Sector Detector: Rest and Refuel

We have all heard the old Wall Street adage to “sell in May and go away” until October, as the market historically underperforms in the May-September timeframe. And indeed, after the “bin Laden gap up” at the open on Monday, stocks quickly turned tail. Today, the selling intensified following the disappointing ISM Non-Manufacturing Index for April, with Energy and Materials the hardest hit.

So, with the Fed planning to end its quantitative easing as scheduled in June, it might be time to lock in gains and put away some cash for the summer. However, there still are several positive things for stock investors to focus on:

1. For starters, the Fed will remain accommodative, despite the demise of QE2. They will keep their balance sheet steady by continuing to reinvest maturing assets into the debt markets. They will also keep the Fed Feds Rate near zero. 
2. Although it goes through some fits and starts, the economy is demonstrating real recovery, albeit with little improvement in unemployment. Persistent unemployment, a moribund housing industry, and creeping energy prices all threaten the recovery, but the signs of strength continue to build.
   
3. Corporate earnings continue to strengthen, with earnings beats outnumbering misses by 4 to 1. Analysts are upgrading their earnings projections, and corporate CEOs are giving improving outlooks. Stock prices tend to track the direction of corporate earnings.
4. Valuations are attractive on a historical basis, with 2011 estimates for the S&P 500 indicating a P/E ratio less than 14. 
5. There is still plenty of cash on the sidelines – both with investors as well as in the corporate coffers. With bonds and real estate flat or falling, stocks remain the most attractive (and liquid) alternative.
6. May-September market performance is typically positive during the third year of a presidency.
7. Overall, the Sabrient SectorCast Rankings have a cautiously bullish bent, as discussed below.
8. The chart is still bullish. 

Let’s look at the SPY chart. Up until Monday morning, the SPY was the on fire and its chart was a thing of beauty. But as I pointed out in my Monday morning pre-market commentary, charts are backwards-looking (i.e., historical only), and trends can change quickly for a lot of reasons. After the “bin Laden gap up,” price fell hard to the bottom of the rising channel. And then on Tuesday, it fell below the uptrend support line and is now looking for new support.  I speculated on Monday that failure of the uptrend line could see the SPY fall to 134, and today indeed it bounced very close to there. If 134 fails to hold as support, then the rising (but flattening) 20-day moving average is just below, followed by the 50-day around 132.

Volume is rising on market weakness, and RSI and MACD are rolling over, but I don’t think they will cross over. I think price is forming a bull flag pattern as shown. I see this as likely a brief consolidation of gains and a test of support before heading higher.

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 22.25. Fear as measured by the CBOE market volatily index (VIX) closed at 17.08, which is up significantly from its 52-week lows from last Thursday of 14.27, but still quite low in its normal range (it spiked as high as 48 last May). 

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 observations in this week’s Sabrient’s SectorCast Outlook scores are:

1. Basic Materials (IYM) solidified its place at the top with a dominant Outlook score of 96, as its valuation improved and analysts came through with earnings upgrades. 
2. Healthcare (IYH) remains second with a 75. It remains solid in most of the model factors, with the exception of year-over-year projected growth rate, which is average.
3. Consumer Services (IYC) has risen off the bottom and out of the bottom two, but it was mainly due to falling scores for Utilities (IDU) and Telecom (IYZ). 
4. There is a clear gap between the top four sectors – Materials (IYM), Healthcare (IYH), Financial (IYF), Technology (IYW) – and the other six. If Industrial (IYJ) and Consumer Services (IYC) were ranked a little stronger, the overall rankings would be clearly bullish. As it is, they are cautiously bullish, in my view.

Looking at the Bull scores, Energy (IYE) has reemerged as the strongest during strong markets, followed by Basic Materials (IYM) and Industrial (IYJ). No one else is very close to these three. Consumer Goods (IYK) is the biggest laggard on strong market days, and in fact, IYK is the only one with a Bull score below 50.

As for the Bear scores, we are seeing the weak Bull scores leading and strong Bull scores trailing. Consumer Goods (IYK), Healthcare (IYH), and Telecom (IYZ) are the favorite “safe haven” sectors. Previous favorite Utilities (IDU) continues to lose favor as a safe haven. Energy (IYE) is now the clear laggard on weak market days, reflecting quick abandonment among investors. Industrial (IYJ) and Basic Materials (IYM) are the only other sectors scoring below 50. For a time, Energy was holding up in all market conditions, but worries of severe supply disruptions due to unrest in the Middle East seems to have faded.

Overall, Basic Materials (IYM) still displays the best combination of the three scores. And surprisingly, Telecom (IYZ) now displays by far the best combination of Bull/Bear, perhaps indicating caution among investors. Both its Bull and Bear scores increased significantly over the past week.

Top ranked stocks in Basic Materials and Healthcare include Westlake Chemical (WLK), Freeport McMoRan (FCX), Teva Pharmaceutical Industries (TEVA), and Medco Health Solutions (MHS).

Low ranked stocks in Telecom and Utilities include ViaSat (VSAT), Crown Castle International (CCI), DigitalGlobe Inc. (DGI), and National Fuel Gas (NFG).

These scores represent the view that the Basic Materials and Healthcare sectors may be relatively undervalued overall, while Telecom 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.