Sector Detector: Fundamentals-based Rankings Unbowed by Market Turmoil
Last week, the S&P 500 came perilously close to the dreaded 50-day moving average cross down through the 200-day moving average. This is usually considered by technicians to be an extremely bearish development. The S&P 500 came closer last week than the other major indexes, and actually set new lows for the year. Today, the “death cross” happened for the S&P 500, but not for the other major averages.
Moreover, all major market indexes have fallen beneath or are challenging their 2010 lows from February, May, and June. If the market is going to gather support and mount some sort of effort to climb out of this situation, it’s going to have to get started soon or risk a much larger decline that could carry the S&P 500 down to 950.
Nevertheless, Sabrient’s SectorCast-ETF rankings are showing remarkable stability. Back in January, after the market had become a bit frothy with optimistic speculation after the bull run off the March 2009 V-bottom, the SectorCast-ETF model took a decidedly conservative turn, with defensive sectors Healthcare, Consumer Staples, and Utilities at the top and Financials, Industrials, and Materials at the bottom.
But this time, despite the immense doom & gloom we hear in the news, the model is indicating that Wall Street analysts are still showing optimism about earnings improvements in some of the more economically sensitive sectors, and it is telling us that forward valuations are still quite reasonable – especially in the wake of this sharp recent correction.
Latest rankings: Information Technology (IYW) maintains its stranglehold on the top ranking with a score of 73. IYW fares the best (on a composite basis across its constituent stocks) 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.
The second place spot has been moving around among XLE, XLF, and XLV, and in fact this week, Healthcare (XLV) has yielded to Energy (XLE). Despite having the worst score (along with XLB) in the percentage of analysts increasing earnings estimates, XLE has by far the best score in projected price/earnings ratio (PPE). Its aggregate PPE is a low 8.7, which easily outdistances the 9.5 of second-place Financials (XLF). XLE also scores quite well in projected year-over-year change in earnings.
Top-ranked stocks within IYW and XLE include Micron Technology (MU), Seagate Technology (STX), Valero Energy (VLO), and Hess Corp (HES).
Telecommunications (IYZ) remains at the bottom by a wide margin with a score of 37. It scores poorly on a composite basis (across the U.S. telecom stocks that make up the ETF) 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) continue to fight it out to stay out of the bottom two. Consumer Discretionary (XLY) got that indignity last week, but this week it happily gives it back to Consumer Staples (XLP), which scores a 48, joining IYZ in the short portfolio.
The spread between the top and bottom sector scores remains at 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, but this range seems to be the new reality for now – at least until a firmer market trend develops.
Low-ranked stocks within IYZ and XLP include Verizon (VZ), Global Crossing Ltd (GLBC), Proctor & Gamble (PG), and Colgate-Palmolive (CL).
These scores represent the view that InfoTech and Energy stocks may be relatively undervalued overall, while Telecom and Consumer Staples 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, 7/6/2010. 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.
As the market remains quite weak, our top-ranked sector ETF (IYW) has been hit pretty hard. However, the more defensive XLV has held up better than the market. Only the 6/16 portfolio, which had XLF as a long position, is negative. The other long/short portfolios are all positive, and all four are well ahead of a straight long position in the SPY. The more recent addition of economically-sensitive XLB and XLY as short positions has been helpful to short performance, since IYZ and XLP are more defensive in nature and tend to hold up better in a weak market.
This fundamentals-based quantitative model portfolio is positioned to thrive in a bull market that favors high-quality stocks, while also being prepared to protect the investor if the market continues to weaken.
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.