Sector Detector: QE2, the Rising Market, and Now the 2011 Federal Budget – Three’s a Crowd?

Bulls on Wall Street continue to call the shots and have their way. Bears who dare try to venture out of hibernation are smacked back into the cave before they’ve barely seen the light of day. The unshakably bullish action and buy-the-dip mentality has many market observers wondering if it can be sustained, given the struggling economy, moribund housing market, rising food and energy prices, skyrocketing deficit, and persistent unemployment. So, the obvious question becomes, is a sharp correction imminent?

For its part, Sabrient’s SectorCast quant model remains mostly stable with its rankings, but some defensive signs are emerging.

Looking at the SPY chart, it recently has been following a pattern of gapping up followed by consolidation at the upper Bollinger Band as it continues to trudge forward in the face of overbought technicals.

RSI tested the neutral line at the end of January and then bounced, but MACD only gave a head fake before returning to extreme overbought status. The market can stay overbought for a long time. But it will pay to be cautious with your long positions, because such a market can reverse and fall quite quickly. However, for now, the bulls have fire in their bellies and little in the way of resistance.

Today, strong quarterly results from Comcast (CMCSA), Dell (DELL), and Deere (DE), plus M&A announcements from Genzyme (GENZ) and Sanofi-Aventis (SNY) and from Trian Group’s proposal to acquire Family Dollar (FDO) helped stoke the bulls’ fire.

Fear as measured by the market volatility index (VIX) is still quite low. Although it spiked to above 20 during the initial crisis in Egypt, it has since returned to its long-term support around the 16 level where it has remained. Although it dropped to as low as 14.86 on February 8, it closed today at 16.72. The TED spread (i.e., indicator of credit risk measuring the difference between the 3-month T-bill and 3-month LIBOR interest rates) continues to climb more noticeably, and is now up to 20.19. This is still low in its normal range, but up substantially from the 13-14 range it has seen recently.

I’m a bit amazed that the fairytale Federal budget that was trotted out this week didn’t send investors running for cover. For example, over the next five years, individual income tax receipts are projected to double, and corporate tax receipts are projected to increase by more than 145%. Sure, most of the focus in the media has been on the spending side of the equation, because that’s what is immediately controllable, but to hit the all-important deficit-reduction targets, it is the revenue growth side of the equation that should have everyone looking on incredulously. The Office of Management and Budget is depending upon total receipts as a percentage of GDP to return to cyclical highs of around 19-20% in order to meet their goals. Right now we’re in the 14-15% range, so we have quite a bit of work to do in the way of economic growth.

Nevertheless, the market focuses on the near term, and Federal Reserve Chairman Bernanke has pledged to provide all of the liquidity necessary to achieve maximum employment and price stability. Moreover, Mr. Bernanke has said that higher stock prices create a wealth effect that spurs consumer spending, which extrapolates into increased business activity, hiring, and stable (or slightly increasing) prices. With the second phase of Quantitative Easing (QE2) in full swing, what more encouragement does a bull need?

The only question that remains, however, is what happens when QE2 ends in June? We certainly can’t keep printing money forever, but can the stock market—and by extension the overall economy—sustain its momentum without it? The OMB’s highly optimistic budget depends upon it.

So, although we might not see a significant correction in the near term, the more cautious bulls will likely start locking in gains well in advance of June.

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.

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

Sabrient’s SectorCast model continues to favor Technology (IYW) and Healthcare (IYH). IYW is holding strong above 90, with an impressive 92 in its Outlook Score this week, while IYH is trying mightily to catch up, rising from 83 to 88 this week. Basic Materials (IYM), which surged 28 points two weeks ago, remains solidly in third place with a 76. IYW and IYH have consistently scored at the top as their price performance has maintained reasonable valuations relative to analyst expectations.

Telecommunications (IYZ) remains at the bottom with a score of 11, as the U.S. Telecom companies just don’t show much in the way of compelling growth or projected valuations. In fact, the Telecom sector and IYZ have put in the weakest year-to-date performance among the major U.S. sectors, which confirms the consistently low scores in the SectorCast model. Consumer Services (IYC) is still in the bottom two, once again scoring 24 for the third week in a row, although Utilities (IDU) continues to slip and now scores a 28.

Looking at the Bull scores, stocks within Financial (IYF), Basic Materials (IYM), Energy (IYE), and Technology (IYW) have all tended to perform the best during recent periods of overall market strength. These are the more “offensive” sectors. There were some notable developments this week in Bull scores. First, IYF has surged this week from a 55 to a 59, making it the clear leader on particularly strong market days. Second, Healthcare (IYH) saw a significant drop in its Bull score, from 42 to 37, reflecting its relative non-participation on strong market days. IYH has now dropped below Utilities (IDU) as the weakest sector on bullish days.

As for the Bear scores, traditionally “defensive” sectors represented by Healthcare (IYH), Utilities (IDU), and Consumer Goods (IYK) not surprisingly have held up well during recent periods of overall market weakness. But we see that Energy (IYE) and Technology (IYW) are also posting relatively strong Bear scores. This is indicative of a confident bull market. On the other hand, Financial (IYF) is by far the weakest performer on bearish days. 

Overall, Technology (IYW) still easily displays the best combination of the three scores, while Energy (IYE) maintains the best combination of Bull and Bear scores. This illustrates that investor sentiment is bullish on Energy in all market conditions even though it appears to be getting ahead of itself on a forward-looking valuation basis – perhaps reflecting a speculative bet due to unrest in key energy-producing regions of the world. After all, if the global economy continues to improve, energy demand will increase leading to higher prices, and if unrest in the Islamic world disrupts production and shipping, energy supply will decrease leading to higher prices. Either way, the Energy sector should benefit (or so goes the speculative reasoning).

IYW remains strong across most all factors in the quantitative model, scoring highly (on a composite basis across its constituent stocks) in return on equity, return on sales, projected year-over-year change in earnings, and analysts increasing earnings estimates. IYH continues strong in return on equity and return on sales, and it has by far the lowest (best) projected P/E, although its projected long-term growth rate is lagging.

Top ranked stocks in Technology and Healthcare include Flextronics (FLEX), Arrow Electronics (ARW), Humana (HUM), and Forest Labs (FRX).

IYZ has by far the highest projected P/E and the worst return on equity. It also continues to be plagued by more analyst earnings downgrades. IYC is notably weak in return on sales as retail margins continue to be squeezed despite improving consumer spending, and retail sales disappointed somewhat this week. It also has a relatively high projected P/E.

Low ranked stocks in Telecom and Consumer Services include Viasat (VSAT), Crown Castle International (CCI), Zale Corp. (ZLC), and amazon.com (AMZN).

These scores represent the view that the Technology and Healthcare 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 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: ARW, ETF, FLEX, FRX, HUM, IDU, iShares, IYC, IYE, IYF, IYH, IYJ, IYK, IYM, iyw, IYZ, linkedin, long/short, sector, sector-rotation /