Sector Detector: Energy poised to re-energize

Scott Martindale

After flirting with a pullback in the wake of the Goldman Sachs news, the stock market instead decided to abruptly reverse its slide mid-day on Monday and resume its impressive advance in what many observers are calling a “junk rally” due to strength in the more speculative names. Nevertheless, the risk of at least a mild correction is sufficiently great to suggest that either a portfolio hedge or an absolute return approach is particularly warranted at this point.

Sabrient’s fundamentals-based quantitative SectorCast-ETF model shows some changes in the relative rankings among the ten S&P 500 sectors. Overall, however, the model appears to be mostly bullish – despite the apparent ongoing uncertainty indicated by the tight relative scoring across the sectors.

Energy and Financials are showing renewed strength on a forward-looking basis, while Information Technology and Consumer Discretionary are not far behind, and Industrials is showing noticeable improvement in analyst optimism.

Latest rankings: This week, the top and bottom-ranked sector ETFs remain the same, with Healthcare (XLV) coming out on top again with a 69, and Telecommunications (IYZ) holding at the bottom with a 43. The differential scores among sectors remain tight, reflecting uncertainty. However, the spread is continuing to expand slowly.

The spread between the top and bottom sectors has gone from 22 points two weeks ago, to 24 last week, to 26 this week. Although this is still a far cry from the spread of 65 we saw only a few months ago, it is gradually expanding. This tightness among scores illustrates the ongoing uncertainty among analysts regarding future earnings and which sectors are currently undervalued on a forward-looking basis, but the expansion might be hinting that clearer leadership is on the horizon. I would prefer to see the top-ranked sector scoring in the 70’s or 80’s, which would provide a stronger vote of confidence.

For now, XLV continues to show the best combination of value and analyst support. It scores highly in both return on equity (which shows strong current earnings performance) and projected P/E (which indicates strong future earnings performance). Notice that relative scores between XLV and XLP, both of which are traditionally defensive sectors, are quite divergent. This indicates to me that political uncertainty lingers around Healthcare, which is keeping investors cautious on the sector.

The most notable movement in scoring has been in the improvement of Energy, Financials, and Industrials at the expense of Utilities and Materials. Although InfoTech and Consumer Discretionary each dropped two places, their scores didn’t change. Instead, it was Energy and Financials jumping up.

So, Energy (XLE) takes second place this week with a score of 65. It boasts the top score in projected year-over-year change in earnings across the sector and also shows the best (lowest) projected price/earnings ratio as share prices have remained low. Increasing numbers of analysts downgrading earnings estimates was its undoing in prior weeks, but that lessened considerably this week, which was the main driver in allowing XLE to return to the top two.

Top-ranked stocks within XLV and XLE include Quest Diagnostics (NYSE: DGX), Coventry Health Care (NYSE: CVH), ConocoPhillips (NYSE: COP), and Chevron (NYSE: CVX).

The 43 score for IYZ is still relatively high for the bottom-ranked sector, and the fact that nine of the ten sectors continue to score above 50 reflects the ongoing uncertainty among analysts. In other words, the SectorCast-ETF model is not indicating clear-cut leaders and laggards on a forward-looking basis. Industrials (XLI) has jumped from ninth all the way up to sixth this week as a number of analysts have come out with increased earnings estimates. Instead we find Consumer Staples (XLP) in ninth place.

IYZ continues to be saddled with the lowest score in projected year-over-year change in earnings across the stocks in the sector. It also has a below-average return on equity and projected P/E. XLP shows weakness across all factors with the exception of return on equity, in which is actually leads.

Low-ranked stocks within XLP and IYZ include Kraft Foods (NYSE: KFT), Proctor & Gamble (NYSE: PG), Verizon (NYSE: VZ), and Global Crossing (Nasdaq: GLBC).

These scores represent the view that Healthcare and Energy stocks may be relatively undervalued overall, while Telecom and Consumer Staples stocks may be overvalued.

Performance: The table below shows the performance of each of the prior four weekly portfolios as of the market close on Tuesday, 4/20/2010. Each portfolio assumes that the top two ETFs are entered long and the bottom two are entered short, all at the opening prices on Wednesday.

Overall, mixed performance compared with a straight long position on the market. But of course, this portfolio is well positioned to survive a market correction, which could come on quite suddenly. The XLV has been mostly treading water and has held back the long portfolio performance. However, XLE has begun to perform nicely, as predicted by the model four weeks ago.

Again, this long/short absolute return model seeks to profit whether the market goes up or down. And particularly with the market’s persistent rally getting long in the tooth, it seems like a good bet to stick with this approach.

Disclosure: Author has no positions in stocks or ETFs mentioned. 

About SectorCast: The rankings are based on Sabrient’s SectorCast model, which builds a composite profile of each of the ten ETFs in the table below based on bottom-up scoring of their constituent stocks. The model employs a fundamentals-based multi-factor approach including forward valuation, earnings growth prospects, analyst revisions, 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 eight Select Sector SPDRs, but because the SPDRs combine InfoTech and Telecom into one ETF, I use the two iShares for those sectors rather than the SPDR Select Technology ETF. 

About Trading Strategies: Sector Detector has shown how you can use this information in three ways to identify ETFs that have the potential to enhance your upside, downside, or market-neutral trading ideas. First, if you are bullish on the broad market, you can go long the SPDR Trust exchange-traded fund (SPY), which tracks the S&P 500 Index, and enhance it with long positions in SectorCast’s 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 really don’t want to bet on which way the market is going, you could try a market-neutral, long/short trade—that is, go long the top-ranked ETFs and short 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.

About Performance Tracking: I track each week’s set of ETFs (2 longs and 2 shorts) as a mini-portfolio over the course of four weeks. Because SectorCast does not include any technical triggers, this will give the fundamentals-based model a chance to achieve its predicted move.

Sector Detector