Sector Detector: Investors get their overdue pullback
You knew a bigger pullback would happen eventually. It was only a matter of when it would come, what would be the catalyst, and how far it would fall. In fact, investors have been hoping for a pullback to serve as an entry point to put more cash to work.
As I have been noting, the recent underperformance of quality-oriented quantitative models has shown all the signs of a “junk rally” phase that generally precedes a significant pullback. But it should remain contained. Optimism for U.S. stocks continues to improve as bears struggle to get any downside traction…and of course the liquidity spigot is still open.
Sure, the domestic economic data has been mixed and often disappointing, and yes, Spain appears to be struggling worse than hoped as the European debt contagion continues into the unknown. But it all seems to have merely provided an excuse for the overdue technical pullback. Wednesday’s bounce after Tuesday’s elevated-volume selloff is certainly promising. Alcoa’s (AA) positive earnings report helped bolster conviction.
On Tuesday, the major indexes were back below round-number resistance-turned-support levels at 13,000 on the Dow, 3000 on the Nasdaq, and 1400 on the S&P 500, but the Nasdaq recaptured 3000 on Wednesday, and the S&P 500 bounced back near prior resistance-turned-support at 1370. Looking at the SPY chart, it closed Wednesday at 137.00, which is below its near-term uptrend line (since late December) and very close to its longer-term uptrend line.
SPY is now trying to claw its way back above the 50-day simple moving average. A failure here might take it down to test its 100-day. However, RSI and Slow Stochastic have worked off overbought conditions, while MACD has made good progress in doing so. So, this is probably a spot where buyers will test bullish conviction by putting some cash back to work.
The VIX (CBOE Market Volatility Index—a.k.a. “fear gauge”) closed Wednesday at 20.02—essentially right at the important 20 threshold. 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) closed Wednesday at 38 bps, which is right around the 40 level that it has settled at.
I still believe that unless the bottom falls out on high volume (likely due to a major external event), taking out important support levels, “buy the dip” will remain the working mantra.
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.
Observations:
1. As we head into earnings season, Technology (IYW) remains at the top of the Outlook rankings with an 80, but Financial (IYF) has pulled into a tie. IYW is particularly strong in its return ratios as margins remain high in tech products, but it is strong pretty much across the board on all relevant factors. IYF continues to gain strong support among analysts, along with Consumer Services (IYC), and its projected P/E is still relatively low.
2. Energy (IYE) and Materials (IYM) continue to be beaten down by the analysts and reflect by far the lowest projected P/Es.
3. Telecom (IYZ) remains at the bottom of the rankings with a 2. IYZ is saddled with the worst return ratios and the highest projected P/E. It is again joined in the bottom two by Utilities (IDU) with a score of 21. IDU has low long-term growth projections and a relatively high projected P/E.
4. Looking at the Bull scores, Financial (IYF) has been the clear leader on strong market days, scoring 56. Utilities (IDU) is by far the weakest on strong days, scoring 37.
5. As for the Bear scores, IDU is the investor favorite “safe haven” on weak market days, scoring 67, followed by IYK at 64. Notably, IYF continues to strengthen on this metric. IYM shows the lowest Bear score of 40. This means that Basic Materials stocks tend to sell off the most when the market is pulling back.
6. Overall, IYF now shows by far the best combination of Outlook/Bull/Bear scores. Adding up the three scores gives a total of 190. IYW is close behind at 186. IYZ is by far the worst at 103. IYF also shows the best combination of Bull/Bear with a total score of 110. IYE and IYM share the worst combination with a 94.
These scores represent the view that the Technology and Financial sectors may be relatively undervalued overall, while Utilities and Telecom sectors may be relatively overvalued based on our 1-3 month forward look.
Top ranked stocks within Technology and Financial sectors include Apple (AAPL), TIBCO Software (TIBX), Discover Financial (DFS), and Regions Financial (RF).
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.