Sector Detector: Long/Short ETF Portfolio Strong in Weak Market

Given the recent market weakness, it’s no surprise that Sector Detector’s long/short portfolios have outperformed. This week, Sabrient’s SectorCast-ETF model remains defensive. Of course, the underlying quantitative model isn’t aware that we are entering a time of year that is traditionally bullish. It simply reads the data and tells us which sectors appear to be relatively overvalued.

Latest rankings: Once again, Sector Detector tells us that Healthcare (XLV) has the best valuation. Its score has come down from last week’s impressive 93 (on a scale of 100) to a still-strong 87, powered primarily by its low aggregate projected price to earnings ratio for the constituent stocks.

It also benefits from analyst upward earnings revisions and a solid trailing 12-month return on equity. Consumer Staples (XLP) remains firmly in second place with a score of 82. Top-ranked stocks within these sectors include Cigna (NYSE: CI), CareFusion (NYSE: CFN), Molson Coors Brewing (NYSE: TAP), and Dean Foods (NYSE: DF).

At the bottom, Materials (XLB) is still scoring as the fundamentally weakest sector with a low score of 26. It is saddled with the highest aggregate projected P/E and a negative trailing 12-month return ratios. Industrials (XLI) remains in ninth (of the 10 sectors) with a score of 37. Low-ranked stocks within these sectors include Alcoa (NYSE: AA), Vulcan Materials (NYSE: VMC), Caterpillar (NYSE: CAT), and PACCAR (Nasdaq: PCAR).

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

In the middle of the rankings, InfoTech (IYW) ended its slide in the rankings by getting a few extra positive revisions to its earnings estimates from Wall Street analysts. This helped it rise back up to fourth place as its composite score rose from 54 to 60. Financials (XLF) remains in the middle of the pack, despite the woes of so many of the banks, mainly because of the strength of insurance stocks.

Performance: The table below shows the performance of each of the prior four weekly portfolio as of the market close on Tuesday, 12/08/09. The top-ranked XLV has nicely outperformed the SPY in every portfolio. However, the best performance has come from the shorts—especially XLB.

With the market’s recent weakness, our weekly long/short portfolios are all in the black, easily outperforming a straight long position on the market (represented by SPY). This continues to show how a sound absolute return approach can be effective in any market climate—but particularly during periods of market weakness.

Make money when the market goes down? That should help you sleep better at night.

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

About SectorCast: The rankings are based on Sabrient’s SectorCast model, which builds a virtual profile of each of the 10 ETFs in the table below based on bottom-up scoring of their constituent stocks. The model employs a fundamentals-based multi-factor approach including forward valuation, earnings growth prospects, analyst revisions, and various return ratios.

SectorCast has tested to be highly predictive for identifying the best (most undervalued) and worst (most overvalued) sectors, with a 1-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 8 Select Sector SPDRs, but because the SPDRs combine InfoTech and Telecom into one ETF, I use the two iShares for those sectors rather than the SPDR Select Technology ETF.

About Trading Strategies: Sector Detector has shown how you can use this information in three ways to identify ETFs that have the potential to enhance your upside, downside, or market-neutral trading ideas. First, if you are bullish on the broad market, you can go long the SPDR Trust exchange-traded fund (SPY), which tracks the S&P 500 Index, and enhance it with long positions in SectorCast’s 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 really don't want to bet on which way the market is going, you could try a market-neutral, long/short trade—that is, go long the top-ranked ETFs and short 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.

About Performance Tracking: I track each week’s set of ETFs as a mini-portfolio 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.