Sector Detector: Consumer Discretionary Falls Further in Rankings

Sabrient’s SectorCast-ETF rankings are holding mostly steady; however, the continued fall in Consumer Discretionary against the other sector ETFs has suggested near-term weakness ahead for the markets – which has definitely played out since the minor top on June 21. Last week, the S&P 500 lost important technical support levels that it had fought so hard to reclaim, and then today it all came crashing down pretty hard – with perhaps more carnage to come.

The market has been searching for direction, and today it might have found it. Last week, strong opens led to weak closes, and the important 200-day moving averages for all major indexes gave way. Now, all indexes are challenging the 2010 lows from February, May, and June. Today’s weakness might have sealed the deal for the near-term market direction, unless bulls can put together some kind of bounce tomorrow (other than the “dead cat” variety).

Nevertheless, analysts are still showing optimism about earnings improvements, and forward valuations are still reasonable. And, as I mentioned last week, cash on hand among the S&P 500 companies is now at record levels. Once that gets put to work through share buybacks, M&A, or dividend increases, which could happen once the weak holders exhaust their short-term selling, we should see some strength return – and get an added boost from short-covering.

The SectorCast-ETF model employs a fundamentals-based multi-factor approach including forward valuation, earnings growth prospects, recent analyst consensus sentiment, and various return ratios. Recent rankings have reflected a more cautious tone, although not overly defensive.

Latest rankings: Information Technology (IYW) retains its lock on the top ranking with a score of 72. It consistently has held the top spot for several weeks by a healthy margin.

The second place spot has been moving around among XLE, XLF, and XLV. This week, Healthcare (XLV) holds the spot for the second week in a row.

IYW fares the best in the percentage of analysts increasing earnings estimates, and it ranks high in return on equity, return on sales, and projected year-over-year change in earnings. XLV scores well across all metrics, but is especially strong in return on equity and projected price/earnings ratio.

Top-ranked stocks within IYW and XLV include Western Digital (WDC), Synaptics (SYNA), Forest Labs (FRX) and WellPoint (WLP).

Telecommunications (IYZ) remains the fundamental weakling with a score of 36. It scores poorly on a composite basis across the stocks in the sector in almost all metrics, particularly projected year-over-year change in earnings across the stocks in the sector, projected P/E, return on equity, and the percentage of analysts increasing earnings estimates.

Consumer Staples (XLP), Materials (XLB), and Consumer Discretionary (XLY) have been fighting it out to stay out of the bottom two. Consumer Discretionary (XLY) gets that indignity by falling into ninth place with a score of 47, joining IYZ in the short portfolio.

The spread between the top and bottom sector scores widened a bit this week to 36, which is still tighter than the mid-60’s we were seeing earlier in the year. I prefer to see wider top-bottom spreads to provide added confidence in the relative rankings.

Low-ranked stocks within IYZ and XLY include PAETEC (PAET), Global Crossing Ltd (GLBC), Amazon.com (AMZN), and Pulte Home (PHM).

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

Performance: I have tracked the performance of each of the prior four weekly portfolios as of the market close on Tuesday, 6/29/2010. 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. Of course, for those who prefer not to sell short, this could be run as a sector rotation strategy – with perhaps the top 3 or 4 sector ETFs long.

The market has turned decidedly weak, and our top-ranked sector ETF (IYW) has taken a nasty turn for the worse. However, the more defensive XLV has held up better than the market. On the short side, IYZ and XLP are generally considered defensive plays, so we’re not getting the level of protection needed on horrid days like today for the long/short portfolios to stay positive, but the newer XLB from last week was a stellar performer as a short position.

All four of the weekly long/short portfolios lost around -1% over the past 5 days while the SPY lost around -4%. So, the relative performance of the long/short approach against the SPY has been quite good, even though we aren’t always getting the positive absolute return we seek. Nevertheless, this fundamentals-based model is positioned to thrive in a bull market that favors high-quality stocks, while also being prepared to protect the investor in a significant market pullback.

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: 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.