Sector Detector: Rankings freeze as market takes a needed breather

Last week ended with a thud as concerns about the Financial industry's foreclosure processes put a damper on the party that Google was trying to throw for everyone. Then on Monday, the bulls tried to overwhelm the bears before they can gain any traction, but today’s news about China raising rates sent the dollar surging and precious metals and oil tumbling, which finally gave the bears the artillery they needed to force some overdue profit-taking. Also, it is notable that we are seeing increasing volume. Higher volumes make the market more difficult to manipulate.

Nevertheless, the bulls have consistently managed to keep the bears at bay since the beginning of September, so there’s a lot of work that the bears have in front of them. Friday's trading in the SPY produced what I interpreted to be a bearish "hanging man" candlestick formation on the daily chart, which when occurring after a sustained advance usually signals a change in trend. Tuesday seems to have confirmed that trend change…for the moment.

Combined with the likelihood for "mean reversion" (given how far above the moving averages　price had become) and　the observation that MACD had become overdue for a　cycle back down, the market has been past due to take a breather and re-confirm its bullish support levels.　I would expect at least a retest of SPY resistance-turned-support at 115 (it closed today at 116.73).

Last week, the Fed reiterated that they stand ready to do whatever it takes to keep the economy moving forward, and that has been keeping the bulls　blissfully　optimistic. But it's still not at all clear　whether their intervention is only "bubblegum in the dam leak" that is merely setting us up for a Volcker-era type of currency devaluation and hyper-inflation—or worse, the stagflation that preceded it, which would be the worst outcome of all.

The financial sector seems to have stemmed the bleeding for the moment from the "Foreclosure-gate" revelations last week involving false documents and forged signatures. The delays in new foreclosure proceedings could cost as much as $2 billion per month and hurt the fledgling housing recovery—and by extension, the entire global economic recovery.

FDIC head Sheila Bair said if foreclosure documentation is procedural rather than fundamental, she doesn't expect the impact to be significant. But if this turns into a major legal issue, it could impact the giant mortgage backed securities market to the extent that they lack clear title to the homes backing the securities.

The Fed plans to continue purchasing at least $5-8 billion per week in Treasuries from Wall Street primary dealers via its Permanent Open Market Operations (POMO), which the primary dealers have been pumping into the equity and commodity markets. Although the old slogan, "Don’t fight the Fed," is generally true, one would prefer that the Fed’s intervention would actually stimulate economic activity…and not just artificially prop up the market.

After hanging around near the bottom of its 21-28 trading range, the VIX volatility index (measure of investor fear) dropped precipitously through support last week to as low as 17.90. Today, however, it spiked above 21 and closed at 20.63. Nevertheless, the VIX remains low and complacency (or a lack of fear) still carries the day, as market participants bask in the warm glow of Fed support.

The TED spread (i.e., indicator of credit risk measuring the difference between the 3-month T-bill and 3-month LIBOR interest rates) is still comfortably at the low end of its range, reflected a lack of fear. It has bounced around from 13 up to 17.5, and today closed at 15.42.

Also, the major indices of course remain well above their 50 and 200-day moving averages. And corporate cash continues to be put to work acquiring strong, well-positioned, undervalued companies.

Latest Rankings:  Sabrient’s SectorCast-ETF fundamentals-based quantitative rankings of the ten U.S. business sector iShares is virtually frozen at current scores. It still reflects the same generally defensive bias. And once again, this week we see only minor scoring changes from last week. The evolving　trend towards gradually improving optimism for the economy and the market seems to be stuck at this level—at least until there is greater visibility. This might be way things remain for awhile.

Technology (IYW) continues to score well, and after giving up the top spot to Healthcare (IYH) last week, it moves back on top this week by 1 point with a the same score as last week of 82. IYH drops into second place with a 81 score, but these two ETFs are essentially running in place right now. Financials (IYF) keeps its hold on third place, scoring 72 again this week. 

IYW remains mostly strong across the board, scoring highly (on a composite basis across its constituent stocks) in return on equity, return on sales, projected P/E, and projected year-over-year change in earnings. Its score has come down over the past several weeks from its dominant spot primarily because of fewer analysts increasing earnings estimates. IYH continues strong in return on equity, return on sales, and projected P/E (low valuation).

Top ranked stocks in IYW and IYH include Seagate Technology (STX), Lexmark (LXK), Forest Labs (FRX), and Humana (HUM).

Unfortunately for the bulls, Consumer Services (IYC) lost a few points this week to fall back into the bottom two with a score of 36, along with perennial cellar-dweller Telecommunications (IYZ), which once again scores 0. IYZ has the highest projected P/E and the worst return on equity.

Low ranked stocks in IYZ and IYC include Crown Castle International (CCI), SBA Communications (SBAC), MGM Resorts International (MGM), and Amazon.com (AMZN).

These 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:  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 model employs a fundamentals-based multi-factor approach considering forward valuation, earnings growth prospects, Wall Street analysts’ consensus revisions, accounting practices, 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 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.