Sector Detector: Financials and Healthcare re-emerge at top of rankings

The market is flashing signs that it might want to breakout to the upside, and Sabrient’s SectorCast-ETF model seems to be projecting that it just might do it. This unbiased, value-oriented, quantitative model continues to favor sectors that are more dependent on economic growth, like Financials, InfoTech and Energy, which remain comfortably above the more defensive sectors like Utilities, Consumer Staples, and Telecom.

Nevertheless, Consumer Discretionary and Industrials continue to lag in the rankings, and given the tenuous state of the U.S. and global economies, an absolute return approach (as opposed to a directional bet) is still warranted.

Latest rankings: This week, SectorCast-ETF’s top four sectors remain the same as last week, but not without a bit of shuffling. Financials (XLF) and Healthcare (XLV) have re-emerged as the top two after Energy’s strong recovery was just enough to push its projected price/earnings ratio slightly higher than Financials. These two sectors are very close on projected P/E, so small price moves during the week can easily make them switch positions.

XLF scored an 86 (out of 100), which is a 13-point jump from last week. It now boasts the lowest aggregate projected price to earnings (P/E) ratio and the top score in projected year-over-year change in earnings across the sector. It is also continuing to see improvement in the percentage of analysts making upward revisions among its constituent stocks during the week. (However, it still ranks dead last in trailing return on equity.)

XLV actually has the same score as last week, coming in at 71, but it moved up from fourth to second place to make it into the model portfolio, due to XLE and IYW dropping slightly.

Top-ranked stocks within these sectors include Travelers (NYSE: TRV), Goldman Sachs (NYSE: GS), Forest Labs (NYSE: FRX), and Cephalon (Nasdaq: CEPH).

At the bottom of the rankings, we again find this week the fundamentally most overvalued sectors are Telecommunications (IYZ) with a score of 27 and Consumer Discretionary (XLY) at 38. Although the model indicates that international telecom stocks and ADRs have excellent forward valuations, IYZ contains only U.S. telecoms, and they are showing an increase in analyst downgrades to earnings estimates. It now ranks dead last in both analyst revisions and projected year-over-year change in earnings. And for its part, XLY continues to display the worst (highest) aggregate projected P/E.

Low-ranked stocks within these sectors include Starwood Hotels & Resorts Worldwide (NYSE: HOT), Harley-Davidson (NYSE: HOG), LEAP Wireless (Nasdaq: LEAP), and Sprint Nextel Corp. (NYSE: S).

These scores represent the view that Financials and Healthcare stocks may be undervalued overall, while Consumer Discretionary and U.S. Telecom 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, 2/16/10.

Our short position in Materials was the main driver behind the relatively strong performance of Sector Detector’s long/short model portfolio from January 20. Even during the past week of market strength (SPY up 2.5%), you can see that our two top-ranked ETFs both outperformed the SPY (3.7% and 2.6%) while the two lowest-ranked ETFs underperformed the SPY (2.3% and 1.0%).

This reflects well on the SectorCast relative ranking model and our absolute return approach, which seeks to capture the performance spread between the top and bottom-ranked sectors, no matter the market direction.

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.