Sector Detector: Mixed signals in the rankings continue

Scott Martindale

The market twice threatened to pullback over the past week, but each time it resumed its methodical upward trajectory. The S&P 500 set a new intra-day 52-week high on Monday, and then set another 52-week closing high on Tuesday. Sabrient’s SectorCast-ETF model shows little change from last week, with Healthcare on top, again followed by InfoTech and Consumer Discretionary.

This value-oriented, fundamentals-based model employs both historical and forward-looking value and growth metrics as well as factors related to Wall Street analyst consensus sentiment. It has proven effective for relative rankings among ETFs, as well as sector rotation, enhanced ETF, and sector-specific long/short portfolios. 

As many market players prepare their portfolios for the possibility of a sudden and sharp pullback on the horizon, many technicians and chartists see nothing but clear skies ahead. For its part, the SectorCast-ETF model continues to reflect mixed signals among Wall Street analysts, as economically sensitive sectors like InfoTech and Consumer Discretionary score highly while the spread in the scores between the top and bottom ranked sectors remains historically tight.

Latest rankings: This week, we see the scores are mostly the same as last week. However, this might change as earnings reports come out over the next few weeks.

Healthcare (XLV) strengthened its hold on the top spot with a score of 69 (up from 67 last week). It scores highly in both return on equity and projected P/E.

Information Technology (IYW) is again tied for second place with Consumer Discretionary (XLY) with a score of 63, but I give it the second spot in the model portfolio based on its consistency across almost all factors. IYW scores in the top half for all factors with the exception of projected P/E), while XLY gets its ranking primarily from its chart-topping score in just one factor – the percentage of analysts’ positive revisions to earnings estimates. In fact, I would guess that XLY is getting the fuel for its recent strong technical performance from the ongoing parade of analyst earnings upgrades.

Take note, however, that the overall scores among sectors remain tight, reflecting uncertainty. Last week, the spread between the top and bottom sectors was down to 22 points, and this week you can see that it is at 24. As I’ve been reminding you, this is a far cry from the spread of 65 we saw only a few months ago. This illustrates the ongoing uncertainty among analysts regarding future earnings and which sectors are currently undervalued on a forward-looking basis.

The economically-sensitive InfoTech and Consumer Discretionary sectors remain near the top, which is bullish for the market. This week we saw a bit of a pullback in the rankings for Materials and Industrials after they flashed signs of wanting to move up, but in reality there was little significant movement in their scores and the change in their relative rankings came about primarily because of the tightness of the scores, i.e., it’s within the statistical noise.

Top-ranked stocks within XLV and IYW include Quest Diagnostics (NYSE: DGX), CareFusion (NYSE: CFN), Ingram Micro (NYSE: IM), and Tech Data (Nasdaq: TECD).

Telecommunications (IYZ) again holds onto to the bottom of the rankings with a score of 45, but this week we see Industrials (XLI) back in the ninth spot after showing signs of wanting to rise. As mentioned earlier, there was only a negligible one-point swing with Consumer Staples (XLP), so it does not foreshadow anything particularly ominous.

The low score of 45 for IYZ is the same as last week, and it’s actually quite high for last place. You can see that the top nine ETFs all have scores above 50, which illustrates both the historically tight range among the sectors as well as the lingering uncertainty among analysts as to which sectors might lead going forward.

IYZ continues to be saddled with the lowest score in projected year-over-year change in earnings across the stocks in the sector. It also has a below-average return on equity and projected P/E.

Low-ranked stocks within XLI and IYZ include Textron (NYSE: TXT), Monster Worldwide (NYSE: MWW), PAETEC Holding (Nasdaq: PAET), and Global Crossing (Nasdaq: GLBC).

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

Performance: The table below shows the performance of each of the prior four long/short weekly portfolios as of the market close on Tuesday, 4/13/2010. 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.

The last few model long/short ETF portfolios appear to be treading water has the market continues its surprisingly steady upward trend. The XLV has been a poor performer for us, which is one of the reasons why it continues to score highly in the SectorCast model, i.e., its price has remained depressed even though its fundamentals look solid.

Nevertheless, an absolute return portfolio based on a proven ranking model like SectorCast-ETF is positioned to thrive in a bull market that favors high-quality stocks, while also being prepared for a significant market pullback. In other words, it seeks to capture the performance spread between the top and bottom-ranked sectors, which over time should allow it to profit whether the market goes up or down.

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: 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 (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.

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