Sector Detector: Stocks provide a tepid breakout as Fed greases the skids. So now what?

Early last week, stocks broke out, with the S&P 500 setting a new high with blue skies overhead. But then the market basically flat-lined for the rest of the week as bulls just couldn’t gather the fuel and conviction to take prices higher. In fact, the technical picture now has turned a bit defensive, at least for the short term, thus joining what has been a neutral-to-defensive tilt to our fundamentals-based Outlook rankings.

In this weekly update, I give my view of the current market environment, offer a technical analysis of the S&P 500 chart, review our weekly fundamentals-based SectorCast rankings of the ten U.S. business sectors, and then offer up some actionable trading ideas, including a sector rotation strategy using ETFs and an enhanced version using top-ranked stocks from the top-ranked sectors.

Market overview:

Last Wednesday’s FOMC minutes confirmed investor expectations by indicating that economic data does not yet warrant a fed funds rate hike in June, and investors took this as a reason to finally break out above stubborn technical resistance. Both PMI manufacturing and the Philly Fed index came in with readings that show some growth, but below expectations. The 4-week average on jobless claims fell to 266,000, which is quite promising. Equities remain the favored asset class this year, particularly those playing catch-up, like China, Japan, Europe -- and even emerging markets.

It now has been almost three years since the market pulled back at least 10%. Nevertheless, bulls are having a hard time gaining traction after this latest technical breakout (basically flat-lining after last Monday), and a test of conviction is sure to come. The psychological thresholds of Dow at 18,000, S&P 500 at 2100, NASDAQ at 5,000, and Russell 2000 at 1200 all must hold as support levels, or we are back to the market churn, searching for a new catalyst.

The CBOE Market Volatility Index (VIX), a.k.a. fear gauge, closed Friday at 12.13 and has held below the 15 fear threshold since a brief spike to that level back on May 6-7. In addition, the volatility of volatility (i.e., the VVIX) reached its lowest level since July 2014. In fact, ConvergEx points out that the expected volatility has fallen over the last month for a range of equities including U.S. small caps, emerging markets, and 8 of 10 business sectors. On the other hand, bonds and precious metals have seen elevated volatility. But clearly equity investors have remained largely unfazed by the recent pop in long-term interest rates.

The 10-year Treasury yield closed Friday at 2.22%. In the battle of central bankers in their race to debase, Fed chair Janet Yellen has previously stated that she does not want the euro to fall below 1.07 versus the dollar, and the ECB recently indicated that it doesn’t want the euro above 1.15. So there is the target range. It closed Friday around 1.10.

Oil has been the big question mark lurking in the minds of investors, with new reports coming out saying oil has bottomed and others saying oil has more downside. For now, price has stabilized and volatility has calmed. Notably, OPEC is actually predicting that crude oil prices would rise back to only $76 per barrel by 2025, which illustrates the marked erosion in the cartel’s ability to manipulate prices.

Also, worth mentioning is Goldman Sachs’ projection that nearly 50% of stock total returns over the next decade will come from dividends. Thus, they are recommending that investors seek companies with good growth prospects that also pay a reasonable dividend. Included in their list of solid companies with strong market position and growth prospects, high margins, strong balance sheets, and a low dividend payout ratio is Cummins Inc (CMI), which is a member of Sabrient’s Baker’s Dozen annual portfolio.

SPY chart review:

The SPDR S&P 500 Trust (SPY) closed Friday at 212.99 after breaking out through tough resistance to achieve new highs last week. Price seems to waiting for its moving averages to catch up and will likely test resistance-turned-support just above 212. The long-standing uptrend line has been providing reliable support, giving the bulls confidence, and it has crossed above 208 on its way to 209. SPY took six separate runs at that line of resistance at 212 before finally breaking out. However, oscillators RSI, MACD, and Slow Stochastic have all either flattened out or are pointing down bearishly. The pinched Bollinger Bands are spreading out nicely on this move. If SPY pulls back to test support around 212, next support levels include the 50-day simple moving average (approaching 210), the uptrend line and 100-day SMA (above 208), and the critical 200-day SMA (near 204), followed by round-number support at the 200 price level.

SPY chart

Somewhat unsettling is the divergent negative behavior in the transports, as represented by the iShares Dow Jones Transportation Average ETF (IYT), which fell 2% on Wednesday and is displaying a series of lower highs and lower lows since November. Airlines led the decline, with some falling as much as 10% on the day. This is not necessarily an omen of bad things to come for the overall market, but it bears watching.

Latest sector rankings:

Relative sector rankings are based on our proprietary SectorCast model, which builds a composite profile of each equity ETF based on bottom-up aggregate scoring of the constituent stocks. The Outlook Score employs a forward-looking, fundamentals-based multifactor algorithm considering forward valuation, historical and projected earnings growth, the dynamics of Wall Street analysts’ consensus earnings estimates and recent revisions (up or down), quality and sustainability of reported earnings (forensic accounting), and various return ratios. It helps us predict relative performance over the next 1-3 months.

In addition, SectorCast computes a Bull Score and Bear Score for each ETF based on recent price behavior of the constituent stocks on particularly strong and weak market days. High Bull score indicates that stocks within the ETF recently have tended toward relative outperformance when the market is strong, while a high Bear score indicates that stocks within the ETF have tended to hold up relatively well (i.e., safe havens) when the market is weak.

Outlook score is forward-looking while Bull and Bear are backward-looking. As a group, these three scores can be helpful for positioning a portfolio for a given set of anticipated market conditions. Of course, each ETF holds a unique portfolio of stocks and position weights, so the sectors represented will score differently depending upon which set of ETFs is used. We use the iShares that represent the ten major U.S. business sectors: Financial (IYF), Technology (IYW), Industrial (IYJ), Healthcare (IYH), Consumer Goods (IYK), Consumer Services (IYC), Energy (IYE), Basic Materials (IYM), Telecommunications (IYZ), and Utilities (IDU). Whereas the Select Sector SPDRs only contain stocks from the S&P 500, I prefer the iShares for their larger universe and broader diversity. Fidelity also offers a group of sector ETFs with an even larger number of constituents in each.

SectorCast ETF rankings
Here are some of my observations on this week’s scores:

1.  Financial takes first place with a strong Outlook score of 88. Financial displays the lowest (i.e., best) forward P/E, and reasonably good sell-side analyst sentiment, forward long-term growth rate, and insider sentiment (buying activity). Utilities stays in second place with a score of 75, primarily due to its low forward P/E and solid Wall Street sentiment. Healthcare falls to third this week with a score of 70.

2.  Telecom stays in the cellar with a feeble Outlook score of 1. Other than a solid forward long-term growth rate, the sector scores poorly in most factors in the model, and in fact, stocks within Telecom have been hit the hardest by net downward revisions to Wall Street earnings estimates. Energy remains in the bottom two with a score of 12, even though the sell-side community is starting to show some optimism.

3.  Looking at the Bull scores, Technology and Energy display the top score of 64, followed by Materials and Industrial, all scoring above 60. Telecom shows the lowest Bull score of 48, which is the only one below 50. The top-bottom spread remains 16 points, reflecting relatively low sector correlations on particularly strong market days. However, it is generally desirable in a healthy market to see low correlations reflected in a top-bottom spread of at least 20 points, which indicates that investors have clear preferences in the stocks they want to hold.

4.  Looking at the Bear scores, Materials and Consumer Goods (Staples/Noncyclical) display the highest (i.e., best) score of 52, followed by Financial and Energy, which means that stocks within these sectors have been the preferred safe havens (relatively speaking) on weak market days. Healthcare scores the lowest at 40. The top-bottom spread remains 12 points, which still reflects somewhat elevated sector correlations on particularly weak market days (i.e., broad risk-off selling). Ideally, certain sectors will hold up relatively well while others are selling off, so it is generally desirable in a healthy market to see low correlations reflected in a top-bottom spread of at least 20 points.

5.  Financial displays the best all-around combination of Outlook/Bull/Bear scores, while Telecom is by far the worst. Looking at just the Bull/Bear combination, Energy and Basic Materials are the best, indicating superior relative performance (on average) in extreme market conditions (whether bullish or bearish), while Telecom and Consumer Services (Discretionary/Cyclical) score the worst.

6.  Overall, this week’s fundamentals-based Outlook rankings look neutral, with Healthcare, Utilities, and Consumer Goods (Staples/Noncyclical) in the top five, but less defensive than last week with improved rankings in Technology and Materials. Keep in mind, the Outlook Rank does not include timing or momentum factors, but rather is a reflection of the fundamental expectations of individual stocks aggregated by sector.

Stock and ETF Ideas:

Our Sector Rotation model, which appropriately weights Outlook, Bull, and Bear scores in accordance with the overall market’s prevailing trend (bullish, neutral, or defensive), retains its bullish bias and suggests holding Technology, Basic Materials, and Healthcare, in that order. (Note: In this model, we consider the bias to be bullish from a rules-based trend-following standpoint when SPY is above both its 50-day and 200-day simple moving averages.)

Other highly-ranked ETFs in SectorCast from the Technology, Basic Materials, and Healthcare sectors include PowerShares Dynamic Semiconductors Portfolio (PSI), iShares US Financial Services ETF (IYG), Market Vectors Pharmaceutical ETF (PPH).

For an enhanced sector portfolio that enlists some top-ranked stocks (instead of ETFs) from within the top-ranked sectors, some long ideas from Technology, Basic Materials, and Healthcare sectors include Integrated Device Technology (IDTI), Ambarella (AMBA), Moody’s (MCO), Raymond James Financial (RJF), Actavis plc (ACT), and Valeant Pharmaceuticals (VRX). All are highly ranked in the Sabrient Ratings Algorithm.

If you prefer to maintain a neutral bias, the Sector Rotation model suggests holding Financial, Utilities, and Healthcare, in that order. But if you prefer a defensive stance on the market, the model suggests holding Financial, Consumer Goods (Staples/Noncyclical), and Basic Materials, in that order.

IMPORTANT NOTE:  I post this information each week as a free look inside some of our institutional research and as a source of some trading ideas for your own further investigation. It is not intended to be traded directly as a rules-based strategy in a real money portfolio. I am simply showing what a sector rotation model might suggest if a given portfolio was due for a rebalance, and I may or may not update the information each week. There are many ways for a client to trade such a strategy, including monthly or quarterly rebalancing, perhaps with interim adjustments to the bullish/neutral/defensive bias when warranted -- but not necessarily on the days that I happen to post this weekly article. The enhanced strategy seeks higher returns by employing individual stocks (or stock options) that are also highly ranked, but this introduces greater risks and volatility. I do not track performance of the ETF and stock ideas mentioned here as a managed portfolio.

Disclosure: Author has no positions in stocks or ETFs mentioned.
Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into account their personal financial circumstances in acting on any rankings or stock selections provided by Sabrient. Sabrient makes no representations that the techniques used in its rankings or selections will result in or guarantee profits in trading. Trading involves risk, including possible loss of principal and other losses, and past performance is no indication of future results.

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