Sector Detector: Stocks pause to enjoy the view
Stocks are finally showing a willingness to ease up on their bull run, if for no other reasons than to do some much-needed technical consolidation and to digest the latest news. You might say they are pausing to take in the view from these lofty heights—especially the Nasdaq, which hasn’t seen this level since 2000...when it was moving rapidly in the other direction.
Volume remains light, and a real breakout attempt likely will need broader participation to get follow-through. Still, the Fed’s actions have rendered undesirable any alternatives to stocks, and Warren Buffett continues to extol the virtues of stocks over cash, bonds, or gold. So stock market bulls definitely have friends in high places for the time being.
Among the 10 U.S. sector iShares, economically-sensitive Industrial (IYJ) was hit the hardest on Wednesday, although Basic Materials (IYM) is the biggest loser for the week so far. Energy (IYE) along with defensive sectors Consumer Goods (IYK) and Healthcare (IYH) have shown relative strength this week.
Have you taken a bite of Apple (AAPL) yet? It seems that the juggernaut’s legions of followers and investors are growing in leaps and bounds, and loyalists just can’t get enough of anything and everything the company produces. On Wednesday, AAPL reached above $526 before falling precipitously starting around mid-day.
Its recent strength might have been driven by rumors about an imminent unveiling of an iPad 3 that supports 4G technology, which would be huge. Not everyone is aware that Apple’s products employ only 3G technology, and anyone who has experienced 4G speed knows there is an incredible difference. The stock is still rated StrongBuy in Sabrient’s quantitative ratings algorithm, with a near-perfect Growth score of 99.
On Wednesday, China expressed its commitment to invest in Europe. Also, economic reports were good, with strong industrial production, New York manufacturing, and homebuilder confidence numbers. However, the FOMC minutes from its late-January meeting showed only a few members favoring further quantitative easing. But the biggest downer was talk that the EU might postpone the next round of aid to Greece on doubts that the country will have the fortitude to follow through on its promised austerity measures.
To be sure, the masses in Greece are throwing quite a tantrum over what they are being asked to endure, and they are convinced that destruction and protesting will make the powers that be knuckle under yet still come through with a massive bailout that lets Greece “stay whole.” I guess the thinking goes that the world cannot handle a Greek default on its debt, so a bailout “must be” imminent even without the severe austerity measures. It’s a game of chicken.
Unfortunately, Portugal’s experience so far in implementing severe austerity measures last year has not yet proven to be an encouraging role model. Their economy has shrunk, leading to an increase in the ratio of debt to GDP. The prospects for Greece are even worse, as their economy is already in shambles.
But I’ve been reading some compelling arguments (and historical examples) about how a default on its debt might be a comparatively better option for Greece by allowing a process labeled “creative destruction” to cleanse its dire situation. Economist Joseph Schumpeter championed this as an important aspect of capitalism’s ongoing economic renewal and innovation. Otherwise, you are essentially keeping the dying beast on perennial life support. A lot of smart people are struggling mightily with these issues.
Here in the U.S., we have our own questions about whether government actions will help or hinder our ability grow our way out of our predicament. Through “Operation Twist,” the Fed has been manipulating the long-end of the yield curve. Since October (which is also when this stock market rally launched), the Fed has bought over $50 billion in new 20- to 30-year Treasury bonds. They have created a bubble in the bond market by buying up bonds in order to lower those rates so that interest on government debt and mortgage rates remain low. Once Operation Twist ends the Fed may have to implement QE3 to prevent bond yields from soaring. In fact, San Francisco Fed President John Williams gave a recent speech in which he implied that the Fed was indeed prepared to implement QE3.
In a recent Sector Detector column a few weeks ago, I talked about the low levels of the M1 multiplier (actually it is well below 1.0, indicating less than a dollar in economic value for each dollar injected into the system), as the Fed has kept the banking system flush with cheap cash but the banks have been reluctant to lend it.
Along this same line of thought, the eminent Charles Schwab himself wrote an op-ed for the WSJ last week on February 6 in which he described “a massive rise in liquidity but negligible movement of that money.” He believes that the Fed has sent “a signal of crisis, not confidence,” and so companies aren’t borrowing to invest and banks are loath to lend. He says that income investors have been forced to move out of safer assets such as bonds and CDs and into risk assets like stocks, as well as scaling back on their personal spending to live more modestly—which of course is the exact opposite of what a recovering economy needs. Consumer spending is an economy’s lifeblood. Mr. Schwab feels that what is really needed is for the government to step back and let the free market work.
Still, the “risk on” trade is alive and well. ConvergEx examined the flow of capital into ETFs since the beginning of the year, and they report that U.S. equity ETFs have brought in over $8.3 billion so far, which is double the amount of assets flowing into fixed income ETFs.
With all of these contradictory predictions ranging from deflation and global financial devastation ruining the stock market, to hyper-inflation leading to robust appreciation in stocks and commodities, perhaps we should look to some less obvious but still historically predictive indicators to give us guidance for the balance of 2012. For this I refer to Business Insider (http://businessinsider.com), which recently listed some of these unusual indicators. For example, the Super Bowl indicator tells us that the markets will be strong because this year’s winner was the NY Giants, which is one of the original NFL teams. Then there’s the Sports Illustrated swimsuit cover indicator, which tells us that an American model on the cover foreshadows outperformance, and for this year the cover model is an American. Another good one is the Chinese Year of the Dragon indicator, which predicts economic growth during 2012 since this is a dragon year in the Chinese zodiac. So, now are you ready to go all-in to stocks?
Hmmm….perhaps we should look at the charts for some more clues. SPY has shown incredible resiliency as bulls just won’t give up much ground. The overbought technicals have grown even more overbought despite some weak attempts to cycle back down and gather strength. Indicators like RSI, MACD, and Slow Stochastic are all threatening to roll over, but keep in mind that at the end of the day, price action is king. I have highlighted in the chart a comparison of the current rally that started at the beginning of October 2011 versus the prior year’s rally that started a bit earlier—at the beginning of September 2010—and basically peaked around late February. You can see that both time periods are strikingly similar in their indicators as well as their turbulence in November.
Might this foreshadow something about the current market as we hit late February? Sure, a market top could happen again. In fact, I fully expect a test of support at the uptrend line around 128-130 on the SPY, so now might be a time to lock in some bullish gains. Nevertheless, I still expect a challenge of the 2011 highs within the next several weeks. In fact, the Dow and Nasdaq have already eclipsed their 2011 highs, so the SPY is due to catch up.
The VIX (CBOE Market Volatility Index—a.k.a. “fear gauge”) closed Wednesday at 21.14, which is well up from last week and back above the 20 threshold that had been serving as resistance until last Friday. This is cautionary for stocks as it indicates some elevation in 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 retreat. It closed Wednesday at 39 bps. The trend change from its recent highs near 60 reflects improving investor confidence—although it is still well above the teens we saw early last year.
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.
Observations:
1. Technology (IYW) remains at the top of the Outlook rankings with a robust 89. IYW is particularly strong in its return ratios as margins remain high in tech products. It is also strong in analyst positive sentiment.
2. Healthcare (IYH) has returned to the second spot, but it remains nearly neck-and-neck with Industrial (IYJ). The surge in IYJ has stalled, but it is still sitting bullishly in the rankings. IYJ enjoys better growth projections, while IYH displays more compelling valuations.
3. Financial (IYF) strengthened slightly this week, but Basic Materials (IYM) dropped in the relative rankings. IYF still shows the strongest (lowest) projected P/E, as investors remain uncertain about analysts’ earnings projections. IYM has suffered erosion in analyst support.
4. Telecom (IYZ) still dwells at the bottom of the rankings with a weak score of 1. IYZ remains saddled with the worst return ratios, lack of analyst support, and one of the highest projected P/Es. It is again joined in the bottom two by Utilities (IDU) with a score of 21. IDU has poor long-term growth projections and relatively high projected P/E.
5. Looking at the Bull scores, IYM has been the leader on strong market days, scoring 56, followed by IYF and IYJ at 55. Utilities (IDU) is by far the weakest on strong days, scoring a meager 33.
6. As for the Bear scores, IDU is the investor favorite “safe haven” on weak market days, with a score of 60, followed by IYH at 59. IYE has recovered nicely on its Bear score, so IYM now displays the lowest Bear score of 46, which means that stocks within this ETF sell off the most on weak market days. Only IYM and IYF score below 50 in this measure of defensiveness.
7. Overall, IYW still shows the best combination of Outlook/Bull/Bear scores. Adding up the three scores gives a total of 191. IYZ is the worst at 99. IYJ shows the best combination of Bull/Bear with a total score of 106, while IDU has the worst combination at 93, as the “risk on” trade prefers alternatives to defensive-oriented Utilities, Telecom, and Consumer Goods stocks.
Top ranked stocks in Technology and Healthcare include VMware (VMW), NetEase.com (NTES), HMS Holdings (HMSY), and Jazz Pharmaceuticals (JAZZ).These scores represent the view that the Technology and Healthcare sectors may be relatively undervalued overall, while Utilities 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 sector.
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.