Sector Detector: Market Takes an Overdue Pause
The market posted a big red candle today. It was much overdue … and in fact needed for a healthy market. It simply cannot go up in a straight line and engender confidence among investors. Backing and filling is a necessary aspect of a healthy bull market.
The market has been on a steady upward path since the first of December. At some point it will break below the uptrend line and pull back more significantly. Perhaps this is the start of the inevitable correction. The 20-day moving average has been providing support to the uptrend line, and I am still anticipating another test of support at the 20-day, and hopefully the 50-day and lower Bollinger Band.
After flatlining near overbought territory for several weeks, MACD might be threatening to cycle back down. Like it did in September and October, MACD has been trying hard to avoid its inevitable downward cycle. Similarly, the RSI(14) is again pointing back toward the neutral line. And after hugging the upper Bollinger Band for several weeks, price is threatening to cycle back down to the lower band. All of these signal a possible start of a healthy pullback.
The SPY was able to remain between the upper Bollinger Band and the 20-day moving average for 2-1/2 months during the September-to-mid-November timeframe. We’ll soon see if it plans to correct sooner this time. Options expiration this week might provide some support, but I’m expecting a more significant pullback before going much higher.
In any case, with everyone awaiting a pullback for a new buying opportunity, it might be a quick and shallow one that gets bought up quickly (like we saw in November).
The market volatility index (VIX) closed today at a low 17.31 after dropping to as low as 15.23, and the TED spread (i.e., indicator of credit risk measuring the difference between the 3-month T-bill and 3-month LIBOR interest rates) dropped even further and remains low within its normal range, coming in at 15.10. Both indicators remain relatively low and still reflect complacency (and investor optimism). Also, the CBOE Put/Call Ratio closed as low as 0.37 on Friday, which is as low as it has been in quite some time, further pointing to the need for a market pullback to bring out the put buyers.
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 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.
Healthcare (IYH) has seen a resurgence, with a robust Outlook Score of 87. Technology (IYW) comes in second this week with an 85. These two have consistently scored at the top as their performance hasn’t outrun reasonable valuation and analyst expectations. Defensive sector Consumer Goods (IYK) remains a distant third with a 55.
Telecommunications (IYZ) is once again in the cellar with a 15, as the U.S. Telecom companies just don’t show much in the way of compelling growth or projected valuations. Basic Materials (IYM) continues to strengthen – this time at the expense of Industrial (IYJ). Consumer Services (IYC), which has over-performed lately and needs a pullback according to the fundamentals-based quant model, again joins IYZ in the bottom two this week with a score of 34. Energy (IYE) continues to strengthen in the rankings.
Looking at the Bull and Bear scores, Basic Materials (IYM) and Industrial (IYJ) have tended to perform the best in recent periods of overall market strength, while not surprisingly Consumer Goods (IYK) and Utilities (IDU) have held up the best on weak market days. Healthcare (IYH) is now boasting the best overall combination of the three scores, although Technology (IYW) is in a virtual tie.
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 P/E, 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.
Top ranked stocks in Technology and Healthcare include Arrow Electronics (ARW), Yingli Green Energy (YGE), The Medicines Co. (MDCO), and Cigna (CI).
IYZ has by far the highest projected P/E and the worst return on equity. IYM has the lowest analyst rank as it was hit hard by a net increase in analysts reducing earnings estimates. IYC is notably weak in return on sales as retail margins continue to be squeezed despite improving consumer spending.
Low ranked stocks in Telecom and Consumer Services include American Tower (AMT), Crown Castle International (CCI), Amazon.com (AMZN), and Green Mountain Coffee Roasters (GRCR).
These scores represent the view that the Healthcare and Technology 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.