Sector Detector: Getting More Defensive

Scott Martindale

Sabrient’s SectorCast ETF rankings solidified its defensive bent this week. Healthcare continues to lead, but Consumer Staples moved ahead of InfoTech into the second spot. On the bottom, Materials remains in the basement as the fundamentally most overvalued sector, but Industrials dropped quite a bit in the wake of its recent price momentum, which added to its already overvalued levels.

Latest rankings: This week, Sector Detector indicates that Healthcare (XLV) remains on top on a forward-looking basis, with the highest score of 87. It is now followed by Consumer Staples (XLP) at 75, which gives the model a more defensive bent.

Recall that last week, XLP had reached a tie with InfoTech (IYW) for second place, and this week XLP edged up past it. Top-ranked stocks within these sectors include WellPoint (NYSE: WLP), Quest Diagnostics (NYSE: DGX), Kellogg (NYSE: K), and Molson Coors Brewing (NYSE: TAP).

At the bottom, we see that the score for Materials (XLB) remains firmly in the 10th spot with a low score of 30. Industrials (XLI) is again in ninth at 35, which is 7 points lower than last week. Low-ranked stocks within these sectors include Alcoa (NYSE: AA), Weyerhaeuser (NYSE: WY), Monster Worldwide (NYSE: MWW), and PACCAR (Nasdaq: PCAR).

These scores represent the view that Healthcare and Consumer Staples stocks may be undervalued, while Materials and Industrials stocks may be overvalued.

Performance: The table below shows the performance of each week's portfolio as of the market close on Tuesday, 11/24/09. The top-ranked ETFs have continued to outperform the SPY, so a bullish-biased enhancement strategy worked well.

Furthermore, with the market taking a breather lately after its strong start to the month, the long/short portfolio has provided a solid return, easily outperforming a straight long position in the SPY. You can see that the two earlier long/short ETF portfolios are still lagging the SPY, which can happen during strong momentum rallies in which the more speculative names lead the market. But the table illustrates that a sound absolute return approach can churn out positive returns in any market climate.

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. 

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