Sector Detector: As Europe disappoints, stocks look to Santa for support
After a nice pop last Friday and an aborted attempt to get it going again on Tuesday, stocks were down 3% for the week through Wednesday. Among the ten U.S. sector iShares, Energy (IYE) and Basic Materials (IYM) have led the market down this week. The “risk-off” movement has sent investors into the safety of the dollar and Treasuries at the expense of stocks and commodities.
As usual, the main story is the lack of a confidence-inducing solution to the debt crisis in Europe. The latest fears are being driven by rumors of further sovereign debt downgrades.
The big EU summit resulted in France and Germany essentially issuing an ultimatum to all euro-zone members to agree to greater central control over their national budgets, such as annual budget deficits limited to 3% of GDP, lest automatic sanctions kick in. Supporters are saying that France and Germany are simply trying to get euro-zone members to reaffirm the conditions they accepted when they joined the Union. In addition, the EU agreed to provide up to 200 billion euros in loans to the IMF, and to accelerate the start of a permanent 500 billion euro rescue fund called the European Stability Mechanism.
Nevertheless, investors aren’t confident that this is an adequate plan.
Although the austerity part of it is encouraging, what is lacking is a compelling plan for stimulus. Fitch responded by downgrading five major European financial groups. S&P and Moody’s warned that they will review all EU country credit ratings.
The launch of the euro currency in 1999 gave the perception that risk would be spread among all of the participating countries, and indeed government bond rates traded in lock-step until the Lehman Bros bankruptcy in 2008. Since then, the variations among yields are now similar to what they were pre-euro. Today, the Greece 10-year bond is yielding around 35%, and the 1-year commands 330%--a rate that effectively makes it priced for imminent default.
Though the European summit disappointed, it doesn't necessarily mean we won’t get our beloved Santa rally, but in any case, 2012 remains a big question mark. The sovereign debt crisis may well continue to plague global markets through 2012—and likely keep us in this high volatility, low volume trading environment.
As the euro has plunged and euro-zone bond yields surged, the dollar has strengthened and commodities—and stocks—have fallen. Gold, silver and oil all sunk on Wednesday. Gold has fallen so quickly that contrarian traders are now predicting an imminent reversal, perhaps to new highs. And those who follow gold closely will tell you about the favorable seasonality, i.e., the bulk of gold’s return over the past 10 years has come primarily in the last several weeks of each calendar year.
Now let's look at the charts. The SPY closed Wednesday at 121.74. It had been fighting with resistance at the 200-day simple moving average before giving up and retreating. Price, RSI, MACD, and Slow Stochastic are all pointing down bearishly. Nevertheless, we are now in a period of historically strong seasonality. Although SPY lost support at the 50-day moving average on Wednesday, the 50-day recently crossed up through the 100-day, which is positive.
I have drawn a symmetrical triangle formation on the chart. There seems to be a test of support happening at the current level around 122, which is the convergence of the lower line of the triangle, prior resistance-turned-support at 122, and the 100-day simple moving average. A confirmed failure of the triangle would pretty much put a final dagger in any chance of a Santa rally, but a bounce from this level might be just the ticket for the sleigh ride. It’s all in Santa’s hands now.
The VIX (CBOE Market Volatility Index – a.k.a. “fear gauge”) closed Wednesday at 28.67. It continues to hold below the important 30 mark, which is bullish for equities, and the recent market action has allowed the VIX to work off some of its oversold technicals without the market having to give up much ground, which is promising.
Last week I showed a chart illustrating that 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 its monotonic climb since the first of August. It hit another 52-week high on Wednesday, closing at 56.01. This is far above the low teens from earlier this year, and indicates elevated investor worry about bank liquidity and a preference for the safety of Treasuries bonds over corporate bonds.
Of note, forensic accounting research firm and recent Sabrient acquisition Gradient Analytics (http://www.EarningsQuality.com) continues to knock it out of the park with many of the stocks on which they have published negative views. For example, First Solar (FSLR) took another 20% hit on Wednesday alone, and is down a total of 75% since coverage was initiated late last year. Institutional investors should take a closer look at Gradient’s work.
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. Energy (IYE) is now at the top, with an Outlook score of 73. Recent leader Technology (IYW) falls to third place with a score of 65. Sell-side analysts have been net downgrading their earnings expectations of tech stocks within IYW, while stocks within IYE have enjoyed net upgrades. Healthcare (IYH) remains in the second spot with a steadily improving score of 71.
2. In the middle of the pack, Materials (IYM) and Financial (IYF) continue to be held back by net downward revisions by the Wall Street community; although they still sport the best (lowest) projected P/Es. Apparently investors still think the analysts are too optimistic. Consumer Services (IYC) has been receiving the most support among analysts with net earnings upgrades, which is an encouraging sign for the economy.
3. As usual, Utilities (IDU) and Telecom (IYZ) are in the bottom two. Stocks within these iShares are saddled with relatively high projected P/Es.
4. Seeing IYW, IYE, IYF, and IYJ in the top half is a relatively bullish sign. It would be better to see IYM and IYC scoring above IYK, and to see the top score above 80. As a whole, the Outlook rankings for the 10 U.S. sector iShares reflect caution and uncertainty.
5. Looking at the Bull scores, IYM has been the leader on strong market days, scoring 59, followed by IYE and IYF. IDU remains the weakest with a 39. It is notable that IYW is not a leader on strong market days.
6. As for the Bear scores, IDU is the clear investor favorite “safe haven” on weak market days with a score of 67. IYK is second at 61. IYF and IWM share the lowest Bear score of 39, which means that stocks with these ETFs sell off the most on weak market days.
7. Overall, IYE now displays by far the best combination of Outlook/Bull/Bear scores. Adding up the three scores gives a total score of 180. IYE also displays the best combination of Bull/Bear with a total score of 107, while IYM has the worst combination (98), followed by IYF (96).
Top ranked stocks in Energy and Healthcare include Mitcham Industries (MIND), Tesoro Corp (TSO), Humana (HUM), and Momenta Pharmaceuticals (MNTA).
These scores represent the view that the Energy 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 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.