Sector Detector: Market Remains Frothy

This week brings a clean slate among stock traders as the holidays and end-of-year positioning has come to an end. The market continues to show signs that it wants to pull back a bit to work off its overbought condition and allow technical indicators like RSI and MACD to cycle back down in their normal swings. But the cash just keeps flowing in.

Looking at the SPY chart, it has been getting strong support from its 8-day moving average, but it's been awhile since it has tested its 20-day, and it really needs to do that from time to time, but of course there can be a lot more upside before that inevitable pullback.

The SPY flatlined near overbought territory to close out the year without much action, and now the RSI is again climbing back into overbought while price hugs the upper Bollinger Band. The price behavior, Bollinger Bands, and MACD all look very much like they did in early November after the big bounce off the lower Bollinger Band and oversold MACD.

If that pattern repeats, we might see one more push up into next week in a “blow-off” top before getting a correction. However, unless a major negative news event hits, such a correction will likely be a buying opportunity.

The market volatility index (VIX) closed today at 17.02, 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) remains low within its normal range, coming in at 16.79. Both indicators are relatively low and still reflect complacency (and optimism).

Latest rankings: In addition to Sabrient’s proprietary Outlook Score, which employs a forward-looking fundamentals-based algorithm to create a composite profile of the constituent stocks in each of the ten U.S. industrial sector iShares (ETFs), I now also show 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.

Many of our clients find the Bull and Bear scores quite handy, particularly when viewed in conjunction with the Outlook Score. As a group, these three scores can be quite helpful for positioning a portfolio for a given set of anticipated market conditions.

Technology (IYW) rose back to the top last week with a strong Outlook Score of 89, and this week it maintains that position with an 87. Healthcare (IYH) holds the second spot with an 85. Consumer Goods (IYK) remains a distant third, scoring 56. Telecommunications (IYZ) remains in the cellar with a 20, and Basic Materials (IYM) stays in the bottom two for the second week in a row with a score of 34. Like last week, 7 of the 10 iShares are scoring mediocre to poor with a 51 or below, which indicates to me that the market is still frothy and in desperate need of a pullback.

Looking at the Bull and Bear scores, Basic Materials (IYM) and Financial (IYF) have tended to perform the best in recent periods of overall market strength, while not surprisingly Consumer Goods (IYK) and Utilities (IDU) have held up the best on weak market days. Technology (IYW) seems to boast the best overall combination of the three scores. It has consistently scored near the top of the Outlook Score, but its Bull Score has been average, which is why it continues to show good relative valuation.

IYW remains strong across most all factors in the quantitative model, scoring highly (on a composite basis across its constituent stocks) in return on equity, return on sales, projected P/E, projected year-over-year change in earnings, and analysts increasing earnings estimates. IYH continues strong in return on equity and return on sales, and it has the lowest (best) projected P/E.

Top ranked stocks in Technology and Healthcare include Jabil Circuit (JBL), Arrow Electronics (ARW), Forest Labs (FRX), and Skilled Healthcare Group (SKH).

IYZ has by far the highest projected P/E and the worst return on equity. IYM has the lowest analyst rank as it was hit hard by a net increase in analysts reducing earnings estimates. IYC is notably weak in return on sales as retail margins continue to be squeezed despite improving consumer spending.

Low ranked stocks in Telecom and Materials include American Tower (AMT), Crown Castle International (CCI), Nucor (NUE), and Monsanto (MON).

These scores represent the view that the Technology and Healthcare sectors may be relatively undervalued overall, while Telecom and Basic Materials sectors may be relatively overvalued, based on our 1-3 month forward look. The reason IYM and IYE have fallen recently in the value-intensive Outlook Score is because they have shown high Bull Scores and performed so well during the recent bull market. This divergence indicates that they might be getting ahead of themselves during this strong momentum run.

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.