Sector Detector: Market Shifts into Neutral
This month marks the first time since July 1 that the first trading day of the month wasn’t an up day. That’s 8 months in a row of money pouring in on the first trading day. Furthermore, recall that July 1 marked a low for the SPY at 101.13 that ended a 2-month correction to the 13-month rally off the March 2009 V-bottom, and launched a new 8-month rally. Is the fun over now? Or is this just a speed bump – a needed shift into neutral for the market to test bullish support and reload for the next run?
Oil remains front and center. It finished at a two-year closing high today at $102.23, mostly due to deterioration in the situation in Libya and the threat of unrest continuing to spread throughout oil-producing regions of the world. High oil prices are making a noticeable impact on some sectors (especially Airlines), but a widespread belief (hope?) that things ultimately will smooth out seems to be keeping the markets from selling off hard.
Or maybe it’s Charlie Sheen’s maniacal rants that dominate the news and distract everyone from the cold hard global realities.
Or maybe it’s the latest economic reports. Tuesday’s Beige Book release showed that economic activity continues to improve across all 12 Federal Reserve Districts. Labor markets strengthened, inflation seems to be developing, manufacturing production improved, and commercial real estate is showing signs of improvement, although residential real estate activity remains weak. And then today, a stronger-than-expected ADP Employment Change was reported.
Or maybe it’s the Federal Reserve’s aggressive Permanent Open Market Operations (POMO) buying of Treasuries to free up cash for investment in stocks.
Looking at the SPY chart, it seems to have shifted from pedal-to-the-metal into neutral. In fact, the pattern since mid-February is looking very much like it did from early to late November, when price fell from the upper Bollinger Band, down through the 20-day moving average to the 40-day, and then tried to recover before making another test of support at the 40-day and lower Bollinger Band. Like it did in November, RSI is bouncing along the neutral line, and MACD had a bearish crossover and is now looking for support. If things play out as they did before, SPY will find support and re-launch on its bullish trajectory. But as they say, historical performance is no guarantee of future results.
Still, even a healthy bull market needs to cycle periodically and test support. I’m just not real confident that the Fed’s Monopoly money propping up this market constitutes a “healthy” bull.
Fear as measured by the market volatility index (VIX) has moderated from over 22 last week to close today at 20.70. It was as low as 14.86 on February 8. The TED spread (i.e., indicator of credit risk in the general economy, measuring the difference between the 3-month T-bill and 3-month LIBOR interest rates) is down from last week, coming in at 18.98. This is still low in its normal range. 
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.
As a group, these three scores can be quite helpful for positioning a portfolio for a given set of anticipated market conditions.
There were noticeable changes in Sabrient’s SectorCast model this week. Perennial favorite Technology (IYW) has dropped 19 points from an impressive 92 Outlook score last week to a 73, which puts it in second place. The big move comes from Basic Materials (IYM), which continues its climb in the rankings to finally reach the top spot with an Outlook score of 85. IYM surged 28 points four weeks ago, then remained flat for a few weeks before surging to the lead this week. Healthcare (IYH) has fallen from an 86 last week to a modest 67 this week, where it is being threatened by improving Consumer Goods (IYK) with a 63.
As I predicted it would, recent price action in the markets has led to significant changes in the sector scores for this week. Besides the surge in Basic Materials, we now see five sectors scoring well above the 50 mid-point on Outlook score, and the other five sectors are now all well below 50, including Industrial (IYJ) with 44 and Energy (IYE) at 35. The speculative run in oil stocks has helped suppress the Outlook score for IYE.
Telecommunications (IYZ) remains at the bottom with a score of 3, as the U.S. Telecom companies languish. Utilities (IDU) has replaced Consumer Services (IYC) in the bottom two, scoring 27 this week finally pass up the sinking IDU.
Looking at the Bull scores, Financial (IYF) remains the clear winner during particularly strong markets with a leading Bull score of 58. Stocks within Basic Materials (IYM), Energy (IYE), Industrial (IYJ), and Technology (IYW) have also tended to perform relatively better during recent periods of overall market strength. These five sectors are clearly the more “offensive” sectors. Healthcare (IYH) and Utilities (IDU) are still struggling on a relative basis on strong market days.
As for the Bear scores, traditionally “defensive” sectors represented by Healthcare (IYH), Utilities (IDU), and Consumer Goods (IYK) not surprisingly have held up well during recent periods of overall market weakness. Utilities (IDU), while its Outlook score has fallen, has seen its Bear score jump again to a robust 66 to remain by far the biggest “safe haven” sector.
Overall, Basic Materials (IYM) now displays the best combination of the three scores, while Energy (IYE) has distanced itself from the others with the best combination of Bull and Bear scores. The analysts are clearly favoring natural resources, miners, and aluminum and chemical producers. It also illustrates that investor sentiment is bullish on Energy in all market conditions even though it appears to be getting ahead of itself on a forward-looking valuation basis – perhaps reflecting a speculative bet due to unrest in key energy-producing regions of the world.
IYM is particularly strong in the important metrics of analysts increasing earnings estimates and projected P/E. 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 year-over-year change in earnings, and analysts increasing earnings estimates.
Top ranked stocks in Materials and Technology include Mercer International (MERC), Lubrizol (LZ), Nanometrics (NANO), and Integrated Silicon Solutions (ISSI).
IYZ has by far the highest projected P/E and the worst return on equity, although it scores reasonably well in return on sales. It also continues to be plagued by more analyst earnings downgrades. IDU is particularly weak in projected year-over-year change in earnings and analyst upgrades.
Low ranked stocks in Telecom and Consumer Services include Viasat (VSAT), Crown Castle International (CCI), EnerNoc (ENOC), and Calpine (CPN).
These scores represent the view that the Basic Materials and Technology sectors may be relatively undervalued overall, while Telecom and Utilities 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.