Sector Detector: Market at a Crossroads
A relentlessly strong September is making the market quite overbought from a technical standpoint. So much for September being historically the worst month of the year for stocks. But it now appears to be at a crossroads. And Sabrient's quantitative SectorCast rankings are even more defensive this week.
Although volume today was higher, largely due to trading in the wake of the FOMC announcement, it has been surprisingly low since the Labor Day and Jewish holidays. In such an environment, the fortitude of the bulls has kept the short sellers on the sidelines. Is there more fuel available?
Before anyone positions themselves for an expected fall rally, the market definitely needs some backing and filling to establish support. And if the market simply has been manipulated by the big money players in a low-volume environment, it might be nearing a waterfall decline to cleanse out all the weak holders before mounting a more sustainable rally.
The chart shows that the SPY might be in the midst of a head-and-shoulders topping pattern with a dreaded down-sloping neckline. If that is the case, the price projection would indicate as low as 84 from today’s close near 114. If a sell-off does begin, strong support just below the 105 level should provide a significant test of support and bullish conviction.
The VIX volatility index has been hanging around near the bottom of its 21-28 trading range, 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 13. 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 starting to find its way into picking up strong, well-positioned, undervalued companies.
But still, the market is at an important crossroads. Despite impressive strength, few participants believe that the “all clear” signal has been flashed. 
Latest rankings: Sabrient’s SectorCast-ETF ranking of the ten U.S. business sectors continues to reflect a defensive bias, and this week appears to be even more bearish. Other than the continued high ranking for Technology (IYW), which scored a robust 92 (down from its recent 97), the current fundamentals-based quantitative rankings reflect a continued cautious stance among analysts.
The only other sector iShares scoring significantly above the 50 level are Healthcare (IYH) with a score of 78 to remain in second place, and Consumer Goods (IYK), coming in at a 67. Healthcare and Consumer Goods are defensive in that they tend to have relative inelasticity of demand. Only Technology continues to buck the defensive trend by maintaining reasonable margins and relative enthusiasm among analysts.
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 Teradyne (TER), Lexmark (LXK), Forest Labs (FRX), and Wellpoint (WLP).
In fourth place is ultra-defensive Utilities (IDU), and the other six sectors all score below 50, including economically sensitive Financials, Energy, Industrials, Basic Materials, and Consumer Services. The fact that Energy continues to fall – now scoring only 44 – might be reflecting moribund projections for fuel demand, which would be indicative of a struggling economy. It scores the worst in the percentage of analysts increasing earnings estimates, actually getting a net reduction from the analysts, and is weak in projected year-over-year change in earnings growth.
At the bottom of the list, we continue to find Telecom (IYZ), with the highest projected P/E and the worst return on equity. This week it scores a dismal 6. Joining it in the bottom two yet again is Consumer Services (IYC), scoring 20 primarily due to tight margins giving it the worst return on sales and the third worst return on equity. It also scores poorly in the percentage of analysts increasing earnings estimates. Retailers and their Wall Street analysts remain worried about the near term outlook.
Low ranked stocks in IYZ and IYC include Frontier Communications (FTR), Sprint Nextel (S), Amazon.com (AMZN), and Live Nation Entertainment (LYV).
These scores represent the view that the Technology and Healthcare sectors may be relatively undervalued overall, while Telecom and Consumer Services 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.