Sector Detector: Energy on the rise
Although the market is flashing signs of a strong breakout for the New Year, Sabrient’s SectorCast-ETF model continues to flash defensive signals. Given the quantitative model’s reliance on value-based fundamentals, this shouldn’t be surprising after such a lengthy and sustained rally. This week, there are few changes to the sector rankings. Most notable is the continued rise in Energy, which now scores a 62 but hasn’t yet cracked the Top 2.
As I mentioned last week, the emergence of InfoTech in early December was a bullish signal for a year-end rally, but the latest rankings continue to warn that certain sectors might be getting ahead of themselves in this technicals and sentiment-driven rally.
Latest rankings: There is little movement in this week’s rankings vs. last week’s. However, it’s notable that Healthcare (XLV) made something of a comeback after dropping into second place last week. It’s now tied for first with Consumer Staples (XLP) with a strong score of 82. The high score for XLP is still powered primarily by its top rank for the number of analyst upward earnings revisions among its constituent stocks this week and its strong return on equity rank. For XLV, its main driver is still its low aggregate projected price to earnings ratio for its constituent stocks and strong return on equity. 
Top-ranked stocks within XLP and XLV include Humana (NYSE: HUM), AmerisourceBergen (NYSE: ABC), ConAgra (NYSE: CAG), and Archer Daniels Midland (NYSE: ADM).
At the bottom of the rankings, once again we find Materials (XLB) as the fundamentally most overvalued sector with a low score of 30. Despite its recent technical strength, it remains saddled with the highest aggregate projected P/E and negative trailing 12-month return ratios. Industrials and Consumer Discretionary have both fallen somewhat in their scores from last week, but Industrials (XLI) has dropped more and finds itself back in the second-to-the-bottom spot, supplanting XLY. It is hampered by a poor projected change in year-over-year earnings across the sector.
Low-ranked stocks within these sectors include Alcoa (NYSE: AA), International Paper (NYSE: IP), Textron (NYSE: TXT), and Eaton (NYSE: ETN).
These scores represent the view that Consumer Staples and Healthcare stocks may be undervalued overall, while Materials and Industrials stocks 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, 1/5/10. Strength in XLB has put a big hurt on the short portfolio.
According to the SectorCast-ETF model, the Materials sector has inadequate forward-looking numbers to support current valuations. However, optimism about a global economic recovery, expectations of rising inflation, and a weakening dollar seem to be fueling its technical strength. Energy is also benefiting from a weak dollar, but at least its fundamentals lend support to investor optimism.
Nevertheless, Sector Detector has demonstrated that an absolute return approach is highly desirable for positioning an ETF portfolio to survive and thrive in any market climate.
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.