Sector Detector: Rankings Tighten as Global Uncertainty Reigns

Despite a weak bounce off of a scary Tuesday morning gap down, and generally positive action for the week, the market remains in a precarious position. Many market technicians are predicting weakness ahead – either during June or later this summer. And in fact, the subtle bullish sentiment reflected by the Sabrient’s SectorCast-ETF rankings over the past few months has moderated a bit this week.

Market volatility is the norm now, with the VIX back above 35. The Dow and S&P 500 both found resistance when they tried to recapture their 200-day moving averages, but interestingly, the Nasdaq 100 (QQQQ) and the Russell 2000 (IWM) are holding strong above theirs, which is bullish. Nevertheless, there seems to be more room to the downside than upside at the moment.

Sabrient’s quantitative SectorCast-ETF rankings are getting squeezed by the global uncertainty. With no technical factors in the model, the weekly rankings tend to be pretty stable, but consensus sentiment among Wall Street analysts plays an important role in the model, and analysts are showing some caution and concern lately.

Although the model continues to reflect relative optimism with the more economically sensitive sectors remaining relatively strong in the rankings, the tightening scores is a yellow caution flag.

Latest rankings: Once again, the top and bottom-ranked sector ETFs remain the same. Information Technology (IYW) and Energy (XLE) remain at the top, but both slipped in their scores, as did most of the higher ranked sectors. IYW is now firmly ahead of XLE by six points, with a score of 69 versus 63 for XLE. The biggest change is with Materials (XLB), which got hit with a wave of analyst downgrades, falling from a 63 last week to a 46 this week (17 point drop!), to move from a strongly positioned fifth place all the way down to a tie for eighth place with Consumer Staples.

IYW is still strong 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. XLE remains strong in projected price/earnings ratio and near the top in projected year-over-year change in earnings, even though it got hit with some earnings downgrades this week.

Top-ranked stocks within IYW and XLE include ON Semiconductor (Nasdaq: ONNN), Lexmark (NYSE: LXK), Marathon Oil (NYSE: MRO), and Hess Corp (NYSE: HES).

Although it remains in the Sector Detector cellar, Telecommunications (IYZ) came on strong this week, jumping from a feeble score of 33 all the way to a 45, almost entirely due to some analyst upgrades (while most other sectors were seeing downgrades in earnings estimates). Nevertheless, it remains weak in its projected year-over-year change in earnings across the stocks in the sector, projected P/E, and return on equity.

Also remaining in the bottom two this week is Consumer Staples (XLP). Although its score remained the same while Materials (XLB) dropped down into a virtual tie, I kept XLP in the model portfolio rather than introduce XLB just in case the huge drop in XLB was a one-week aberration. XLP sports the best return on equity, but remains relatively weak in all other metrics.

After widening to 38 last week, the spread between the top and bottom sector scores narrowed considerable this week to 24 as uncertainty reigns. As I’ve been reporting, I prefer to see wider top-bottom spreads to give me added confidence in the relative rankings.

Low-ranked stocks within XLP and IYZ include Whole Foods Market (Nasdaq: WFMI), H.J. Heinz (NYSE: HNZ), Sprint Nextel (NYSE: S), and LEAP Wireless (Nasdaq: LEAP).

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

Performance: The table below shows the performance of each of the prior four weekly portfolios as of the market close on Tuesday, 6/1/2010. 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 short, this could be run as a sector rotation strategy – with perhaps the top 3 or 4 sector ETFs long. 

Overall, although each of the long/short portfolios are down, they are still holding up much better than the overall market. IYW continues to show relative strength, but unfortunately XLE has been taking it on the chin despite strong valuations, most likely due to the ongoing catastrophic spill in the Gulf of Mexico. The generally bullish bias of the rankings has prevented us from profiting in this downdraft.

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.