Sector Detector: Seeing rotation in fundamentals
As earnings season gets underway with mixed results but a generally positive trend, Wall Street analysts are coming out with upgrades and downgrades to earnings estimates that are significantly impacting our sector rankings this week.
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. Overall, the model still looks mostly bullish – despite the apparent ongoing uncertainty indicated by the tight relative scoring across the sectors, and despite today’s sell-off. On the one hand, Financials and InfoTech have strengthened, which is bullish, but on the other hand Consumer Discretionary and Industrials have weakened somewhat.
Latest rankings: This week, we have new ETFs at the top and bottom of the rankings. Although Healthcare and Energy only lost a couple of points each, Financials (XLF) and InfoTech (IYW) jumped significantly, mostly due to big moves in one factor: the percentage of analysts increasing earnings estimates. Both sectors showed marked improvement in this important metric. XLF and IYW each rose by 6 points this week, scoring a 70 and 69, respectively. 
XLF also shows strength in projected price/earnings ratio, while IYW has strengthened in return on equity and return on sales.
Top-ranked stocks within XLF and IYW include Chubb Corp (NYSE: CB), Goldman Sachs (NYSE: GS), Seagate Technology (Nasdaq: STX), and Western Digital (NYSE: WDC).
In the middle of the pack, Consumer Discretionary fell 9 points, mostly due to fewer analysts increasing earnings estimates. But because the metric is still strongly net positive, I don’t look at this as a major negative or bearish indication. Consumer Discretionary is now in a virtual tie with Materials and Consumer Staples on a one-month forward-looking basis.
Telecommunications (IYZ) remains at the bottom of the rankings as it continues to be saddled with the lowest score in projected year-over-year change in earnings across the stocks in the sector. It also has a below-average return on equity and projected P/E. Industrials (XLI) has fallen back into ninth even though it held strong on the number of analysts increasing earnings estimates – because some of the other sectors showed strong improvement in this important metric.
Low-ranked stocks within XLI and IYZ include Textron (NYSE: TXT), FedEx Corp. (NYSE: FDX), Verizon (NYSE: VZ), and Global Crossing (Nasdaq: GLBC).
These scores represent the view that Financials and InfoTech stocks may be relatively undervalued overall, while Telecom and Industrials 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, 4/27/2010. 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.
With the recent market pullback, the long/short model is holding up nicely compared with a straight long position on the market, which would be negative. This portfolio is well positioned to survive a market correction, which could come on quite suddenly. The XLV has been weak and has held back the long portfolio performance, despite really good fundamentals and guidance. However, XLE has performed nicely, as predicted by the model four weeks ago.
Again, this long/short absolute return model seeks to profit whether the market goes up or down. And particularly with the market’s persistent rally get long in the tooth, it seems like a good bet to stick with this approach.
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: Sector Detector has shown how you can use this information in three ways to identify ETFs that have the potential to enhance your upside, downside, or market-neutral trading ideas. First, if you are bullish on the broad market, you can go long the SPDR Trust exchange-traded fund (SPY), which tracks the S&P 500 Index, and enhance it with long positions in SectorCast’s 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.