Sector Detector: Is That a Glimmer of Optimism?

After last week’s Sector Detector article in which I talked about the “relentlessly strong September” making the market quite overbought from a technical standpoint, it looked like the market was going to waterfall into a healthy correction on Thursday. But alas, the bulls pulled a rabbit out of their hat and closed the week with a flourish.

And this week, SectorCast-ETF fundamentals-based quantitative model is indicating that a glimmer of optimism might be returning. But first, please indulge me in a little chart analysis.

For the SPY, 112 seems to be an important inflection point. It was the high of the left shoulder of a possible head-&-shoulders formation, then served as a support level for the head of the formation, and more recently has served as strong support for the past 12 sessions. It is also very close to the important 200-day moving average. After the August head-&-shoulders was seemingly confirmed with a breach of the down-trending neckline, it turned out to be only a head-fake, and the market has decided to defy historical trends by remaining strong throughout the historically weak month of September.

The arrow on the chart shows that the MACD was aiming to roll over on Thursday, but price formed a mildly bullish inverted hammer pattern, and then Friday brought back the bullish conviction. It is now finding strong resistance at the 115 level and in fact looked quite weak intraday today, but the cavalry arrived just in time to save the day and form a bullish hammer at the top of the range.

Nevertheless, I am still skeptical that this trend can continue without higher trading volume and more testing of bullish conviction and levels of support. Last Thursday and today have shown signs of doing just that, but then a strong bid arrives before anything too nasty occurs, as if the bulls are determined to close out the month with fortitude.

As you know, technical patterns are only backward looking and can turn on a dime. Patterns tend to repeat themselves, and the more traders follow them, the more self-fulfilling the patterns can become. Nevertheless, the market also likes to fool the greatest number of people possible, which is why it often reverses just when a trend (whether shorter term or longer term) appears to be firmly established.

The VIX volatility index has been hanging around near the bottom of its 21-28 trading range, closing today at 22.60, and the TED spread (i.e., indicator of credit risk measuring the difference between the 3-month T-bill and 3-month LIBOR interest rates) continues to drop in the low end of its range, trading today around 14. Both of these indicators show a lack of fear in the markets, which is positive for the bulls. Also, the major indices remain well above their 50 and 200-day moving averages. And then, of course, there is the record levels of corporate cash that is finding its way into picking up strong, well-positioned, undervalued companies.

Latest rankings:  Sabrient’s SectorCast-ETF ranking of the ten U.S. business sectors continues to reflect a defensive bias. However, this week’s rankings seem to be indicating a ray of improved optimism, particularly among analysts – via the percentage of analysts increasing earnings estimates metric.

Technology (IYW) continues to lead the pack, but this week, it dropped a few points while Healthcare (IYH) increased 9 points, such that IYW only has a single point margin over second place IYH – 88 vs. 87. By itself, this is somewhat bearish; however, it is notable that Financials jumped 16 points this week to take third place with a 65 and the recently moribund Consumer Services (IYC) jumped 20 points to score a 40 this week.

The change in relative scores was virtually entirely due to Wall Street analysts’ earnings revisions for the stocks within each sector. So, this might be giving a glimmer of optimism among Wall Street analysts after seeing a lot of reductions in earnings estimates over the prior weeks. We’ll see over the coming weeks whether this was simply a one-week anomaly.

IYW remains strong across the board, scoring highly (on a composite basis across its constituent stocks) in the percentage of analysts increasing earnings estimates as well as in return on equity, return on sales, and projected year-over-year change in earnings. IYH is strong in return on equity, return on sales, and projected P/E.

Top ranked stocks in IYW and IYH include RF Micro Devices (RFMD), Lexmark (LXK), Endo Pharmaceuticals (ENDP), and Wellpoint (WLP).

At the bottom of the list, we continue to find Telecom (IYZ), with the highest PPE and the worst return on equity. This week it scores a dismal 5. However, joining it in the bottom two this time is Basic Materials (IYM), which falls to 33 while Consumer Services (IYC) jumps to 40. The main difference is that IYC got a bunch of analyst upward revisions while IYM stocks got hit with downward earnings revisions. 

Low ranked stocks in IYZ and IYC include Frontier Communications (FTR), Sprint Nextel (S), Carpenter Technology (CRS), and RTI International Metals (RTI).

These scores represent the view that the Technology and Healthcare sectors may be relatively undervalued overall, while Telecom and Basic Materials sectors may be relatively overvalued, based on our 1-3 month forward look.

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

About SectorCast: Rankings are based on Sabrient’s SectorCast model, which builds a composite profile of each equity ETF based on bottom-up scoring of the constituent stocks. The model employs a fundamentals-based multi-factor approach considering forward valuation, earnings growth prospects, Wall Street analysts’ consensus revisions, accounting practices, 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 ten iShares ETFs representing the major U.S. business sectors.

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 prefer not to bet on market direction, you could try a market-neutral, long/short trade—that is, go long (or buy call options on) the top-ranked ETFs and short (or buy put options on) 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.