Sector Detector: A "Healthy" Change

This week, the Healthcare sector moves to the top of Sabrient’s SectorCast rankings, making for a “healthy” change. A back-tested, fundamentals-based quantitative model, SectorCast is quite useful for identifying the best (most undervalued) and worst (most overvalued) sectors, with a one-month forward look. This week, I’m making one final change to how I’m incorporating the model into Sector Detector.

The basic SectorCast model scores and ranks all stocks in the Sabrient database that are components of a given sector. However, many of these are ADRs of foreign companies that are not constituents of the ETFs that I am using in this column. As it turns out, those ADRs can have a significant impact on the sector composite score, so I’m going to use the SectorCast-ETF score rather than the overall sector score. This impacts Telecom again this week, since some of the top-rated telecoms are foreign ADRs that are not included in the IYZ iShares Telecom ETF.

New rankings: This week, SectorCast-ETF is telling us that Healthcare (XLV) has the highest score of 81, followed by Consumer Staples (XLP) at 67. Top-ranked stocks within these sectors include UnitedHealth (NYSE: UNH), Biogen (Nasdaq: BIIB), Safeway (NYSE: SWY), and Reynolds American (NYSE: RAI).

At the bottom are Consumer Discretionary (XLY) with a low score of 45 and Materials (XLB) at 48. Low-ranked stocks within these sectors include Abercrombie & Fitch (NYSE: ANF), Harman (NYSE: HAR), Alcoa (NYSE: AA), and Vulcan Materials (NYSE: VMC).

These scores represent the view that Healthcare and Consumer Staples stocks may be undervalued, while Consumer Discretionary and Materials stocks may be overvalued.

If you have a bullish bias on the broad market, you can go long SectorCast’s top-ranked sector ETFs. Conversely, if you are bearish, you can short (or buy put options) the two lowest-ranked sector ETFs. However, if you really don't want to bet on which way the market is going, you can do both with a market-neutral, long/short trade that attempts to profit no matter which way the market goes. This is commonly called “absolute return.”

And to further juice performance, you might consider trading some of the strongest and weakest stocks from within those top and bottom-ranked ETFs—like the ones I identified above.

As for performance tracking, I’ll track the given set of ETFs as a mini-portfolio each week 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.

Looking at last week’s portfolio (IYZ/XLP long and XLI/XLB short) after one week: IYZ is down 2.74%, XLP down 2.12%, XLI down 3.83%, and XLB down 4.87%. They are all down, but the long positions are down much less than the shorts, which allows the trader to capture the performance spread. This illustrates the benefit of an absolute return strategy.

Simply looking at these returns in dollar terms (assuming $1,000 per ETF position), a market-neutral long/short (with shorts margined against $2,000 all-cash longs) would have gained $38 (+1.9%). For comparison, putting $2,000 into the SPY would have lost $51 (-2.5%).

Because of the change to SectorCast-ETF scoring rather than overall sector score (including ADRs), I won’t track last week’s portfolio any further. But I’ll track today’s portfolio (XLV/XLP long and XLY/XLB short) for the next 4 weeks.

Disclosure: Author has no positions in stocks or ETFs mentioned.