Sector Detector: Materials, Energy, Healthcare Dominate Forward Rankings

Last week I mentioned that a pullback was due, and indeed we’ve seen some market weakness this week. The 50-day simple moving average is trying to support the large, mid, and small caps at this point, but the Dow Industrials and MSCI Emerging Markets are holding up better as they are supported by their 20-day. Among the major sectors, Healthcare has actually displayed strength this week despite overall market weakness.

On Tuesday, Goldman Sachs provided a negative call on oil and commodities, saying their rise was driven more by speculation than fundamentals. Then, President Obama made his budget speech, and he proposed reduced growth in Medicare spending, cuts in defense spending, a tax system overhaul to plug loopholes, and an end to Bush-era tax cuts for the wealthy – all with the goal of “living within our means” – a worthy goal, to be sure. The speech contained strong political posturing, as he laid blame for ballooning debt on the Bush administration and the recession that started on Bush’s watch. Nothing new here.

I listened in on the WisdomTree quarterly call today. Highly-respected Professor Jeremy Siegel thinks there’s “no chance” of a QE3 stimulus program

 once QE2 expires at the end of June, and instead the Fed will begin the process of “normalizing” toward a Fed Funds rate of 1.0% (it is 0.25% today). He thinks the market will sell off and the dollar will spike upward when the end to quantitative easing is announced, but he thinks that stocks will quickly recover, especially given that earnings yield is so low on a historical basis relative to the low level of interest rates. Stock value rises when earnings rise, so as long as earnings per share continues to rise, the market will remain in recovery mode. Professor Siegel’s biggest worry, however, is how high oil prices might rise, which has severe impact on consumer confidence and real inflation.

The SPY chart shows how the bulls’ are struggling to hold on. Last Thursday, price violated the lower trend line of the bullish rising channel. RSI has crossed back down through the neutral line, and MACD is similarly rolling back down and indicating a bearish crossover.

We’ll watch to see if the 50-day simple moving average can stop the slide, or if the 100-day near 128 is destined to be tested. I have drawn a line near 131 where price has been oscillating since February as it has been alternately providing resistance and then support. Perhaps it can help provide support at current levels. And of course, options expiration this week is likely providing some measure of support, too.

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) closed at 22.73, which is down from last week. Fear as measured by the CBOE market volatility index (VIX) briefly spiked above 31 in mid-March during the initial reports from Japan, but it has since come back down. It got to near 18.50 on Tuesday, but closed today (Wednesday) at 16.92, which is flat from last week’s Sector Detector article, despite the market weakness. Neither of these metrics is signaling impending doom.

I still see weakness as a buying opportunity. For its part, Sabrient’s SectorCast-ETF rankings show a bullish tilt, with the exception of the extreme low score for Consumer Services.  

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.

The most notable changes in this week’s Sabrient’s SectorCast rankings are: 1) the growing strength in Basic Materials (IYM) and Energy (IYE), 2) the continued weakness in Technology (IYW) after having led the rankings for so long, 3) the continued weakness in Outlook score for defensive sector Utilities (IDU) despite overall market weakness, and 4) the steady fall in Consumer Services (IYC), which falls into last place this week with a 23.

Basic Materials (IYM) has strengthened its hold on the top spot with an impressive Outlook score of 90. Healthcare (IYH) falls to third place this week despite maintaining a sound Outlook score of 75. Rising 18 points to take second with a 79 is Energy (IYE), which has been jumping in leaps and bounds – much like IYM did recently when it rose quickly up the ranks. IYE has risen 30 points in its Outlook score in the past two weeks, and now easily outdistances former leader Technology (IYW), which dropped a bit further to a decidedly mediocre Outlook score of 58.

Consumer Services (IYC) now takes the bottom spot with a 23, switching places with Utilities (IDU).

Looking at the Bull scores, Basic Materials (IYM) has been the strongest during strong markets, followed by Energy (IYE) and Industrial (IYJ). Utilities (IDU) and Consumer Goods (IYK) are the biggest laggards on strong market days, and in fact, IDU and IYK are the only two with Bull scores below 50.

As for the Bear scores, we are seeing the weak Bull scores leading. Consumer Goods (IYK) and Utilities (IDU) are the favorite “safe haven” sectors, followed closely by Healthcare (IYH). Energy has fallen somewhat in its Bear score as the sector has shown weakness during this market pullback. Industrial (IYJ), which performs among the best on strong market days, continues to show the lowest Bear score, reflecting quick abandonment by investors on weak market days. Basic Materials (IYM) and Technology (IYW) are the other weak sectors during a weak market.

Overall, Basic Materials (IYM) still displays the best combination of the three scores, while Energy (IYE) has the best combination of Bull/Bear. 

Top ranked stocks in Basic Materials and Energy include Mercer International (MERC), First Majestic Silver (AG), Gulfport Energy (GPOR), and Mitcham Industries (MIND).

Low ranked stocks in Consumer Services and Utilities include StoneMor Partners (STON), Barnes & Noble (BKS), DigitalGlobe (DGI), and National Fuel Gas (NFG).

These scores represent the view that the Basic Materials and Energy sectors may be relatively undervalued overall, while Consumer Services 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.