Sector Detector: Healthcare and InfoTech top the forward rankings
After a brief consolidation period and staying flat for two weeks, the market has resumed its upward march, with the S&P 500 setting new 52-week highs each day. Healthcare now tops the forward-looking rankings, followed by InfoTech and Consumer Discretionary, both of which continue their impressive climb.
Also notable is that higher quality stocks have come back into favor, after playing second fiddle to the more speculative stocks during March. This has allowed Sabrient’s quality-oriented SectorCast-ETF model to shine once again.
The model continues to flash conflicting signals, however. It is indicating uncertainty among Wall Street analysts on the one hand, as well as continued improvement in the rankings among some of the more economically-sensitive sectors on the other hand. Overall, a cautious optimism for continued recovery appears to be indicated.
Latest rankings: This week, after four weeks in the top spot, Energy has fallen all the way to fourth, primarily due to a spate of analyst earnings downgrades. XLE still 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 as share prices have remained stubbornly low. But the continued increase in the number of analysts downgrading earnings estimates was its undoing this week, and XLE has lost 12 points off its score over the past two weeks. 
Notably, the rankings have tightened even further this week. Last week, the spread between the top and bottom-ranked sectors was only 25 points, and this week you can see that it is now only 22 points, which is a far cry the spread of 65 we saw only a few months ago. This illustrates the ongoing uncertainty among analysts regarding future earnings and which sectors are currently undervalued after such a long and sustained market rally.
InfoTech and Consumer Discretionary – arguably the most economically sensitive sectors – have continued to strengthen versus the other sectors. They have jumped from fifth and sixth two weeks ago all the way up to second and third. Their strong relative ranking, coupled with the improvement in Materials and Industrials relative to defensive sectors like Consumer Staples and Utilities, continues to flash bullish signs for the overall market. Nevertheless, the tightening of scores across the board suggests a cautious optimism is warranted.
Healthcare (XLV) comes in at a modest 67, which is good enough to claim the top spot in the overall rankings without any chart-topping factor scores. It ranks second in both return on equity and projected P/E. Information Technology (IYW) gets the nod for second place with a score of 63, as it gets its strength from consistency across all factors. It scores in the top half for all factors with the exception of projected P/E. In fact, it would easily lead the rankings if the forward valuations were a little better, but InfoTech typically shows higher P/Es due to the inherent growth (rather than value) orientation of the sector.
Although XLY is actually tied with IYW at 63, I gave the second spot in the model portfolio to IYW because of its consistent strength across almost all factors, whereas XLY gets its strength primarily from its chart-topping score in just one factor – the percentage of analysts’ positive revisions to earnings estimates.
Top-ranked stocks within XLV and IYW include Humana (NYSE: HUM), Cephalon (Nasdaq: CEPH), Corning (NYSE: GLW), and Tech Data (Nasdaq: TECD).
At the bottom of the rankings, once again we find Telecommunications (IYZ) and Consumer Staples (XLP). IYZ came in with a low score of 45 – which is actually quite high for last place. Although XLP is now in 9th place, its score is an above-average 52. Again, both of these scores reflect the tight range among the sectors and uncertainty among analysts looking forward.
IYZ again showed fewer analyst downgrades to earnings estimates this week, which helped support its score. (Actually, it was XLE, XLF, and XLU that had the most analyst earnings downgrades.) But IYZ continues to be saddled with the lowest score in projected year-over-year change in earnings across the stocks in the sector.
Low-ranked stocks within XLP and IYZ include Proctor & Gamble (NYSE: PG), Kraft Foods (NYSE: KFT), Sprint Nextel (NYSE: S), and Virgin Media (Nasdaq: VMED).
These scores represent the view that Healthcare and InfoTech stocks may be undervalued overall, while Telecom and Consumer Staples 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, 4/6/2010.
The model long/short ETF portfolio has returned to its winning ways over the past two weeks, with XLE in particular showing excellent relative performance. This absolute return portfolio is prepared to participate in a continued bull market while also being well-positioned to hold up if the market instead turns south. It 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