Sector Detector: Energy showing strong value
After suffering a tough sell-off, Energy is now showing top value and has emerged as the highest ranked sector in Sabrient’s fundamentals-based SectorCast-ETF model on a one-month forward-looking basis. The uncertainty of sovereign debt issues in certain European nations has spooked investors, but Tuesday’s speculation about a bailout for Greece created a calming effect. Looking at analyst consensus forward estimates, some of the sectors that are more dependent on economic growth continue to score highly this week, staying comfortably above the more defensive sectors like Utilities, Consumer Staples, and Telecom.
As I said last week, Sabrient remains cautious on the market given the tenuous state of the U.S. and global economies and the higher stock valuations, but the relatively high scores for Energy, InfoTech, and Financials in the SectorCast-ETF rankings would appear to be near-term bullish. Nevertheless, an absolute return approach seems warranted more than ever.
Latest rankings: This week, there is little change – with one major exception. Energy (XLE) has completed its steady climb from the middle of the pack, finally making its way to the top with a high score of 74 (out of 100). With no one scoring in the 80’s this week, XLE was able to take the top spot with only a relatively modest score, as the top four sectors are bunched together within 3 points of one another. Nevertheless, this is a 13-point jump from last week. After selling off quite a bit, XLE is powered by its top score in aggregate projected price to earnings (P/E) ratio plus a good score in projected year-over-year change in earnings across the sector and. (However, it ranks dead last in trailing return on sales.) 
After two weeks at the top, Financials has taken a breather and dropped back into a tie for second place with Information Technology with a score of 73. But because InfoTech (IYW) has a more consistently strong profile across all of the relevant factors, I’m going to include it in the model portfolio over Financials this week. Like last week, IYW is buoyed primarily by a host of new analyst upward revisions among its constituent stocks during the week.
Top-ranked stocks within these sectors include Hess Corp. (NYSE: HES), Consol Energy (NYSE: CNX), Western Digital (NYSE: WDC), and Seagate Technology (Nasdaq: STX).
There is no change in the relative rankings of the middle and bottom of the list. At the bottom of the rankings, we again find this week the fundamentally most overvalued sectors are Telecommunications (IYZ) with a score of 24 and Consumer Discretionary (XLY) at 40. Although the model indicates that international telecom stocks and ADRs have excellent forward valuations, IYZ contains only U.S. telecoms, and they are showing more analyst downgrades than upgrades and a poor projected year-over-year change in earnings across the sector. XLY is saddled with the worst (highest) aggregate projected P/E.
Low-ranked stocks within these sectors include Marriott International (NYSE: MAR), Pulte Homes (NYSE: PHM), Cbeyond Inc. (Nasdaq: CBEY), and Alaska Communications Systems Group (Nasdaq: ALSK).
These scores represent the view that Energy and InfoTech stocks may be undervalued overall, while Consumer Discretionary and U.S. Telecom stocks are overvalued.
Performance: The table below shows the performance of each of the prior four weekly portfolios as of the market close on Tuesday, 2/9/10.
Our short position in Materials was the main driver behind the relatively strong performance of Sector Detector’s long/short model portfolio. And of course, it is periods of market weakness like this that demonstrates the value of an absolute return approach to the market…while allowing the investor to sleep better at night.
Disclosure: Author has no positions in stocks or ETFs mentioned.
About SectorCast: The rankings are based on Sabrient’s SectorCast model, which builds a virtual profile of each of the 10 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 1-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 8 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 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.