Sector Detector: Volatility Reigns, Led by Financials

In case you hadn’t noticed, we have entered a fear-driven stock market. After a huge down day on Monday in reaction to the U.S. credit rating downgrade by S&P, Tuesday brought an incredible sequence of up-down-up price movement, with the final hour giving an unprecedented short-term rally driven by a combination of bargain-hunting and short-covering. Bears were sent back to their caves and bulls snorted with glee that the bottom was in (at least temporarily). But then today (Wednesday) brought it back to the reality that perhaps happy days aren’t quite here again.

All of this has come after last week’s weakness that sent the market to what seemed like extreme oversold levels. As you can see, it can always get more oversold.

The truth is, the FOMC’s announcement on Tuesday that they would keep interest rates low indefinitely merely highlighted the fact that the economy has slowed and they have run out of bullets. They talked about “dramatic risks to the economy,” and they had an unusual number of dissenters (3) to the final decision on rates.

Now we face a situation in which the FOMC has all but admitted that their hands are tied, while the pressure remains on Congress to take on austerity measures to get spending under control. Some observers think that is the wrong approach for a struggling economy.

What more can I say about this week’s craziness? There is no shortage of opinions out there. In fact, it seems those bearish on the market get more emboldened and squawk on Twitter while the market is going down, but then they get quiet as it roars back up, while the bulls get bold in their messages. On balance, I think the airwaves are generally dominated by those with something negative to say. My inclination is to not add much more to the pontificating, but for those of you who tell me that you like to know what I think about it all, I’ll offer a few observations.

First, you would think that S&P’s untimely downgrade of U.S. debt last Friday would have resulted in a flight from bonds and higher interest rates, but the opposite happened, as cash has moved from stocks to bonds. A flight to safety still targets U.S. Treasuries, no matter what S&P has to say about it. The European debt crisis is still the elephant in the room, in my opinion, and France joined the crowd of countries being threatened with a debt downgrade.

There is an element of “snowball effect” in this yo-yo market action, as technical levels trigger sell stops, margin calls trigger more selling, and momentum traders pile in to exacerbate strong directional moves (both up and down). The extreme volatility has been led, both up and down, by the Financial sector. Although the threats to the financial system that arose in 2008 are no longer there, uncertainty still prevails. The CBOE Market Volatility Index (VIX) has moved around wildly and broken out of the lower trading range that it has been in for the past year. After Financials seemed to gain back investor confidence yesterday, today there were renewed concerns about capital levels among the banks, and the sector dropped 7%.

The Federal government is not exactly inspiring confidence in investors anywhere, and the task ahead for the Congressional super-committee will be no easier than it was for Congress as a whole. Europe is even worse off. Nevertheless, this isn't 2008, when scores of “toxic assets” had no verifiable market value when “marked to market,” and a financial collapse seemed possible.

Instead, we have an environment in which U.S. corporations (including banks) are making record profits and sitting on record amounts of cash. Almost 3/4 of companies beat analyst estimates for the second quarter. And although lower oil prices have hurt the Energy sector somewhat, it has been a boon to the global economy.

Also, stocks are relatively cheap. With the recent correction, the S&P 500 is trading at only around 11x estimated earnings for 2012. The elevated level of fear has led to more compelling valuations – in a short amount of time.

There is a difference, of course, between real risks and perceived risks, and fear generated by inflated perceived risks can generate opportunities for those who can keep a level head and focus on the real risks.  Also, the investment concept of “time arbitrage” holds that investors can take a longer term approach at the expense of traders and portfolio managers who must constantly worry about short-term performance. It seems to me that, assuming the global economy is not heading into the abyss, stocks are as oversold as they were in March 2009.

Let’s look at the SPY chart. Volume has been highly elevated during the last few days of volatility. The bullish hammer candlesticks have failed to confirm each time, as the markets have continued lower. Each time it appears that RSI and MACD are highly oversold, they show that they can get even more oversold. And the important 200-day moving average is all the way up around 129.

On the positive side, the “rubber band” has stretched awfully far. Bollinger Bands are extremely wide right now. Tuesday showed how quickly a combination of bargain-hunting and short-covering can move the market back up. A more sustained, multi-day, snap-back rally will happen. It’s just hard 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 27.04. This appears to be the new “normal” range after trading in the mid-teens just a few months ago. Also, the CBOE market volatility index (VIX) closed at 42.99, which was up almost 23% over yesterday’s 35.06, but still lower than Monday’s close of 48. Both are reflecting higher 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.

A few changes in the rankings this week. Here are some observations about Sabrient’s latest SectorCast scores.

1. Financial (IYF) remains at the top of the heap, although with a relatively low Outlook score of 69, which is 5 points higher than last week. Analysts are still coming out 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), having dropped below 10, which has been rare until lately.
2. With the current market weakness, Materials (IYM) and Energy (IYE) also have projected P/Es below 10. IYM holds second place with a 60, the same score as last week.
3. Technology (IYW) has fallen into fourth place, falling 5 points from last week largely due to relatively light support from analysts. Energy (IYE) takes third place with a 58, which is 6 points up from last week, largely on valuation and analyst support after its big pullback.
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.
5. Overall, the Outlook rankings remain with a more conservative slant, as the top scores are only in the 60’s. But after the recent pullback, the scores are creeping up a bit, and would expect to see 70’s again soon. 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, Basic Materials is the clear leader on strong market days, scoring 61. Healthcare and Utilities are the weakest with a 44.
7. As for the Bear scores, Utilities is the clear investor favorite on weak market days with a score of 62, with Consumer Goods a distant second. Basic Materials is the lowest score at 43.

Overall, Financial (IYF) now displays the best combination of Outlook/Bull/Bear scores. Adding up the three scores gives it a total score of 169. Technology (IYW) has the best combination of Bull/Bear with a total score of 107, followed by Utilities (IDU) at 106, which is defensive.

Top ranked stocks in Financial and Materials include MasterCard (MA), Universal American (UAM), Kronos Worldwide (KRO), and Randgold Resources (GOLD).

Low ranked stocks in Consumer Services and Telecom include Equinix (EQIX), Six Flags Entertainment (SIX), Leap Wireless (LEAP), 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.