Sector Detector: Another technical breakout as bulls build their army
Well, the bulls took that minor pullback last week, and rather than wait for a test of support at the uptrend line, they jumped right in and brought a few more friends along for the ride. Rather than fearing that their run is over, bulls held their ground and found support from bears throwing in the towel (i.e., short-covering) as well as investors sitting on cash who just couldn’t bear (pardon the pun) to watch the train leaving the station without them. Never has the phrase “Don’t fight the Fed” been more predictive, particularly when the Fed is joined by virtually every other central bank in the world.
Look, I can’t deny the dangers pointed out by the doomsayers. I absolutely can appreciate the view that the market (and the economy) has become a house-of-cards. It may well turn out that we have chosen to avoid enduring a little discomfort now in exchange for severe pain in the future. The eventual unwinding of the central bank balance sheets most likely won't be pretty.
But for now, as long as the world remains awash in fiat currency, U.S. stock market fundamentals on balance look pretty good. I just have not seen any indications that a market crash scenario is imminent. My regular readers know that I have been in the bullish camp for quite awhile, dating back to last fall when the market was trying to break out of a long trading range with resistance around 1220 on the S&P 500. It closed Wednesday at 1391. Sabrient’s SectorCast-ETF rankings of the 10 sector iShares have leaned cautiously bullish for several months, and the charts have been decidedly bullish.
I have been saying that a breakout through resistance levels of 13,000 on the Dow, 3,000 on the Nasdaq, and 2011 highs on the S&P 500 would be difficult without elevated volume, and that is what we got. Financial stocks led the way, which is quite important to the sustainability of the rally. Bank of America (BAC), JP Morgan (JPM), Wells Fargo (WFC) and others all broke out of technical patterns on huge volume. Technology, too, has been quite strong, and IYW continues to sit atop the Sabrient rankings, followed by Financial (IYF).
Speaking of Tech, I can’t help but talk about Apple Inc. (AAPL) again this week. The stock was up another 4% on Wednesday on big volume. It was just last month that it crossed the $500 threshold, and now it is already approaching $600, as its new iPad 3 delights the world and sucks in more Apple converts and as analysts project huge growth in emerging markets. This is nearly a 50% gain year-to-date and 580% in the three years since the March 2009 market lows. For the largest market cap company in the world, such rapid appreciation is truly amazing. This company is a true leader in every sense of the word, including in the stock market.
From a historical standpoint, volume is still relatively light, but it jumped well above recent levels on this technical breakout, and that was all the bulls needed to attract reinforcements, build on their conviction, and chase away the bears. Now we watch for a possible pullback to test support at those former resistance levels.
Now that the breakout has occurred, I’m seeing lots of bullish headlines imploring us to get onboard the train and predicting targets like Dow 14,000 / 15,000 / 17,000. Even some of the formerly bearish or ultra-cautious commentators are throwing in the towel and switching sides (which worries me a bit). Besides Financials and Technology, they are suggesting buying gold miners, steel producers, oil, and oil producers.
Indeed, looking at the Sabrient quant models, it does appear that the Basic Materials stocks are undervalued. The IYM displays the lowest projected P/E among the 10 sector iShares, Sabrient’s favorites in this space include Companhia Siderurgica Nacional (SID), Cliffs Natural Resources (CLF), Globe Specialty Metals (GSM), and Kronos Worldwide (KRO). In fact, GSM and KRO are members of Sabrient’s “Baker’s Dozen” Top Stocks for 2012: http://sabrient.com/individuals/Bakers-Dozen-2012-Signup.html
Moreover, it appears that GARP (Growth At a Reasonable Price) and quality-oriented rankings are underperforming as long/short strategies this year due to the “junk rally”—in which stocks that have been beaten down or have high short interest outperform due to speculation and short-covering during a “risk on” phase. This often occurs near the tail end of powerful rally.
During the fourth quarter of 2011, high-quality stocks easily outperformed. But so far in 2012, we have seen many lower-quality names outperforming. Does this indicate a “blow-off top,” which would portend an end to the rally? Perhaps. Or it might simply be the prelude to a long-awaited technical consolidation, after which the higher quality stocks will again take a leadership role. Another possibility is that the market will find a way to rotate back into quality names without giving up much ground. But in any case, a return to quality will happen—it always does so eventually.
Looking at the charts, SPY closed Wednesday at 139.91 after blasting above 140 on Tuesday for the first time since mid-2008. Last week, it made a false breakout above that tough resistance level at 137 before making a false breakdown through the near-term uptrend line. But rather than continuing down to test the long-term uptrend line, it quickly reversed again, and now it appears to have its sights set on the top of the channel shown.
RSI, MACD, and Slow Stochastic each made a brief attempt to complete a cycle back down to oversold territory, but the bulls were too enthusiastic to wait. The short-term technicals are once again overbought, but as we have seen, they can stay that way for a long while as the market creeps higher. Nevertheless, the overbought conditions will likely keep the magnitude of further up-moves in check. In other words, don’t expect many huge days like we got on Tuesday until the market consolidates.
The VIX (CBOE Market Volatility Index—a.k.a. “fear gauge”) closed Wednesday at 15.31, which is comfortably below the important 20 threshold. After a brief visit above 20 last week, it fell quickly, indicating a persistence of investor confidence and complacency. 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) closed Wednesday at 39 bps. It has held right around the 40 level since mid-February after falling rapidly from near 60 at the beginning of the year. This, too, reflects investor confidence—although it is still well above the teens we saw early last year.
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.
Observations:
1. Technology (IYW) remains at the top of the Outlook rankings with an 83. IYW is particularly strong in its return ratios as margins remain high in tech products. It is also relatively strong in its long-term growth rate and in analyst positive sentiment.
2. Financial (IYF) retains its hold on second place and crept up further to score a 75. Healthcare (IYH) moves back into third with a 61. Financial and Consumer Services (IYC) stocks are getting the most support from Wall Street analysts, but IYF is also maintaining a low (desirable) projected P/E ratio.
3. Telecom (IYZ) remains at the bottom of the rankings with a 17. IYZ remains saddled with the worst return ratios and one of the highest projected P/Es. It is again joined in the bottom two by Utilities (IDU) with a score of 19. IDU has poor long-term growth projections and relatively high projected P/E.
4. With economically sensitive Technology, Financial, Industrial, and Consumer Services all in the top 5, the rankings are looking decidedly bullish.
5. Looking at the Bull scores, Financial (IYF), Industrial (IYJ), and Materials (IYM) are tied for the lead on strong market days, scoring 53. These three are the only ones scoring above 50. Utilities (IDU) is by far the weakest on strong days, scoring 32.
6. As for the Bear scores, IDU is back as the investor favorite “safe haven” on weak market days, scoring 58, followed by IYC at 54. IYM shows by far the lowest Bear score of 40. This means that Basic Materials stocks tend to sell off the most when the market is pulling back (which hasn’t been happening very often).
7. Overall, IYW still shows the best combination of Outlook/Bull/Bear scores. Adding up the three scores gives a total of 184. IDU is the worst at 109. IYW shows the best combination of Bull/Bear with a total score of 101. IDU now has the worst combination at 90, with IYE close by at 91. Also notable is that IYJ and IYH are very close in total scores, but they are nearly opposite on their Bull and Bear scores as one is clearly defensive (IYH() and the other aggressive (IYJ).
These scores represent the view that the Technology and Financial sectors may be relatively undervalued overall, while Utilities and Telecom sectors may be relatively overvalued based on our 1-3 month forward look.
Top ranked stocks within Technology and Financial sectors include Yandex N.V. (YNDX), Qihoo 360 Technology (QIHU), Banco Latinoamericano de Comercio Exterior S.A. (BLX), and Apollo Commercial Real Estate Finance (ARI).
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.