrient acquisition Gradient Analytics (http://www.EarningsQuality.com) saw a number stocks that it had red-flagged fall after their earnings reports, including Ritchie Bros (RBA), International Flavors & Fragrances (IFF), Medicis Pharma (MRX), Green Mountain Coffee Roasters (GMCR), and Netflix (NFLX), just to name a few.

David Trainer of New Constructs, a regular contributor to the Sabrient blog, has his own take on forensic accounting and the current environment, as described in his recent post: http://www.sabrient.com/blog/?p=5490#more-5490.

The SPY closed Wednesday at 124.08. The market basically has been treading water as it reacts daily to the latest prognostications for Europe. Price is forming a symmetrical triangle (like a coiled spring) from which it will try to either breakout bullishly or breakdown bearishly. After the recent bullish breakout from an 11-week trading range (between 112 and 122), I think this is possibly a pennant formation, which is a continuation pattern of the new bullish trend. However, it is hard to read, especially since it is so news-driven these days.

The flat 200-day simple moving average is providing resistance while the rising 20-day MA is lending support. The Bollinger Bands (two standard deviations above and below the 20-day moving average) continue to converge while MACD and Slow Stochastic have been reverting to the mean from overbought territory.

The VIX (CBOE Market Volatility Index – a.k.a. “fear gauge”) closed Wednesday at 33.51. It has made a few attempts to hold below the important 30 mark, but there is too much fear out there. The TED spread (indicator of credit risk in the general economy, measuring the difference between the 3-month T-bill and 3-month LIBOR interest rates) has continued its upward trajectory, closing Wednesday at 46.60. Although not nearly so high as the extremes it hit during the 2008 financial crisis, it nevertheless is a far cry from the low-teens earlier this year, and indicates elevated investor worry about bank liquidity and a preference for the safety of Treasuries bonds over corporate bonds.

Latest rankings: The table ranks each of the ten U.S. industrial sector iShares (ETFs) by Sabrient’s proprietary Outlook Score, which employs a forward-looking, fundamentals-based, quantitative algorithm to create a bottom-up composite profile of the constituent stocks within the ETF. In addition, the table also shows Sabrient’s proprietary Bull Score and Bear Score for each ETF.

High Bull score indicates that stocks within the ETF have tended recently toward relative outperformance during particularly strong market periods, while a high Bear score indicates that stocks within the ETF have tended to hold up relatively well during particularly weak market periods. Bull and Bear are backward-looking indicators of recent sentiment trend.

As a group, these three scores can be quite helpful for positioning a portfolio for a given set of anticipated market conditions.

Here are some observations about Sabrient’s latest SectorCast ETF scores.

1. No changes at the top. Healthcare (IYH) and Technology (IYW) iShares continue to hold the top two spots, with Outlook scores of 72 and 65, respectively. However, their scores have been gradually falling … but so have all the other sectors. Stocks within IYH continue to get a lot of analyst support. IYW sports the best return ratios.

2. Financial (IYF) and Industrial (IYJ) come in third and fourth, which is a bullish sign. IYF shows the lowest (best) aggregate projected P/E due to investor caution about investing in the sector.

3. Materials (IYM) and Energy (IYE) continue to be held back by analysts’ net downward revisions.

4. Consumer Services (IYC) stays in the bottom two along with perennial bottom-dweller Telecom (IYZ). Stocks within IYC and IYZ are saddled with high projected P/Es and low analyst support. Utilities (IDU) has managed to stay above the bottom two due to its support among analysts. Although its projected growth rate is low, few analysts have been downgrading expectations.

5. Overall, I would say that the Outlook rankings are still relatively bullish, although not by much. Economically-sensitive sector iShares like IYW, IYF, IYJ, and IYM rank higher than IYK and IDU. Only consumer-oriented IYC continues to lack relative fundamental support. And I would prefer to see higher scores among the economically-sensitive sectors.

6. Looking at the Bull scores, IYM and IYF has been the leaders on strong market days, scoring 61 and 60. IDU is by far the weakest with a 39.

7. As for the Bear scores, IDU is the clear investor favorite “safe haven” on weak market days with a score of 69. IYK is a distant second at 63, followed by IYH. IYM and IYF carry the lowest Bear scores of 38 and 39, which means that they sell off the most on weak market days.

Overall, IYH displays the best combination of Outlook/Bull/Bear scores. Adding up the three scores gives a total score of 177. IDU displays the best combination of Bull/Bear with a total score of 108, but it is followed closely by four sectors, each carrying a total score of 106: IYC, IYE, IYK, and IYJ.

Top ranked stocks in Healthcare and Technology include Spectrum Pharmaceuticals (SPPI), Intuitive Surgical (ISRG), Constant Contact (CTCT), and SolarWinds (SWI).

Low ranked stocks in Consumer Services and Telecom include Christopher & Banks (CBK), Green Mountain Coffee Roasters (GMCR), Motricity (MOTR), and Meru Networks (MERU).

These scores represent the view that the Healthcare and Technology sectors may be relatively undervalued overall, while Consumer Services and Telecom 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 Outlook Score employs a fundamentals-based multi-factor approach considering forward valuation, earnings growth prospects, Wall Street analysts’ consensus revisions, accounting practices, and various return ratios. It has tested to be highly predictive for identifying the best (most undervalued) and worst (most overvalued) sectors, with a one-month forward look.

Bull Score and Bear Score are based on the price behavior of the underlying stocks on particularly strong and weak days during the prior 40 market days. They reflect investor sentiment toward the stocks (on a relative basis) as either aggressive plays or safe havens. So, a high Bull score indicates that stocks within the ETF have tended recently toward relative outperformance during particularly strong market periods, while a high Bear score indicates that stocks within the ETF have tended to hold up relatively well during particularly weak market periods.

Thus, ETFs with high Bull scores generally perform better when the market is hot, ETFs with high Bear scores generally perform better when the market is weak, and ETFs with high Outlook scores generally perform well over time in various market conditions.

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.

Sector Detector
smartindale / Tag: CTCT, ETF, GMCR, IBM, IDU, ISRG, IYC, IYE, IYH, IYI, IYJ, IYK, IYM, iyw, IYZ, linkedin, long/short, NFLX, sector-rotation, sectors, SPPI, SWI /