Sector Detector: Industrials and Financials lead market bounce

Stocks rallied again today (Wednesday) while Treasuries and gold got hit hard. It is likely that gold is encountering profit-taking in advance of the Fed meeting in Jackson Hole, WY on Friday, in which new stimulus might be introduced. We all know from recent stock market volatility how quickly stop losses and short-selling can propel an otherwise normal "overbought" correction to any asset class – often followed by bargain-hunting and short-covering sending it back up.

Another key item on the will be President Obama’s on September 5, when he plans to unveil his jobs plan. After all is said and done, I expect gold will return to its preferred status. Gold has been on a tear as a traditional safe haven on fears of global financial distress, illiquidity, and stagflation. The underlying problem seems to be public mistrust of their governments and financial institutions.

Volume has moderated a bit as the VIX "fear index" has come back down to the mid-30s. Even with further market upside, VIX is likely going to have trouble getting back below 30 in the near term. The perma-bears and fear-mongers are out in full force, and the recent extreme weather events we’ve seen recently like drought, inordinate heat, tornados, East Coast earthquakes, and hurricanes have only emboldened some of them in a "Mayan Prophecy" sort of way.

Furthermore, Apple’s (AAPL) announcement tonight that Steve Jobs will be stepping down as CEO came at an inopportune time, and AAPL was down about 5% afterhours, dragging the major averages a bit with it.

David Trainer of New Constructs wrote a compelling argument imploring the Fed and Chairman Bernanke to make haste in breaking up all the big banks that are supposedly “too big to fail” – essentially reinstating Glass-Steagall by separating the deposit-taking and lending from trading and investment banking. This would jump-start lending by freeing up capital that is otherwise put at undue risk while restoring confidence in our banking system and government leadership. David believes that time is of the essence as the lack of a truly free market in the financial system and capital markets is responsible for the stalling economy. He may be right – but it will take real fortitude to overcome the powerful Wall Street lobby.

Notably, Financials were weak on Monday, but they have been strong on Tuesday and today (Wednesday). Overall for the week (through Wednesday), all sectors have shown good strength, led by Industrials. Energy had a huge day on Tuesday, and Financials have been strong on Tuesday and Wednesday after taking a hit on Monday. The more defensive sectors of Utilities, Telecom, Consumer Goods, and Healthcare have each risen above their 20-day simple moving averages. Investors have been attracted to their relative safety and/or higher yields. Despite a strong couple of day, the other seven U.S. sectors all remain below their major moving averages.

In spite of the very real threats to the global economy, we are in an environment in which the multinational corporations (including banks) are making record profits and sitting on record amounts of cash. Repatriating revenues in foreign currencies into U.S. dollars has been a boon for them. Strong earnings leads to stock buy-backs…and historically that leads to a stronger stock market.

Looking at the SPY chart, last week gave us the dreaded “death cross” in which the 50-day simple moving average crossed down through the 200-day. Nevertheless, the market got the start of the bounce that I predicted – something of a double bottom around 112. After the bear flag pattern shown was confirmed by the selloff on Thursday, the bullish inverted hammer candlestick produced on Friday was confirmed on Tuesday. The Bollinger Bands are still quite wide, and indicators like RSI and MACD are turning up from oversold – all of which indicates the need for an oversold rally.

SPY closed today at 118.08. First resistance will be near 121, then June support-turned-resistance near 126. The important 200-day moving average is up near 129, where the upper Bollinger Band appears to be headed. However, we’ll have to see what damage (perhaps only temporary) will be wreaked by Apple’s announcement after the close about Steve Jobs stepping down.

It is hard at this point to say whether the markets have indeed bottomed, particularly given how news-driven it has been. This is the main reason that Sabrient likes to espouse a long/short approach to equity portfolio management.

The VIX (CBOE Market Volatility Index – a.k.a. "fear index") closed today 35.90, which is down from the extreme of 48 it reached on August 8. The TED spread (indicator of credit risk in the general economy, measuring the difference between the 3-month T-bill and 3-month LIBOR interest rates) has been going straight up since its V-bottom on July 29 and closed today at 32.45 – its highest level in over a year. This indicates rising investor worry about bank liquidity and a preference for the safety of Treasuries bonds over corporate bonds.

Latest rankings: The table ranks each of the ten U.S. industrial sector iShares (ETFs) by Sabrient’s proprietary Outlook Score, which employs a forward-looking, fundamentals-based, quantitative algorithm to create a bottom-up composite profile of the constituent stocks within the ETF. In addition, the table also shows Sabrient’s proprietary Bull Score and Bear Score for each ETF.

High Bull score indicates that stocks within the ETF have tended recently toward relative outperformance during particularly strong market periods, while a high Bear score indicates that stocks within the ETF have tended to hold up relatively well during particularly weak market periods. Bull and Bear are backward-looking indicators of recent sentiment trend.

As a group, these three scores can be quite helpful for positioning a portfolio for a given set of anticipated market conditions.

Here are some observations about Sabrient’s latest SectorCast scores.

1. Financial (IYF) has dropped from the top of the list to fourth place, even though its Outlook score has only dropped from 70 to 61. The top seven sectors are getting quite bunched again between 68 and 43. Nevertheless, Financial still sports the best (lowest) projected P/E.

2. Materials (IYM) has returned to the top spot with an Outlook score of 68, followed by Energy (IYE) at 66. Despite trailing in its support from the Wall Street analysts, it has one of the best (lowest) projected P/Es and a solid projected long-term growth rate. The top four sectors all have projected P/Es below 10. 

3. Analysts have been favoring stocks within Consumer Services (IYC), Utilities (IDU), Consumer Goods (IYK), and Energy (IYE). 

4. Utilities (IDU), Consumer Services (IYC), and Telecom (IYZ) remain at the bottom. IYC is still held back by the worst return on sales (poor margins). Stocks within Telecom (IYZ) have fared the worst among analysts, and Utilities (IDU) has the lowest projected long-term growth rate.

5. Overall, despite some shuffling in the rankings, the Outlook rankings still reflect a more conservative slant, as the top scores are still relatively low. However, scores are very slowly creeping up. I’d like to see Industrial above 50 along with an improvement in Consumer Services to create a more bullish overall ranking.

6. Looking at the Bull scores, Energy (IYE) is the clear leader on strong market days, scoring 61. Healthcare is the weakest with a 45. 

7. As for the Bear scores, Utilities is the clear investor favorite “safe haven” on weak market days with a score of 66, with Consumer Goods a distant second at 60. Basic Materials now carries the lowest Bear score of 41, indicating quick abandonment during market weakness.  

Overall, Energy (IYE) displays the best combination of Outlook/Bull/Bear scores. Adding up the three scores gives it a total score of 175. Utilities (IDU) has the best combination of Bull/Bear with a total score of 112, which is a defensive sign.

Top ranked stocks in Materials and Energy include Kronos Worldwide (KRO), First Majestic Silver (AG), HollyFrontier (HFC), and Tesoro (TSO).

Low ranked stocks in Utilities and Telecom include Clean Energy Fuels (CLNE), Calpine (CPN), CenturyLink (CTL), and SBA Communications (SBAC).

These scores represent the view that the Materials and Energy sectors may be relatively undervalued overall, while Utilities and Telecom 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 Outlook Score employs a fundamentals-based multi-factor approach considering forward valuation, earnings growth prospects, Wall Street analysts’ consensus revisions, accounting practices, and various return ratios. It has tested to be highly predictive for identifying the best (most undervalued) and worst (most overvalued) sectors, with a one-month forward look.

Bull Score and Bear Score are based on the price behavior of the underlying stocks on particularly strong and weak days during the prior 40 market days. They reflect investor sentiment toward the stocks (on a relative basis) as either aggressive plays or safe havens. So, a high Bull score indicates that stocks within the ETF have tended recently toward relative outperformance during particularly strong market periods, while a high Bear score indicates that stocks within the ETF have tended to hold up relatively well during particularly weak market periods.

Thus, ETFs with high Bull scores generally perform better when the market is hot, ETFs with high Bear scores generally perform better when the market is weak, and ETFs with high Outlook scores generally perform well over time in various market conditions.

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.