Sector Detector: Stocks consolidate in hopes of Santa rally

All eyes continue to be on Europe, as they begin yet another critical summit. Traders and investors have grown accustomed to being disappointed by the lack of a comprehensive solution to the European debt crisis each time the leaders convene for these summits. Perhaps we’ll be pleasantly surprised this time...but I wouldn’t count on it. Nevertheless, so long as there is positive momentum, government borrowing costs in Europe, as reflected by bond yields, should stay at manageable levels.

There are still many naysayers who have been predicting the second shoe to drop in the U.S. economy, but I have remained optimistic. The main reason is that I believe in the capitalist system and entrepreneurial spirit to find a way to prevail in the face of what seems at times to be overwhelming odds. Sometimes the fight is just too difficult, and the economy struggles for awhile. But today, that is not the case, and I think the pieces are in place for a Santa rally.

Corporate earnings are strong. Capitalism, entrepreneurism, and the consumer's will to spend remain alive and well—despite the continual push by socialist-leaning demagogues to thwart them with the same failed policies of the past. In a noble but short-sighted effort to help the lesser-haves at the expense of the haves, they seek to redistribute slices of the pie rather than expand the size of the pie so that everyone can have a bigger piece.

It reminds me of something I recall from the 1980s. It was an interview with Yakov Smirnoff, who was a famous comedian from the old Soviet Union, known for his “What a Country!” comedy as the happy U.S. immigrant. In a more serious moment, he made a memorable point about the difference between the capitalist mentality of hope versus the communist mentality of resignation. His analogy went something like this: In the U.S., if a man's neighbor has a goat but he has no goat of his own, he tries to figure out how he can get a goat, too...but in the Soviet Union, if a man's neighbor has a goat but he has no goat of his own, he wants to kill his neighbor's goat so that neither one of them has one.

In this wonderful country of ours, let's not forget that we have the freedom to seek happiness by pulling ourselves up rather than by pulling our neighbor down. Let's replace envy and resentment with inspiration and industriousness.

Now let's look at the charts. The SPY closed Wednesday at 126.73. It has been fighting with resistance at the 200-day simple moving average. After the huge bullish day on Wednesday of last week, Price, RSI, MACD, and Slow Stochastic have pretty much flat-lined this week as the market awaits its next catalyst. We’ll see if the historically strong seasonality kicks in to close the year in the green.

The VIX (CBOE Market Volatility Index – a.k.a. “fear gauge”) closed Wednesday at 28.67. It continues to hold below the important 30 mark, which is bullish for equities, and the recent market action has allowed the VIX to work off some of its oversold technicals without the market having to give up much ground, which is promising. 

Last week I showed a chart illustrating that the TED spread (indicator of credit risk in the general economy, measuring the difference between the 3-month T-bill and 3-month LIBOR interest rates) has kept on climbing virtually straight up since the first of August. After hitting another 52-week at 54.00 on Tuesday, it closed Wednesday at 53.49. Although not nearly so high as the incredible extremes it hit during the 2008 financial crisis, it nevertheless is a far cry from the low-teens earlier this year, and indicates elevated investor worry about bank liquidity and a preference for the safety of Treasuries bonds over corporate bonds.

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.

1. Technology (IYW) continues to lead with an Outlook score of 82. Healthcare (IYH) has returned to the second spot after a brief hiatus, jumping back up to score of 63.

2. Materials (IYM) continues to be held back by the most net downward revisions among analysts, although it still sports one of the best (lowest) projected P/Es. It falls to eighth place as Consumer Services (IYC) overtakes it.

3. Utilities (IDU) and Telecom (IYZ) are in the bottom two again. Stocks within IYC and IYZ are saddled with high projected P/Es. IYZ scores a dismal 7 this week.

4. Seeing IYW, IYE, IYF, and IYJ in the top half is a relatively bullish sign. It would be even better to see IYM and IYC scoring above IYK. I'm not pleased, however, to see only three of the ETFs scoring above 50. That is a relatively bearish sign.

5. Looking at the Bull scores, IYM has been the leader on strong market days, scoring 61, followed by IYE and IYF with a 59. IDU is by far the weakest with a 37. It is notable that IYW is still not one of the leaders on strong market days.

6. As for the Bear scores, IDU is the clear investor favorite “safe haven” on weak market days with a score of 66. IYK is second at 61. IYF carries the lowest Bear score of 39, which means that stocks with this ETF sell off the most on weak market days.

7. Overall, IYW now displays by far the best combination of Outlook/Bull/Bear scores. Adding up the three scores gives a total score of 182. IYE displays by far the best combination of Bull/Bear with a total score of 108, while IYF has the worst combination (98).

Top ranked stocks in Technology and Healthcare include Western Digital (WDC), Procera Networks (PKT), Humana (HUM), and Spectrum Pharmaceuticals (SPPI).

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