Sector Detector: Volatility moderates, but indecision remains
Last week, the stock market gave us epic swings. Bears came out with predictions of global economic meltdown as the market tanked, and then bulls came out trumpeting once-in-a-generation valuations when the market bounced. But, in both directions, the combination of bargain-hunting/short-covering to the upside and capital-preservation/short-selling to the downside led to tremendous momentum that shocked even the most jaded of long-time “I’ve seen it all” market observers. If last week showed us anything it is how quickly modern electronic trading can move the market in momentum fashion—up or down.
Today (Wednesday), Technology started out pretty strong but ended up weak, as Dell (DELL) cast a big pall over the sector. Despite a moderating of the extreme volatility, the VIX is still relatively high, and the Financial sector has been at the forefront. Financials were moderately strong today, but the sector led to the downside on Tuesday and to the upside on Monday. And although Sabrient’s SectorCast indicates that the Financial sector ranks the highest on a forward-looking basis, many of the large bank stocks are rated “very aggressive” in their accounting and governance practices, which makes them relatively risky as individual investments. Few carry Buy ratings in the Sabrient Ratings Algorithm.
Investors continue to find some solace in the diversification and ease of trading offered by exchange-traded funds (ETFs). BlackRock reported that the ETF industry in the United States had 1,039 ETFs and assets of $973 billion from 29 providers, as of June 30, 2011. This compares to 846 ETFs and assets of $693 billion from 30 providers one year ago. New exchange-traded funds (ETFs) continue to be filed and launched, with many of them “actively traded” as opposed to passively tracking an index. Still, passively indexed ETFs dominate, and they include those that track “active quant” indexes like Sabrient’s. In fact, Direxion Funds has announced an assortment of ETFs, including two that will track new Sabrient indexes:
http://bit.ly/oHNYFr
There is a lot happening in the news these days.
Google (GOOG) gave the market a boost when it agreed to purchase Motorola Mobility (MMI) at a huge premium. The purchase will give Google a slate of 17,500 patents and another 7,500 patent applications. Apparently the licensing of tech patents has become a highly profitable business. Google had previously bought 1,000 IBM patents, made a failed attempt to buy Nortel Networks’ patent portfolio, and is reportedly considering InterDigital’s (IDCC) 8,800 patents. Google seems to have its sites on Apple’s (AAPL) prowess.
Also, the Republican presidential hopefuls are already jockeying for position ahead of the upcoming election year. It seems that with the election looming, it will be very hard for the Congressional “super committee” tasked with coming up with a budget deal to get much compromise from either side.
Texas Governor Rick Perry has announced his candidacy, and he has come out with guns a-blazing. He said that if Fed Chairman Bernanke printed more money, the act would be “almost treasonous in my opinion,” and suggested that rough Texas justice might be appropriate. This didn’t sit well with either side of the aisle, particularly since Bernanke was appointed by George Bush. NYU economics professor Nouriel Roubini said that “Perry’s Remarks on Bernanke are criminal. This Texan thug is making murder threats on the Fed Chairman.”
Speaking of Roubini, he was the guest at a recent WSJ "The Big Interview” where he said the risk of a global recession is greater than 50% and believes the next 2-3 months will likely reveal its direction. He blames "deleveraging" in indebted nations and projects that austerity programs in European nations will likely lead to recession. Whether you agree with him or not, certainly the situation in Europe and the U.S. debt and budget problems have no easy fix.
On that note, it's interesting that the Reagan Ranch near Santa Barbara hosted a 30th anniversary celebration of the Economic Recovery Act of 1981 last week. Art Laffer, President Reagan's supply-side economics guru, was the guest speaker. He believes that government spending is equivalent to taxation and thus destroys the economy. Here is his WSJ piece from last June in which he predicted much of what has since transpired:
http://on.wsj.com/ocjptf
Laffer's five steps to economic growth are:
1. 12% flat tax – both on business net sales (value-added) and on personal unadjusted gross income
2. Spending constraints on Congress
3. Stable U.S. dollar -- to make investments safer against the ravages of inflation
4. Regulatory restraint -- so as to not unduly inhibit business
5. Free trade -- to enable the production efficiencies of "comparative advantage"
Although we are unlikely to see a flat tax replace our byzantine tax code anytime soon, the intent behind each of these steps is certainly attainable. But it would take strong leadership, fortitude, and a lot less political posturing—which will be difficult as we approach an election year.
Despite the threat of renewed recession, we are in an environment in which U.S. corporations (including banks) are making record profits and sitting on record amounts of cash. Most earnings reports have shown companies beating analyst estimates for the second quarter. So, from the standpoint that stocks go up as earnings go up, stocks look relatively cheap, and in fact, analysts are sticking with their forecasts of improving earnings for the third and fourth quarters.
Many of the renowned long-term value investors like Warren Buffett are buying. But that’s not to say that we don’t have more downside, with stocks getting even cheaper. But, there really is no “safe” place to invest right now. Real estate is illiquid and still looking as though the bottom is not yet in. Treasuries are holding up for now despite the U.S. debt downgrade from S&P, but the threat of increasing interest rates will keep downward pressure on bonds. Gold is still on a tear, but few people would speculate on gold with much more than a small portion of their portfolio. The dollar is weakening, so even cash is a poor investment. If you aren’t putting money into the stronger foreign currencies, then solid stocks—particularly those paying a dividend yield and those with strong exposure to overseas markets—appear attractive on a relative basis.
Let’s look at the SPY chart. With extreme levels of fear last week came elevated volume. But volume has come way down this week. RSI is near the neutral line, but MACD is still quite oversold. Bollinger Bands are still wide, but price has moved back inside, which will start to pinch the bands back in a “mean reversion.” SPY closed today at 119.67, while the important 200-day moving average is all the way up around 129.
So, it appears that there is plenty of room for recovery before coming against resistance at the 200-day simple moving average. However, after last Thursday’s big bounce, price and the technical indicators seem to be leveling out and pointing to trader indecision as to whether to go long or short from here. It is hard at this point to say whether the markets have indeed bottomed. But then, that’s part of the challenge in stock trading, and it’s the reason that Sabrient likes to espouse a long/short approach to equity portfolio management.
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 today at 29.08, which is its highest levels in over a year. Also, the CBOE market volatility index (VIX) closed at 31.58, which is back down from the extreme level of 48 that it reached on Monday, August 8. Nevertheless, both TED and VIX are reflecting elevated levels of investor fear.
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.
Here are some observations about Sabrient’s latest SectorCast scores. Overall, there was little movement in the rankings.
1. Financial (IYF) remains at the top of the list, and its Outlook score has moved into the 70s, which is up only a point from last week, but is now 12 points above the next sector. Analysts are still showing support with improved earnings estimates relative to the other sectors. It is also among the top in return on sales, and its projected price/earnings ratio is the lowest (best valuation).
2. With the current market weakness, Financial (IYF), Materials (IYM) and Energy (IYE) all have projected P/Es below 10.
3. Technology (IYW) is now back in second place, although it is technically in a dead heat at 58 with IYE and IYM. Analysts are generally positive on stocks within Tech and Energy, but they are still net down on earnings for stocks within Materials.
4. Utilities (IDU), Consumer Services (IYC), and Telecom (IYZ) remain at the bottom. IYC is still held back by the worst return on sales (poor margins) and a high projected P/E. Stocks within IYZ continue to receive net downgrades in their earnings estimates.
5. Overall, the Outlook rankings remain with a more conservative slant, as the top scores are are still relatively low. However, scores are very slowly creeping up. The resurgence in Financials is a positive sign, but I’d like to see Industrial above 50 along with an improvement in Consumer Services to create a more bullish overall ranking.
6. Looking at the Bull scores, Energy (IYE) is now the clear leader on strong market days, scoring 62. Healthcare is the weakest with a 46.
7. As for the Bear scores, Utilities is the clear investor favorite “safe haven” on weak market days with a score of 64, with Consumer Goods a distant second at 58. Financial now carries the lowest Bear score of 44, indicating quick abandonment during market weakness.
Overall, Financial (IYF) displays the best combination of Outlook/Bull/Bear scores. Adding up the three scores gives it a total score of 171, followed closely by Energy (IYE) at 168. Utilities (IDU) now has the best combination of Bull/Bear with a total score of 111, which is a defensive sign. It is followed closely by Energy (IYE) at 110.
Top ranked stocks in Financial and Technology include MasterCard (MA), MarketAxess Holdings (MKTX), Apple (AAPL), and Baidu (BIDU).
Low ranked stocks in Consumer Services and Telecom include Green Mountain Coffee Roasters (GMCR), Six Flags Entertainment (SIX), CenturyLink (CTL), and SBA Communications (SBAC).
These scores represent the view that the Financial and Technology sectors may be relatively undervalued overall, while Consumer Services 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.