Sector Detector: Energy and Healthcare look good

The market has gone straight up over the past week since beginning the month of March by breaking through its 50-day moving average. The top and bottom of Sabrient’s SectorCast-ETF rankings look pretty similar to last week, although there has been some shuffling as Energy takes the top spot and Healthcare re-emerges in the top two.

Notably, Consumer Discretionary continues to rise in the rankings at the expense of Information Technology. One might think that they would move in the same direction since they are both cyclical in nature, but the main difference is that InfoTech is more heavily dependent on business spending while Consumer Discretionary (by definition) is tied to consumer spending. In any case, they continue to diverge in our rankings – this time in the opposite direction to how they were scoring last month.

Latest rankings: This week, the top sectors in SectorCast-ETF are no longer so tightly bunched. Last week, the top four were within five points of one another, but this week the bunching is in the middle as Energy (XLE) has clearly jumped ahead of the pack to top the rankings with a score of 78. Financials, which led the rankings for the past three weeks, is now in third place, with Healthcare (XLV) reinserting itself in second place with a 72.

XLE boasts the top score in projected year-over-year change in earnings across the sector and also shows the best (lowest) projected price/earnings ratio. It also scores highly in the percentage of analysts’ positive revisions to earnings estimates. XLV doesn’t stand out in anything in particular (except perhaps recent return on equity), but it scores reasonably well across all of the relevant factors in the model.

Top-ranked stocks within XLE and XLV include Marathon Oil (NYSE: MRO), Diamond Offshore (NYSE: DO), Bristol-Meyers Squibb (NYSE: BMY), and WellPoint (NYSE: WLP).

At the bottom of the rankings, we see that Telecom and Industrials have switched places from last week, with Telecommunications (IYZ) returning to its former place in the cellar with a low score of 37. Industrials (XLI) is now in the ninth spot with a score of 43, Telecom received more analyst downgrades to earnings estimates during the week, while Industrials still sports the worst (highest) projected P/E.

Low-ranked stocks within XLI and IYZ include C.H. Robinson Worldwide (Nasdaq: CHRW), Caterpillar (NYSE: CAT), Cbeyond, Inc. (Nasdaq: CBEY), and Global Crossing Ltd. (Nasdaq: GLBC).

These scores represent the view that Energy and Healthcare stocks may be undervalued overall, while Telecom and Industrials stocks still may be overvalued.

Performance: The table below shows the performance of each of the prior four weekly portfolios as of the market close on Tuesday, 3/9/2010.
 

As the market has continued to rally, long position XLF has outperformed the SPY, but so have both of our short positions. And with XLE lagging a tad, the net performance of our long/short portfolio has worsened. When the market is in rally mode, it can be hard to compare a market neutral long/short strategy against a straight long position in the SPY.

We are only seeking to capture the positive performance spread between the long and short positions, and when the market breaks through its 50-day moving average and keeps going like it has, the fundamentally weaker (more speculative) stocks will often lead, as has been the case. Nevertheless, as the market continues to stretch above its moving averages into overbought territory, an absolute return approach remains warranted.

Disclosure: Author has no positions in stocks or ETFs mentioned.

About SectorCast: The rankings are based on Sabrient’s SectorCast model, which builds a virtual profile of each of the 10 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 1-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 8 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: Sector Detector has shown how you can use this information in three ways to identify ETFs that have the potential to enhance your upside, downside, or market-neutral trading ideas. First, if you are bullish on the broad market, you can go long the SPDR Trust exchange-traded fund (SPY), which tracks the S&P 500 Index, and enhance it with long positions in SectorCast’s 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 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.