Sector Detector: Financials holds on to the top ranking

The market continues to flash signs that it wants to breakout, although mixed news has brought on a consolidation for the first two days of the week. Sabrient’s SectorCast-ETF rankings show little change this week, and this unbiased, value-oriented, quantitative model continues to have a bullish flavor by favoring sectors that are more dependent on economic growth, like Financials, InfoTech and Energy, which remain comfortably above the more defensive sectors like Utilities, Consumer Staples, and Telecom.

However, Consumer Discretionary and Industrials remain relatively weak in the rankings, which tempers the optimism a bit. It appears that corporate spending is increasing in anticipation of consumer spending to improve down the road.

Latest rankings: This week, SectorCast-ETF’s top four sectors remain the same as the last two weeks, but with Energy and Healthcare switching places. Financials (XLF) again tops the rankings with a 76 score, and is now followed by Energy (XLE) close behind at 73. In fact, the top four sectors are closely bunched within 5 points of one another.

After selling off more than the other sectors over the past week, XLE now has an even stronger projected price/earnings ratio, which has brought it back into the top two. These two sectors have the lowest projected P/E, and because they are so close (10.0 vs. 10.1), small price moves during the week can easily make them switch positions. XLF also boasts the top score in projected year-over-year change in earnings across the sector.

However, XLF still ranks last in trailing return on equity, while XLE ranks last in trailing return on sales.

Top-ranked stocks within these sectors include Unum Group (NYSE: UNM), Goldman Sachs (NYSE: GS), Marathon Oil (NYSE: MRO), and Diamond Offshore Drilling (NYSE: DO).

At the bottom of the rankings, we again find the fundamentally most overvalued sectors are Telecommunications (IYZ) with a score of 23 and Consumer Discretionary (XLY) at 39. IYZ contains only U.S. telecoms, which are continuing to show an increase in analyst downgrades to earnings estimates. It still ranks lowest in both analyst revisions and projected year-over-year change in earnings. And for its part, XLY continues to display the worst (highest) aggregate projected P/E. The glimmer of hope in Consumer Discretionary is the fact that it ranks second in new analyst upward earnings revisions among its constituent stocks during the week. This is another positive indicator for continued market strength.

Low-ranked stocks within these sectors include Eastman Kodak (NYSE: EK), Pulte Homes (NYSE: PHM), Virgin Media (Nasdaq: VMED), and Sprint Nextel Corp. (NYSE: S).

These scores represent the view that Financials and Energy stocks may be undervalued overall, while Consumer Discretionary and Telecom stocks still may be overvalued.

Performance: The table below shows the performance of each of the prior four weekly portfolios as of the market close on Tuesday, 2/23/10.

At the moment, none of the prior four weekly long/short portfolios is faring very well against a straight long positions in the SPY. This type of thing can happen from time to time…but rarely for long. Sabrient’s SectorCast relative ranking model used within an absolute return portfolio has generally proven to be effective in capturing the positive performance spread between the top and bottom-ranked sectors, no matter the market direction.

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.