Sector Detector: Volatile Markets, Stable Rankings

Scott Martindale

Market volatility continues, with the Dow gapping down under 10,000 to start the day today before recovering nicely by the close. Most of the major indexes are still below their 200-day moving averages, but interestingly, the Nasdaq 100 (QQQQ) and the Russell 2000 (IWM) actually closed above theirs. I see this as bullish.

Yet despite the unstable markets, Sabrient’s quantitative SectorCast-ETF rankings were impacted very little in this week’s rankings. With no technical factors in the model, the weekly rankings tend to be pretty stable. In mid-January, the sector rankings took a decidedly conservative turn with Healthcare, Utilities, and Consumer Staples at the top, and indeed we saw a market correction follow. Lately however, the model has continued to reflect optimistic projections and analyst sentiment, which has led the more economically sensitive sectors to remain relatively strong in the rankings throughout the latest market weakness.

And this week shows virtually no change once again. As I cautioned last week, this doesn’t preclude a near-term pullback in the markets, and we have certainly gotten that. But the model continues to tell us that overall valuations and analyst projections are displaying optimism for the economy and the markets.

Latest rankings: Once again, the top and bottom-ranked sector ETFs remain the same. Information Technology (IYW) and Energy (XLE) remain at the top, but InfoTech has pulled ahead a bit with a score of 71, followed by XLE at 68. The biggest change is with Healthcare (XLV) riding an increase in the percentage of analysts increasing earnings estimates to move into third place.

IYW now is at the top in the percentage of analysts increasing earnings estimates, and it is ranks high in return on equity, return on sales, and projected year-over-year change in earnings. XLE remains at the top in projected price/earnings ratio and near the top in projected year-over-year change in earnings.

Top-ranked stocks within IYW and XLE include Lexmark (NYSE: LXK), Corning (NYSE: GLW), ConocoPhillips (NYSE: COP), and National Oilwell Varco (NYSE: NOV).

The spread between the top and bottom sector scores widened a bit further to 38 this week. As I’ve been reporting, it was in the 65-point range a few months ago, but then tightened to only 22 points a few weeks ago. I prefer to see wider top-bottom spreads to give me added confidence in the relative rankings.

After several weeks in the cellar, Telecommunications (IYZ) has firmly established its position at the bottom of the rankings, scoring a dismal 33. It is quite weak in its projected year-over-year change in earnings across the stocks in the sector, the net number of analysts increasing earnings estimates, and return on equity.

Also remaining in the bottom two this week is Consumer Staples (XLP). Although as a defensive sector, it has held up well on the big down days, its Outlook score held steady at 45. It sports the best return on equity, but it is weak in all other metrics.

Low-ranked stocks within XLP and IYZ include Estee Lauder (NYSE: EL), H.J. Heinz (NYSE: HNZ), PAETEC Holding (Nasdaq: PAET), and Cbeyond (Nasdaq: CBEY).

These scores represent the view that InfoTech and Energy stocks may be relatively undervalued overall, while Telecom and Consumer Staples stocks may be overvalued.

Performance: The table below shows the performance of each of the prior four weekly portfolios as of the market close on Tuesday, 5/25/2010. 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. Of course, for those who prefer not to short, this could be run as a sector rotation strategy – with perhaps the top 3 or 4 sector ETFs long.

Overall, although each of the long/short portfolios are down, they are all holding up much better than the overall market, which has been getting killed. Nevertheless, the long/short model seeks to profit whether the market goes up or down, and the generally bullish bias of the rankings has prevented us from profiting in the downdraft, as we did back in mid-January when the rankings took a conservative bent.

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: 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 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. You might also watch just the two long positions as a separate long-only sector rotation strategy.

Sector Detector