Sector Detector: Weak Market Finds Support

Bulls put up a valiant offensive in the last 20 minutes of trading on Tuesday to push the Dow Jones Industrial Average (DJX) back above the 10,000 level as the month of August came to a close. For the last six days of August, bears either succeeded or gamely tried to penetrate this psychologically important level intraday only to be repelled by the bulls. And then of course today (Wednesday) the market gapped up strongly and stayed strong all day.

In this low-volume trading environment, the bulls have been able to hold support, and today saw a combination of speculating, bottom-fishing, and short-covering such that almost every component of the S&P 500 finished positive on the day. When volume returns over the next week or so, it will be harder to defend. Plus, the technical picture is still not pretty in my eyes.

The bear flag that I described in my blog post on Sunday night (“Where to Next? Technical Analysis of the SPY Chart” http://www.sabrient.com/blog/?p=2048) was confirmed on Monday when the support line gave way. Yesterday, about the only positive aspect in the charts was the possibility of double-bottom support for the major indices, e.g., SPY (105), DIA (100), QQQQ (43), and IWM (59), and that was what happened, with each index now attempting to overtake its 50-day moving average once again. The SPY is now back up to the resistance line of that bear flag pattern.

From a macro standpoint, as David Brown pointed out yesterday in his What the Market Wants post (“Rabid Dog Days of Summer Drawing to a Close” http://www.sabrient.com/blog/?p=2078), things aren’t great. Housing, LEI, GDP, PMI, FOMC, and unemployment reports have been weak or uninspiring. Safe havens like Gold (GLD) and treasuries (e.g., TLT) are still catching a bid lately (although not today).

On the positive side, the VIX volatility index has not displayed a tremendous amount of fear even during the selloffs, and has been range bound between 24 and 28, closing today right around 24. In addition, we’ve seen early indications that the record levels of corporate cash is starting to get put to work to buy strong, well-positioned, undervalued companies. Also, the TED spread (i.e., an indicator of credit risk measuring the difference between the 3-month T-bill and 3-month LIBOR interest rates) remains at the low end of its range, coming in today at 16.58.

With the market showing a desire to bounce from that important support level, it is now at a crossroads -- just as the summer draws to an end, ushering back the senior portfolio managers and expectations for increasing trading volume. We shall see whether it leads to a broad selloff or a fall rally -- or both. For today, the bulls tried to scare off the short sellers. Nevertheless, the near term still looks bearish to me.

Latest rankings:  Sabrient’s SectorCast-ETF ranking of the ten U.S. business sectors is still reflecting a slightly bearish bias. Other than the high ranking for Technology, the current fundamentals-based quantitative rankings continue to reflect a cautious stance among analysts, which I have been reporting to be a moderately bearish sign for the markets.

This week, Technology (IYW) remains the highest ranked ETF with an impressive score of 99, up from 85 last week. IYW is strong across the board, and is far-and-away the best this week (on a composite basis across its constituent stocks) in the percentage of analysts increasing earnings estimates. It is also strong in return on equity, return on sales, and projected year-over-year change in earnings. The second place spot again goes to Healthcare (IYH), although it is still dropping, coming in this week with a 70. It is strong in return on equity, return on sales, and projected P/E.

Energy (IYE) lost its hold on third place to defensive sector Consumer Goods (IYK), which has risen strongly to score a 68 this week. It holds conservative names like Proctor & Gamble (PG), Coca-Cola (KO), Pepsico (PEP), and Philip Morris (PM).

Top ranked stocks in IYW and IYH include RF Micro Devices (RFMD), Lexmark (LXK), Humana (HUM), and Endo Pharmaceuticals (ENDP).

At the bottom of the list, Telecom (IYZ), with the highest PPE and poor return on equity, continues its cellar-dwelling with a score of 9, which is actually up from a score of 1. Joining it in the bottom two yet again is Consumer Services (IYC), scoring a 15 primarily due to tight margins cutting into return on sales. It also scores poorly on the percentage of analysts increasing earnings estimates. Retailers and their Wall Street analysts remain gloomy about the near term outlook. Actually, this week 6 of the 10 ETFs show a net reduction in aggregate analyst estimates.

Low ranked stocks in IYZ and IYC include Crown Castle International (CCI), Sprint Nextel (S), MGM Resorts International (MGM), and Gaylord Entertainment (GET).

These scores represent the view that the Technology and Healthcare sectors may be relatively undervalued overall, while Telecom and Consumer Services 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 model employs a fundamentals-based multi-factor approach considering forward valuation, earnings growth prospects, Wall Street analysts’ consensus revisions, accounting practices, 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 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.