Sector Detector: Energy Weakens as Healthcare Rises

Scott Martindale

The stock market finally decided to stop messing around last Friday and put in one of its worst days of 2010. And this week the bulls continue to look weak and tentative. Some technicians are calling for a larger sell-off that could carry the S&P 500 past May and February lows around 1,045, and perhaps all the way down to June 2009 support at 945. Today’s action saw SPX drop to or below 1,045 four separate times before recovering into the close. Obviously this is key support.

Market volatility continues, with the VIX finding support at 30. All major indexes are below their 200-day moving averages, with the Nasdaq 100 and Russell 2000 finally losing support there, too. This is a bearish development, of course, and like last week there appears to be more room to the downside than upside.

Sabrient’s quantitative SectorCast-ETF rankings are largely driven by consensus sentiment among Wall Street analysts. And after displaying hesitation and uncertainty last week, they seem to have come out to defend their views about improving earnings outlooks, as net revisions to estimates improved this week.

There are a lot of mixed signals in the SectorCast-ETF rankings. For example, economically sensitive sectors are diverging. InfoTech and Industrials have strengthened in the rankings while Consumer Discretionary and Energy have dropped.

Latest rankings: Information Technology (IYW) still leads the pack with a score of 71, but this time Energy (XLE) has fallen a bit while Financials (XLF) and Healthcare (XLV) have risen. Although they are tied at 64, I will select Healthcare (XLV) for the model portfolio because it is a bit more defensive.

IYW has strengthened by a couple of points since last week, but the biggest changes occurred in the middle of the rankings with Materials (XLB) and Consumer Discretionary (XLY) weakening along with Energy (XLE), while Financials (XLF) and Industrials (XLI) strengthened the most.

The main driver in the scoring this week was the percentage of analysts increasing earnings estimates. Almost all of the sectors saw improvement as analysts came out in force to defend their favorite stocks, but some saw greater increases than others. The one exception was Energy (XLE), which actually got hit with more analyst downgrades than upgrades, falling from a 63 last week to a 60 this week, and from second position to fourth.

IYW fares the best in the percentage of analysts increasing earnings estimates, and it ranks high in return on equity, return on sales, and projected year-over-year change in earnings. XLV scores fairly well on all factors, but particularly return on equity and projected price/earnings ratio.

Top-ranked stocks within IYW and XLV include Western Digital (NYSE: WDC), Corning (NYSE: GLW), Humana (NYSE: HUM), and Coventry Health (NYSE: CVH).

After coming on strong last week and almost rising out of the cellar, Telecommunications (IYZ) weakened and fell back to a score of 37. This was entirely due to getting only a handful of analyst upgrades while most other sectors were seeing robust upgrades. It remains weak in almost all metrics, particularly projected year-over-year change in earnings across the stocks in the sector, projected P/E, return on equity, and the percentage of analysts increasing earnings estimates.

Also remaining in the bottom two this week is Consumer Staples (XLP). Although last week it was tied with Materials (XLB), Materials rose this week due to its very attractive projected P/E. XLP still sports the best return on equity, but remains relatively weak in all other metrics.

The spread between the top and bottom sector scores has been fluctuating quite a bit lately. Two weeks ago it broadened to 37, and then last week it narrowed to 24 as uncertainty returned. This week it increased to 34. I hate to read too much into the weekly gyrations, but I prefer to see wider top-bottom spreads to provide added confidence in the relative rankings.

Low-ranked stocks within XLP and IYZ include Safeway (NYSE: SWY), H.J. Heinz (NYSE: HNZ), TW Telecom (Nasdaq: TWTC), and LEAP Wireless (Nasdaq: LEAP).

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

Performance: I track the performance of each of the prior four weekly portfolios as of the market close on Tuesday, 6/8/2010. 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. Of course, for those who prefer not to sell short, this could be run as a sector rotation strategy – with perhaps the top 3 or 4 sector ETFs long.

Overall, although each of the long/short portfolios are down, they are still holding up much better than the overall market. IYW has struggled as you would expect for a growth-oriented sector during a severe downturn. But the damage to XLE has been inordinate due to the ongoing catastrophic spill in the Gulf of Mexico and its impact on expectations for future offshore development.

Because these long/short portfolios have reflected a generally bullish bias during the market downswing, it has prevented us from profiting the way we would hope. Nevertheless, the shorts have helped soften the blow of the weak market, and the portfolio is well-positioned to flourish if and when the market finds support.

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: 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 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. You might also watch just the two long positions as a separate long-only sector rotation strategy.

Sector Detector
smartindale / Tag: absolute-return, CVH, ETF, GLW, HNZ, HUM, iyw, IYZ, LEAP, long/short, sector, stock-strategies, stock-trading, SWY, TWTC, WDC, XLP, xlv /