Sector Detector: Investors look to Europe for a breakout catalyst

Technology and Materials have been the major drag on the market this week, through Wednesday. Surprisingly, Financials and Energy have held up pretty well. It’s tough for the Technology sector, the S&P 500, and the Nasdaq to perform when the biggest market-cap company—Apple (AAPL)—misses estimates for the first time in forever, I think. Or was it 2004?

Well in any case, seven years seems like forever. AAPL’s 6% slide on Wednesday allowed Exxon Mobil (XOM) to overtake it as the largest market cap company. iPhone sales of 17.1 million units missed analysts’ consensus estimates of 19.8 million units by a wide margin, and their iPad sales of 11.1 million units fell short of the 11.7 million expected. Given that Technology represents 17.1% of the S&P 500 (far outdistancing second place Healthcare’s 13.2% share), and given that AAPL is 62% larger than second place Tech firm Microsoft (MSFT), the S&P 500 and Nasdaq didn’t stand a chance of staying positive on Wednesday—despite strong reports from Yahoo (YHOO) and Intel (INTC). Still, Sabrient’s quant models continue to like Apple’s profile quite a lot. 

The SPY closed Wednesday at 121.13, which is just below the resistance line of the 10-week trading channel between 112 and 122. Price has been consolidating at this level since Friday, and investors are seeking a catalyst to break through resistance at the top of the trading range. Also adding resistance is the falling 100-day simple moving average just above, and beyond that will be even stiffer resistance at the 200-day, which has flattened at around 128. RSI, MACD, and Slow Stochastic are all rolling over, but this may all be just a part of the price consolidation at resistance.

The non-confirmation of the bearish breakdown at the beginning of the month was a good sign. Now we need enough investor conviction to support a confirmed bullish breakout. My guess is that the breakout will happen.

The market certainly looks to Apple for leadership, but despite Apple’s sudden weakness, I remain optimistic. Yes, I acknowledge the unresolved European debt crisis, the depressed housing market, mixed economic reports (in the U.S. and globally), and the acrid air created by our glorious politicians. But I also see increasing consumer spending, an improved trade deficit, likely recapitalization of European banks, China’s economic resilience, and continued strong U.S. corporate profits. The spread between S&P 500 earnings yield and corporate bond yields remains at a multi-decade high, keeping current stock valuations appealing.

The key issue of course is Europe. The next summit starts Sunday in Brussels, and the main fear among investors is that the slow, methodical approach to evaluating options and gaining buy-in among the EU, G20, IMF, and the rest of the world might not be fast enough to avert defaults. German Chancellor Angela Merkel’s chief spokesman said at a briefing in Berlin on Sunday that the search for an end to the crisis would not come on Monday as everyone hoped, but instead would likely extend “well into next year.” Not what investors wanted to hear.

Gradient Analytics, which Sabrient acquired this summer, produces “deep dive” research into forensic accounting, earnings quality, and anomalous executive behavior (in equity incentives). Gradient has been negative on Green Mountain Coffee Roasters (GMCR), and it was down big again on Wednesday. Also, Hospira (HSP) has been under coverage since December in which Gradient identified a number of earnings quality concerns. The stock was down -20% on Tuesday after what was essentially its second pre-announcement in the past two months, and it is down about -47% since negative coverage began.

The VIX (CBOE Market Volatility Index – a.k.a. “fear gauge”) closed Wednesday at 34.44. After falling below 30 for a short time, it is again displaying slightly elevated investor fear.

The TED spread (indicator of credit risk in the general economy, measuring the difference between the 3-month T-bill and 3-month LIBOR interest rates) continues to remain elevated, as it closed Wednesday at 39.13. Although not nearly so high as it was during the 2008 financial crisis, it nevertheless indicates elevated investor worry about bank liquidity and a preference for the safety of Treasuries bonds over corporate bonds. It has been consolidating just below strong resistance at 40.

Latest rankings: The table ranks each of the ten U.S. industrial sector iShares (ETFs) by Sabrient’s proprietary Outlook Score, which employs a forward-looking, fundamentals-based, quantitative algorithm to create a bottom-up composite profile of the constituent stocks within the ETF. In addition, the table also shows Sabrient’s proprietary Bull Score and Bear Score for each ETF.

High Bull score indicates that stocks within the ETF have tended recently toward relative outperformance during particularly strong market periods, while a high Bear score indicates that stocks within the ETF have tended to hold up relatively well during particularly weak market periods. Bull and Bear are backward-looking indicators of recent sentiment trend.

As a group, these three scores can be quite helpful for positioning a portfolio for a given set of anticipated market conditions.

Here are some observations about Sabrient’s latest SectorCast ETF scores.

1.    Technology (IYW) and Healthcare (IYH) iShares continue to dominate the rankings. This week it’s IYH that takes the top spot with an Outlook score of 84. IYW is second at 82. Both are up from a tie at 80 last week. IYW is particularly strong in its return ratios and projected growth rate, while IYH is stronger in its support among analysts, with little net reduction in earnings projections.

2.      There is growing gap down to third place Basic Materials (IYM) iShares. IYM has an Outlook score of 54 again this week, which puts it 28 points behind IYW. IYM continues to get the bulk of the analyst downgrades. So, we now continue to see the unusual situation in which IYM ranks last in net revisors (i.e., the most net downgrades) but highest in Projected P/E (i.e., the lowest—best—valuation). So, although the analysts have been reducing earnings projections, the fall in price among stocks within IYM seems to be out of proportion to the magnitude of the earnings revisions. Financial (IYF) iShare is also getting a large share of the analysts’ downward revisions.

3.     Consumer Services (IYC) and Telecom (IYZ) are still in the bottom two, as they now score a 34 and 16, respectively. Both are weighted down by weak return on sales (poor margins) and high projected P/Es.

4.     Overall, the Outlook rankings are hanging on to a neutral stance, with IYW looking strong in the scoring, but IYM displaying moderate strength, and IYJ, IYE, and IYC lacking fundamental support.

5.     Looking at the Bull scores, IYF has been the leader on strong market days, scoring 60, followed by IYM and IYJ. IDU is the weakest with a 39. This is the first time I can recall a Bull or Bear score for one of the sector iShares under 40.

6.     As for the Bear scores, IDU is the clear investor favorite “safe haven” on weak market days with a score of 70. I think this is the first time I’ve seen any of the sector iShares get a 70 in either Bull or Bear score. IYK is a distant second at 63, while IYH and (surprisingly) IYW are close behind at 62. IYF and IYM reflect the lowest Bear scores of 41 and 42, respectively, as they have led the market up on strong days and down on weak days.

Overall, IYW still displays the best combination of Outlook/Bull/Bear scores. Adding up the three scores gives a total score of 194. IYW also displays the best combination of Bull/Bear with a total score of 112. Both numbers have increased from last week. This is an improving signal of future market strength; however, it is all on the back on the Technology sector that will be suddenly hindered going forward by the disappointment out of Apple.

Top ranked stocks in Healthcare and Technology include VMware (VMW), Spreadtrum Communications (SPRD), Triple-S Management (GTS), and Humana (HUM).

Low ranked stocks in Consumer Services and Telecom include Shutterfly (SFLY), Green Mountain Coffee Roasters (GMCR), American Tower (AMT), and Sprint Nextel (S).

These scores represent the view that the Healthcare and Technology sectors may be relatively undervalued overall, while Consumer Services and Telecom 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 Outlook Score employs a fundamentals-based multi-factor approach considering forward valuation, earnings growth prospects, Wall Street analysts’ consensus revisions, accounting practices, and various return ratios. It has tested to be highly predictive for identifying the best (most undervalued) and worst (most overvalued) sectors, with a one-month forward look.

Bull Score and Bear Score are based on the price behavior of the underlying stocks on particularly strong and weak days during the prior 40 market days. They reflect investor sentiment toward the stocks (on a relative basis) as either aggressive plays or safe havens. So, a high Bull score indicates that stocks within the ETF have tended recently toward relative outperformance during particularly strong market periods, while a high Bear score indicates that stocks within the ETF have tended to hold up relatively well during particularly weak market periods.

Thus, ETFs with high Bull scores generally perform better when the market is hot, ETFs with high Bear scores generally perform better when the market is weak, and ETFs with high Outlook scores generally perform well over time in various market conditions.

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
smartindale / Tag: ETF, GTS, HUM, IDU, IYC, IYE, IYF, IYH, IYJ, IYK, IYM, iyw, IYZ, linkedin, long/short, sector-rotation, sectors, SPRD, VMW /