Sector Detector: New SectorCast Model Favors Tech and Healthcare

The SPY finished the month of July up a robust +7%, and then started the first day of August by tacking on another +2% gain. All market indexes appeared a bit stretched from the mean and ready to pullback today, but the bulls fought on mightily to keep the day’s loss minor. Market resiliency remains intact, and all major indexes held above their important 50-day and 200-day moving averages.

As I said last week, after trending strongly off its March V-bottom last year, this year’s market has not made itself very easy to figure out, so I wouldn’t back up the truck quite yet on bullish positions.

Enhancements to the Model:  Sabrient’s quantitative SectorCast-ETF model employs a fundamentals-based multi-factor approach including forward valuation, earnings growth prospects, recent analyst consensus sentiment, and various return ratios. We are constantly testing, refining, and enhancing our models, and last week we introduced major changes to the SectorCast model.

The biggest change is a reduction in the importance of projected price-to-earnings ratio (PPE) in the composite score, plus differences in the way our proprietary relevance scoring approach is implemented for the given factors and the way the composite scores are compiled. Also, for this column I am now only using the ten iShares sector ETFs. 

This week, we made a further correction to the handling of PPE, so some of the sector scores are quite different this week. Since I’m running out of time tonight to provide my full commentary, I’ll simply post the scores and wait until next week to provide my usual analysis, stock ideas from the top and bottom sectors, and portfolio performance tracking.

Latest rankings:  This week, Technology (IYW) remains the highest ranked ETF with a strong score of 83. 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 goes to Healthcare (IYH) with a score of 81, buoyed primarily by return on equity, return on sales, and projected P/E. The gap between second and third place is substantial, as third place Financial (IYF) scores a 57.

With the correction to the handling of PPE, Telecom (IYZ), having the highest PPE, now comes in dead last as it did under the previous SectorCast model, sporting a dismal score of 1. Joining it in the bottom two is Consumer Services (IYC), scoring a 22 primarily due to tight margins cutting into return on sales.

Overall, the model is looking more neutral than bullish, which isn’t surprising given that it is strongly influenced by consensus sentiment among Wall Street analysts. These sector 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: The rankings are based on Sabrient’s SectorCast model, which builds a composite profile of each of the ten ETFs 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 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 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.