Sector Detector: Bulls Frolic in Manure

The market found pleasure in manure today. When Australian miner BHP Billiton (BHP) proposed to acquire Canadian fertilizer maker Potash (POT), the market saw this as an opportunity to soar. Perhaps traders took it as a sign that corporate cash is ready to be deployed…or perhaps it was simply a low-volume oversold bounce on the flimsiest of catalysts.

In any case, low-volume trading can make for volatile markets. The S&P 500 spent the first seven days of August above its 50- and 200-day simple moving averages, seemingly on the start of a new uptrend. Then during two days of selloff, it plummeted below both moving averages, where it stayed for three full trading days. The start of a new downtrend? Don’t blink, because with today’s rally, it is back above its 50-DMA.

We’ll see what Wednesday brings, but this constant reversing from uptrend to downtrend is tough on swing trading or investing. Only the daytraders are thriving.

Market volatility represented by the VIX spiked on Monday to as high as 28, which has served as resistance over the past month. Keep in mind that VIX tends to move opposite to the market, so the spike corresponded with the selloff and increased fear. Today it closed at 24.33, and 22 has served as recent support.

Although Materials led all sectors today on the back of the BHP/POT news, Sabrient’s SectorCast-ETF ranking of the ten U.S. industrial sectors still places Materials in the middle of the pack in a 1-3 month forward-look. The model employs a fundamentals-based multi-factor approach including forward valuation, earnings growth prospects, recent analyst consensus sentiment, and various return ratios. Other than the high ranking for Technology, the current quant rankings continue to reflect a more neutral stance among analysts, which I take to be moderately bearish.

Latest rankings: This week, Technology (IYW) remains the highest ranked ETF with a strengthening score of 85. IYW is strong across the board, and scores particularly well (on a composite basis across its constituent stocks) in the percentage of analysts increasing earnings estimates, return on equity, return on sales, and projected year-over-year change in earnings. The second place spot again goes to Healthcare (IYH), but its score continues to weaken – going from 81 two weeks ago to 76 last week to 72 this week. It remain strong in return on equity, return on sales, and projected P/E. The gap between second and third place is narrowing considerably, as Energy (IYE) has strengthened from 57 to 64.

Top ranked stocks in IYW and IYH include Micron Technology (MU), Lexmark (LXK), Humana (HUM), and Endo Pharmaceuticals (ENDP).

The bottom of the list is more static. Telecom (IYZ), with the highest PPE and poor return on equity, comes in dead last, sporting a low score of 1. Joining it in the bottom two again is Consumer Services (IYC), scoring a 20 primarily due to tight margins cutting into return on sales. It also scores poorly on the percentage of analysts increasing earnings estimates. It’s hard to get real bullish when the retailers and their Wall Street analysts are gloomy about the outlook. And despite strong performance today, Materials (IYM) is only scoring 39. Notably, IYM and IYZ were the only sectors this week that had more analyst downgrades to earnings estimates.

Low ranked stocks in IYZ and IYC include Crown Castle International (CCI), Sprint Nextel (S), MGM Resorts International (MGM), and Amazon.com (AMZN).

Again, the model is looking more neutral than bullish – which I am taking to be moderately bearish. These sector scores represent the view that the Technology and Healthcare 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: The rankings are based on Sabrient’s SectorCast model, which builds a composite profile of each of the ten ETFs 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 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 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. You might also watch just the two long positions as a separate long-only sector rotation strategy.