Sector Detector: InfoTech Holds Lock on Top Ranking

The stock market is searching for direction, testing support and resistance levels each week. After threatening a waterfall decline last week, it instead found support and has rallied strongly. Today, the S&P 500 and Dow Jones Industrials joined the Nasdaq 100 and Russell 2000 by rising above the important 200-day moving average. However, they all remain below their 50-day moving averages.

I like to define trends in simple terms. So, when a stock or index is above both its 50-day and 200-day moving averages, I consider it to be in a bullish trend. Likewise, when below both its 50 and 200-day, I consider it to be in a bearish trend. When it is between the two, the market is searching for direction. Recapturing the 200-day was important for fighting off what appeared to be the start of a new bear trend. It shows that there is some buyer support for this market.

Market volatility represented by the VIX has settled back to around 25, which is right at its 50-day moving average and still well above its 200-day moving average. Keep in mind that the VIX tends to move opposite the market, so finding support is typically bearish for the market. We should know soon how this is going to play out.

The SectorCast-ETF model employs a fundamentals-based multi-factor approach including forward valuation, earnings growth prospects, recent analyst consensus sentiment, and various return ratios. Like the technical picture, current quant rankings reflect an uncertain outlook.

Latest rankings: Information Technology (IYW) continues its lock on the top ranking with a score of 71, but this Financials (XLF) has taken back the second spot after falling into a tie last week with Healthcare (XLV). Overall, sector scores are quite similar to last week despite the big market rally from the edge of the abyss.

Notably, Consumer Discretionary (XLY) and Materials (XLB) have both weakened somewhat this week. Also worth mentioning is that Energy (XLE) and Materials (XLB) were the only sectors to get hit with more analysts reducing earnings estimates rather than increasing.

IYW fares the best 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. XLF is particularly strong in return on sales and projected price/earnings ratio.

Top-ranked stocks within IYW and XLF include Texas Instruments (NYSE: TXN), Amkor Technology (Nasdaq: AMKR), Loew’s Corp (NYSE: L), and SLM Corp (NYSE: SLM).

Telecommunications (IYZ) remains the weakling with a score of 36. It is weak 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.

Also remaining in the bottom two this week is Consumer Staples (XLP). XLP still sports the best return on equity, but remains relatively weak in all other metrics.

It is notable that we now see four of the ten sectors scoring less than 50. The spread between the top and bottom sector scores remains in the mid-30’s, 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.

Low-ranked stocks within XLP and IYZ include Safeway (NYSE: SWY), Proctor & Gamble (NYSE: PG), RCN Corp (Nasdaq: RCNI), and Global Crossing Ltd (Nasdaq: GLBC).

These scores represent the view that InfoTech and Financials stocks may be relatively undervalued overall, while Telecom and Consumer Staples stocks may be overvalued.

Performance: I track the performance of each of the prior four weekly portfolios as of the market close on Tuesday, 6/15/2010. 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.The market rallied hard over the past week, with the SPY up 4.4%, and that puts all four of the SPY weekly portfolios in the black. Overall, each of the long/short portfolios are holding their own, as well. You can see that the consistently top-ranked IYW and consistently bottom-ranked IYZ are mostly performing the same and canceling out each other from a long/short perspective.

Thus, the positive performance can be attributed to the second pair, which for the four portfolios has variously paired longs XLE, XLF, and XLV with short XLP. In a bullish environment, you would expect those sectors to outperform the slower-moving and defensive XLP.  Despite the ongoing catastrophic oil spill in the Gulf of Mexico, Energy stocks seem to be attracting some support and bargain hunting.

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.