Sector Detector: InfoTech and Energy stay solid at the top

Scott Martindale

The stock market’s technical “topping formation” finally manifested in a correction in early May, and it resumed over the past several days. The 20-day moving average that had provided consistent support during the methodical rally has proven to be formidable resistance (along with the converging 50-day).

Last week, Sabrient’s quantitative SectorCast-ETF rankings were impacted very little by all of the market turmoil. With no technical factors in the mix, perhaps that’s no surprise. However, often the sentiment reflected by the technicals will show up in analyst downgrades or changes in relative valuations – but that didn’t happen.

And this week shows virtually no change. The model employs a fundamentals-based multi-factor approach including forward valuation, earnings growth prospects, recent analyst consensus sentiment, and various return ratios. Energy and Materials have strengthened a bit more, but otherwise the model is still reflecting a slightly bullish outlook, with the more economically sensitive sectors displaying relatively higher scores.

This doesn’t preclude a near-term pullback in the markets. But the model is telling us that overall valuations and analyst projections are showing some optimism for the economy and the markets.

Latest rankings: This week, the top and bottom-ranked sector ETFs remain the same. In fact, scores across the board are almost identical to last week. Information Technology (IYW) and Energy (XLE) remain at the top, and in fact they are now tied with a score of 69. Financials (XLF) holds third place with a 66, followed now by Materials (XLB), which continues to gradually strengthen. All sectors except Consumer Staples (XLP) saw improvement in the percentage of analysts increasing earnings estimates, which indicates a generally positive sentiment on Wall Street.

InfoTech (IYW) continues to hold strong, taking the top spot with the same 69 score for the third straight week. IYW continues to be near the top (behind only XLY) in the percentage of analysts increasing earnings estimates. Also, it is ranks high in return on equity, return on sales, and projected year-over-year change in earnings.

With its depressed pricing, 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), TriQuint Semiconductor (Nasdaq: TQNT), Marathon Oil (NYSE: MRO), and National Oilwell Varco (NYSE: NOV).

The spread between the top and bottom sector scores is holding steady in the 35 range again this week. After being in the 65-point range a few months ago, it had recently tightened to only 22 points. As I’ve been saying, I prefer to see wider top-bottom spreads to give me added confidence in the relative rankings.

Telecommunications (IYZ) continues its firm hold on the bottom of the rankings. 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 fell another point this week. 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), Kraft Foods (NYSE: KFT), Verizon (NYSE: VZ), and Iowa Telecommunications Services (NYSE: IWA).

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

Although the slight relative strength in the forward-looking rankings among the more economically sensitive sectors is encouraging to the bulls, this is not to say that we won’t see a continued correction (perhaps even a sharp one) before market strength resumes.

Performance: The table below shows the performance of each of the prior four weekly portfolios as of the market close on Tuesday, 5/18/2010. 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.

Overall, performance took a big hit over the past week as the generally bullish bias of the long/short model hurt us. You can see that compared with a straight long position on the market (with SPY), it is about flat or (in the case of the 5/5/10 portfolio) faring a bit worse. The conservative XLP and IYZ have held up well in the market selloff, which has hurt our short portfolio. And today, long position XLF got hit extra hard.

This long/short model seeks to profit whether the market goes up or down, so this week was disappointing. But given the continued uncertainty in the markets, an absolute return approach is more appropriate than ever.

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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