Sector Detector: Materials Weakens in Forward Rankings Despite Today’s Strength

It is surely understandable if an investor is afraid to participate in this choppy stock market. Bounces from support are met with selloffs from resistance. In 2008, we got a strong downtrend, and in 2009, we got a strong uptrend, but this year has been difficult to gauge. Yesterday, IBM had a poor earnings report and the market tanked badly in the afterhours and opened quite weak this morning, but then recovered strongly to close at the highs. Apple just gave a great report, and the market is up afterhours. What’s an investor to think for tomorrow?

Although I’ve been looking for more downside, the market’s resiliency has been impressive. Weak housing starts were reported, but then sectors like housing and building materials outperformed, going against the grain of Sabrient’s quality ratings. Our fundamentals-based Company Outook rank has been serving us well this year in this uncertain market, doing a great job of identifying the highest quality stocks to go long and the lowest quality stocks to go short. But today was a crazy day, for sure, as the lowest ranked stocks strongly outperformed the highest. That doesn’t happen often.

Despite market resiliency, the 50/200 moving average crossover (i.e., the “death cross”) is still intact for the large caps, while the mids and smalls are sitting below both their 50 and 200. Today, the indexes are testing resistance from their 20-day moving averages.

Like the overall market’s resiliency, Sabrient’s SectorCast-ETF rankings continue to display remarkable stability. Back in January, after the market had become a bit frothy with speculative optimism in the wake of the bull run off the March 2009 V-bottom, the SectorCast-ETF model took a decidedly conservative turn, with defensive sectors Healthcare, Consumer Staples, and Utilities at the top and Financials, Industrials, and Materials at the bottom. But that has not been the case lately, as we continue to see the same forward-looking leaders and laggards.

Latest rankings:  At the top, Information Technology (IYW) remains the highest ranked, although its score as come down a few points from 74 to 71. IYW fares the best (on a composite basis across its constituent stocks) in the percentage of analysts increasing earnings estimates, and it ranks high in return on equity, return on sales, and projected year-over-year change in earnings.

The second place spot remains with Energy (XLE) with a score of 67. Despite struggling with analysts reducing earnings estimates, XLE is strong in projected price/earnings ratio (PPE) and projected year-over-year change in earnings (after XLB).

Top-ranked stocks within IYW and XLE include Fairchild Semiconductor (FCS), Western Digital (WDC), Chevron (CVX), and Marathon Oil (MRO).

Telecommunications (IYZ) remains firmly at the bottom of the rankings with a score of 39. It scores poorly on a composite basis (across the U.S. telecom stocks that make up the ETF) in almost all metrics, particularly projected year-over-year change in earnings across the stocks in the sector, projected P/E, return on equity, and the percentage of analysts increasing earnings estimates.

Consumer Staples (XLP) remained steady with the same score of 46, but Materials (XLB) dropped 6 points from 49 to 43 to join IYZ in the short portfolio. This was completely due to a strong increase in the percentage of analysts reducing earnings estimates. Interestingly, it was XLB that led all sectors in today’s reversal rally.

Low-ranked stocks within IYZ and XLB include Verizon (VZ), Global Crossing (GLBC), Vulcan Materials (VMC), and Monsanto (MON).

These scores represent the view that InfoTech and Energy stocks may be relatively undervalued overall, while Telecom and Materials stocks may be overvalued.

The spread between the top and bottom sector scores tightened this week from 36 to 32.  I prefer to see wider top-bottom spreads to provide added confidence in the relative rankings, but this range seems to be entrenched until a stronger overall trend emerges.

Performance: I have tracked the performance of each of the prior four weekly portfolios as of the market close on Tuesday, 7/20/2010. Each portfolio assumes that the top two ETFs are entered long and the bottom two are entered short, all at the opening prices on Wednesday. Of course, for those who prefer not to sell short, this could be run as a sector rotation strategy – with perhaps the top 3 or 4 sector ETFs long.

The big market recovery since July 1 still has the 6/30 portfolio lagging a bit, but the 7/7 and 7/14 portfolios are holding up pretty well. In particular, Last week’s long/short portfolio performed well as it got good performance from long position XLE.

Disclosure: Author has no positions in stocks or ETFs mentioned. 

About SectorCast: The rankings are based on Sabrient’s SectorCast model, which builds a composite profile of each of the ten ETFs in the table below based on bottom-up scoring of their constituent stocks. The model employs a fundamentals-based multi-factor approach including forward valuation, earnings growth prospects, analyst revisions, 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 eight Select Sector SPDRs, but because the SPDRs combine InfoTech and Telecom into one ETF, I use the two iShares for those sectors rather than the SPDR Select Technology ETF. 

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 really don’t want to bet on which way the market is going, you could try a market-neutral, long/short trade—that is, go long the top-ranked ETFs and short 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.

About Performance Tracking: I track each week’s set of ETFs (2 longs and 2 shorts) as a mini-portfolio over the course of four weeks. Because SectorCast does not include any technical triggers, this will give the fundamentals-based model a chance to achieve its predicted move. You might also watch just the two long positions as a separate long-only sector rotation strategy.