Sector Detector: Bulls' Dam Springs a Leak

It’s a nice change of pace to talk about something other than the stock market’s persistent uptrend getting more and more overbought. This week has brought some excitement indeed. As I said the last two weeks, it will pay to be cautious with long positions because such a market can reverse and fall quite quickly.

Oil is front and center on the attention meter with the unrest in oil-producing regions of the world. It traded as high as $100 per barrel today before closing at $98.10. Most observers feel that it is getting to a critical level at which further increases will likely short-circuit our fledgling economic recovery. This easily overshadowed yesterday’s surprisingly strong Consumer Confidence reading of 70.4. Weekly oil inventories will be announced Thursday morning.

Until Tuesday, the 10-day moving average had been supporting SPY closing prices every day except one (January 28, when Egypt was front-and-center) since December 1. That’s nearly three full months.

Now the 20-day moving average has been compromised, and we’ll see tomorrow whether it can be quickly recovered. The contagion of unrest in the Middle East and North Africa is widely accepted to be the culprit for this selloff, but in fact history has proven that an over-extended market is always on the lookout for an excuse to pullback and test support. The Federal Reserve’s aggressive Permanent Open Market Operations (POMO) buying of Treasuries with freshly minted cash has created artificial support for stocks.

Some pundits are saying that we are witnessing the “Berlin Wall” of this generation, with the protests in many Islamic countries threatening to create wholesale changes in their governments. The obvious difference is that the fall of the Berlin Wall unambiguously ushered in a Western democratic government. However, what the world will get in the wake of changes in the Middle East and North Africa is not so clear. We may well get more in the way of anti-Western, fundamentalist regimes, at least in the near term. “Freedom” as we think of it does not automatically translate into secular, pro-democracy, capitalist systems that seek to be our friends and trading partners.

Looking at the SPY chart, the bulls have finally met their match, and the weaker holders among them wasted no time in jumping off the Booze Cruise that has kept them drunk and happy for so long. RSI has fallen hard, but still hasn’t quite broken under the neutral line. MACD has crossed down through its EMA, but still has a way to go before reaching oversold territory.

Nevertheless, an immediate bounce would not be a surprise, given the bulls’ powerful friends and all of the other things supporting them. Only recent political instabilities in the energy-producing countries were enough to put the party on temporary hold. However, unless war breaks out, this is likely creating a welcome buying opportunity.

Fear as measured by the market volatility index (VIX) has gone from lounging comfortably at long-term support around the 16 level, to jumping all the way up to close at 22.13 today. It was as low as 14.86 on February 8. The TED spread (i.e., indicator of credit risk in the general economy, measuring the difference between the 3-month T-bill and 3-month LIBOR interest rates) is actually down slightly from last week, coming in at 19.99. This is still low in its normal range, but up substantially from the 13-14 range it has seen recently. 

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.

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

Sabrient’s SectorCast model continues to favor Technology (IYW) and Healthcare (IYH). IYW continues to carry an Outlook score above the important 90 level with a 92 this week, while IYH holds strong at 86. Basic Materials (IYM), which surged 28 points three weeks ago, scores 76 for the third straight week. IYW and IYH have consistently scored at the top as their price performance has maintained reasonable valuations relative to analyst expectations.

However, the price action this week, particularly in Technology and Basic Materials, will likely lead to more significant changes in the sector scores for next week. Energy has been extremely strong for the same reason everything else has been weak – the threat of oil supply disruptions due to political instabilities.

Telecommunications (IYZ) remains at the bottom with a score of 9, as the U.S. Telecom companies’ prospects just can’t get analysts excited. Consumer Services (IYC) is still in the bottom two, but scores 28 this week to edge closer to Utilities (IDU), which scores 30.

Looking at the Bull scores, Financial (IYF) remains the clear winner during particularly strong markets with a leading Bull score of 58. Stocks within Basic Materials (IYM), Energy (IYE), Industrial (IYJ), and Technology (IYW) have also tended to perform the relatively better during recent periods of overall market strength. These five sectors are clearly the more “offensive” sectors. Healthcare (IYH) is still struggling on a relative basis on strong market days, as it retains the lowest Bull score (37).

As for the Bear scores, traditionally “defensive” sectors represented by Healthcare (IYH), Utilities (IDU), and Consumer Goods (IYK) not surprisingly have held up well during recent periods of overall market weakness. But Consumer Services (IYC) has become surprisingly strong. Let’s watch its score over the coming weeks. This is indicative of a confident bull market – before this week’s havoc occurred of course. Notable changes in Bear score are the rise in Financial (IYF) – rising from 43 to 48, which contrasts with the fall in Basic Materials (IYM) from 48 to 44. Also, Utilities (IDU) jumped from 59 to 63 to establish itself far and away as the biggest “safe haven” sector.

Overall, Technology (IYW) still easily displays the best combination of the three scores, while Energy (IYE) maintains the best combination of Bull and Bear scores, followed closely by Technology (IYW) and (somewhat surprisingly) Financial (IYF). This illustrates that investor sentiment is bullish on Energy in all market conditions even though it appears to be getting ahead of itself on a forward-looking valuation basis – perhaps reflecting a speculative bet due to unrest in key energy-producing regions of the world. 

If the global economy continues to improve, increased energy demand will lead to higher prices, and if unrest in the Islamic world disrupts production and shipping, decreased energy supply will lead to higher prices. Either way, the Energy sector should benefit, and that line of thought seems to be panning out this week.

IYW remains strong across most all factors in the quantitative model, scoring highly (on a composite basis across its constituent stocks) in return on equity, return on sales, projected year-over-year change in earnings, and analysts increasing earnings estimates. IYH continues strong in return on equity and return on sales, and it has by far the lowest (best) projected P/E, although its projected long-term growth rate is lagging.

Top ranked stocks in Technology and Healthcare include ReneSola (SOL), Arrow Electronics (ARW), Humana (HUM), and Triple-S Management (GTS).

IYZ has by far the highest projected P/E and the worst return on equity, although it scores reasonably well in return on sales. It also continues to be plagued by more analyst earnings downgrades. IYC continues to be far and away the weakest in return on sales as retail margins are tight. Notably, Walmart (WMT) reported on Tuesday ongoing difficulties with U.S. retail sales, although international sales are growing. IYC also has a relatively high projected P/E.

Low ranked stocks in Telecom and Consumer Services include Viasat (VSAT), Crown Castle International (CCI), MGM Resorts International (MGM), and amazon.com (AMZN).

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 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: ARW, ETF, GTS, HUM, IDU, iShares, IYC, IYE, IYF, IYH, IYJ, IYK, IYM, iyw, IYZ, linkedin, long/short, sector, sector-rotation, SOL /