Sector Detector: Holiday Rainbows and Butterflies

Scott MartindaleOn Tuesday, the market lost support at Nasdaq 2500 after losing S&P 500 1200 last week, and then threatened to breakdown below the psychologically important Dow 11,000. But alas, one bad day does not confirm a trend change, and today (Wednesday) was the exact opposite. Perhaps Tuesday’s weakness was all due to the Korean skirmish…or perhaps due to traders exiting positions in advance of an early start to the holiday. Whatever the case, today was all rainbows & butterflies again as over 90% of the S&P 500 rose.

But I’m not convinced that all is well. As we head into the Thanksgiving holiday, the market is consolidating just under the S&P 500 1200 level, and we await either a breakout or a failure. I’ve been talking for several weeks about how the chart SPY chart is shaping up for the past 4 months almost identically to the first 4 months of the year. As shown on the attached chart, the break of the 40-day moving average on Tuesday seemed to correspond to the break on May 4, and suggested that a similar selloff might be in the offing.

However, rather than continue lower the next day as it did on May 5, the market instead found a strong bid today. Hmmm…does that invalidate the building pattern? Given the holiday, it’s hard to tell. I don’t expect another flash-crash in the next session (either the abbreviated Friday session or regular Monday session) like we saw on May 6, but a retest of prior resistance-turned-support at SPY 115 and then 110 is not out of the question … or even major long-term support at 105, for that matter. But that likely wouldn’t happen until January.

Last week, I wrote that the charts were screaming for a pullback and retest of key support levels, including Dow 11,000. And we got that on Tuesday, although that might be all we get as the Fed’s QE2 money continues to find its way into equities and push the market to new heights for the year. Still, I am watching for further downside in early December.

After spiking during Tuesday’s weakness to above 21, the market volatility index (VIX) fell hard today to as low as 18.73 before up-ticking late to close at 19.56. Also, the TED spread (i.e., indicator of credit risk measuring the difference between the 3-month T-bill and 3-month LIBOR interest rates) remains very low in its normal range, clocking in at 13.54. Both the VIX and TED spread reflect comfort and complacency among traders.

Latest rankings:  Sabrient’s fundamentals-based quantitative SectorCast ETF rankings remain stable. Healthcare (IYH) still holds a comfortable margin over second place Technology (IYW), which used to be the clear leader. Overall, the rankings reflect a cautious bias on the market, as traditionally defensive sectors like Healthcare, Consumer Goods and Utilities continue to show up in the top 5 with scores above 50, and the more economically-sensitive sectors like Energy, Industrial, and Consumer Services rank in the bottom 5 with scores below 50.

Healthcare (IYH) scores 88 this week, followed by Technology (IYW) at 74, and Financial (IYF) at 64. IYH continues strong in return on equity, return on sales, projected P/E (low valuation), and analysts increasing earnings estimates that really drove its dominant ranking. IYW remains pretty strong across the board, too, scoring highly (on a composite basis across its constituent stocks) in return on equity, return on sales, projected P/E, projected year-over-year change in earnings, and analysts increasing earnings estimates.

Top ranked stocks in Healthcare and Technology include Kinetic Concepts (KCI), Endo Pharmaceuticals (ENDP), Arrow Electronics (ARW), Veeco Instruments (VECO).

Telecommunications (IYZ) remains at the bottom with a score of 12, and Consumer Services (IYC) remains in the bottom two, but its score continues to strengthen as it moves from 17 two weeks ago to 22 last week to 28 this week as analysts continue to come out in greater numbers with increased earnings estimates for stocks in the sector. IYZ has by far the highest projected P/E and the worst return on equity. Notably, Energy (IYE) dropped further this week, scoring 36 as analysts came out with reduced earnings estimates, and it scored the lowest in this metric.

Low ranked stocks in Telecom and Consumer Services include Sprint Nextel (S), UTStarcom (UTSI), Barnes & Noble (BKS), and Equinix (EQIX).

These scores represent the view that the Healthcare and Technology 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 model employs a fundamentals-based multi-factor approach considering forward valuation, earnings growth prospects, Wall Street analysts’ consensus revisions, accounting practices, 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 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