Sector Detector: Quant Rankings Hint Gradually Growing Optimism
The market continues to defy gravity, and every small attempt by the bears to push it down – even in this moderate-volume trading environment – is swatted aside like a pesky mosquito and limited to one-day non-events. And now the market has its sights set on new 2010 highs, and it might just get there before some much needed profit-taking and support-testing sets in.
It’s not like the bears have given up completely. There have been signs of increased selling pressure whenever strong technical resistance levels arrive, and there is the general lack of compelling fundamental improvements to the economy to support the relentless market rally since the beginning of September. Nevertheless, bulls continue to forge ahead with gusto. Each attempt by bears to force a test of support levels is quickly rebuffed.
In examining the 2010 chart for the SPY, it appears to be forming a pattern that is strikingly like what we saw between mid-January and early April.
After selling off hard and then finding support around 105, both the current and previous time periods saw a powerful rally over the course of several weeks, followed by a period of price and MACD consolidation around 115-117. And you can see what the ensuing weeks produced back in April, as the SPY continued to surge to as high as 122 on April 26 ... before the waterfall decline set in.
We will see if the market can continue to replicate the prior pattern. If it does, will it lead to sustainable highs this time? Or will it lead to another waterfall decline even more vicious than the last?
So long as the Fed continues to take the interest on maturing securities to purchase Treasuries from Wall Street primary dealers via its Permanent Open Market Operations (POMO) so that the primary dealers take this fresh capital and buy stocks, the market will likely find bullish support. The question is how long this might last. Only through the November elections, perhaps? Or is the Fed giving the all-clear signal that they will continue to support the stock market (and its psychological "wealth effect") for the foreseeable future? In any case, remember the old slogan, “Don’t fight the Fed.”
The VIX volatility index (measure of investor fear) has been showing some intriguing behavior lately. After hanging around near the bottom of its 21-28 trading range, it dropped precipitously on Monday and even further today. After closing the month of September at 23.70, it dropped all the way to close at 18.92 today. You’ll recall my column last week in which I noted that the VIX was showing a bit of a divergence by not falling while the market was strong, which I took to be an indication of some fear or defensiveness returning. But alas, the complacency or a lack of fear has returned this week. This is never a good thing, as the market seems to do better in climbing a “wall of worry.” But it’s also not a timely indicator of anything imminent, either. For now, market participants are simply enjoying the cozy, worry-free price action, supported by the Fed.
The TED spread (i.e., indicator of credit risk measuring the difference between the 3-month T-bill and 3-month LIBOR interest rates) is still at the low end of its range, but it has bounced a bit from around 13-14 up to 17.5 – although it has been flat at this level for the past week.
Also, the major indices of course remain well above their 50 and 200-day moving averages. And then, there is the record level of corporate cash that every week seems to be finding its way into picking up strong, well-positioned, undervalued companies.
Latest rankings: Sabrient’s SectorCast-ETF fundamentals-based quantitative rankings of the ten U.S. business sector iShares has been holding pretty steady, reflecting a generally defensive bias, again with only minor scoring changes from last week. Nevertheless, reading the tea leaves closely, the evolving trend indicates a gradually improving outlook for the market.
Technology (IYW) continues to score well, but after tying with Healthcare (IYH) last week with a score of 83, it drops into second place for the first time in a long time. IYH maintains its 83 score, but IYW comes in this week with an 82. In examining the details behind the scoring, it appears that stocks within the IYH got a little more support in the form of future earnings estimates upgrades from the analysts.
Financials (IYF) continues to solidify its hold on third place, scoring a 72 this week. Last week, it came in with a 65 after jumping 16 points the prior week. And Consumer Goods (IYK) maintains fourth place with a score of 58. Consumer Goods is a defensive sector, so bulls really don’t like to see it strengthen in the rankings at the expense of Technology or Consumer Services (IYC), but in fact IYK lost a few points this week while IYC gained 5 points due to an assortment of earnings upgrades among the stocks within the ETF. This is encouraging.
IYH is strong in return on equity, return on sales, and projected P/E (low valuation). IYW remains mostly strong across the board, scoring highly (on a composite basis across its constituent stocks) in return on equity, return on sales, projected P/E, and projected year-over-year change in earnings. Its score has come down over the past several weeks primarily because of fewer analysts increasing earnings estimates.
Top ranked stocks in IYW and IYH include Seagate Technology (STX), Lexmark (LXK), Endo Pharmaceuticals (ENDP), and Humana (HUM).
At the bottom of the list, we continue to find Telecom (IYZ), with the highest projected PE and the worst return on equity. This week it again scores a rock-bottom 0, which caused me to do some checking. Out of 327 equity ETFs in our rankings, only three are scoring so low. Replacing Consumer Services (IYC) this week in the bottom two Industrial (IYJ), which scores similar to last week with a 38, but lost out because of the aforementioned strengthening in IYC due to analyst support. Notably, stocks within Energy (IYE) are still the ones getting hit the worst with analysts’ downward earnings revisions.
Low ranked stocks in IYZ and IYJ include Crown Castle International (CCI), Sprint Nextel (S), USG Corp (USG), and Monster Worldwide (MWW).
These scores represent the view that the Technology and Healthcare sectors may be relatively undervalued overall, while Telecom and Industrial 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 model employs a fundamentals-based multi-factor approach considering forward valuation, earnings growth prospects, Wall Street analysts’ consensus revisions, accounting practices, 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 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.