Sector Detector: Tightening scores reflect uncertainty
After threatening to pullback in the face of overbought technical conditions and low VIX, not to mention the ongoing uncertainty regarding global economic recovery, the market instead went flat for the past two weeks as it continues to be supported by an underlying bid. With improving consumer spending and consumer sentiment metrics, the S&P 500 now has its sights set on 1180 as the next target. Nevertheless, depleted levels of cash among mutual funds and nervous traders ready to protect profits will continue to be a challenge.
Sabrient’s value-oriented and fundamentals-based SectorCast-ETF model is showing conflicting signals, reflecting uncertainty among Wall Street analysts on the one hand, as well as improving relative rankings among some of the more economically-sensitive sectors on the other hand.
Latest rankings: For the fourth week in a row, the top two sectors in SectorCast-ETF are Energy (XLE), 
with a score of 68, and Healthcare (XLV), coming in a close second at 67. However, that’s not to say that the rankings aren’t showing notable movement.
First of all, the rankings have tightened quite a bit. The spread between the top and bottom sectors is only 25 points. Not long ago the spread was around 65. This further reflects uncertainty among analysts regarding future earnings and which sectors are currently undervalued.
XLE boasts the top score in projected year-over-year change in earnings across the sector and also shows the best (lowest) projected price/earnings ratio. But it continued its decline in the percentage of analysts’ positive revisions to earnings estimates. In fact, the numbers show a net downgrade in earnings estimates, as more analysts reduced estimates vs. those who upgraded. This was the main driver in the reduced score from 73 to 68 for XLE. Still, with the uncertainty in the market, that relatively low score was enough for XLE to remain in the top spot.
InfoTech and Consumer Discretionary – arguably the most economically sensitive sectors – jumped from 5th and 6th up to 3rd and 4th, passing Financials and Utilities. After reigning at the top of the rankings for period of time, Financials have performed quite well, but now the valuations and earnings projections are not so compelling as they were several weeks ago, and XLF continues to fall in the SectorCast-ETF rankings. IYW and XLY rose two spots without much of a change in score. Nevertheless, their strong relative ranking, coupled with the rise in Industrials (XLI), is a bullish sign for the overall market.
XLV continues to hold up well in the rankings without any standout scores. It ranks second in both return on equity and projected P/E.
Top-ranked stocks within XLE and XLV include Murphy Oil (NYSE: MUR), Chevron (NYSE: CVX), CareFusion (NYSE: CFN), and Forest Labs (NYSE: FRX).
At the bottom of the rankings, we again find Telecommunications (IYZ). Industrials has continued to improve in the rankings and has now passed up defensive sector Consumer Staples (XLP), which is now one of the bottom two. IYZ came in with a low score of 43 – a significant improvement over last week’s 34, but still leaves it in last place. Although XLP is now in 9th place, it actually has an above average score of 51. Again, this reflects the tight range among the sectors and uncertainty among analysts looking forward.
IYZ had fewer analyst downgrades to earnings estimates this week, which helped it score better. (Actually, it was XLF that had the most analyst earnings downgrades.) But IYZ is saddled with the lowest score in projected year-over-year change in earnings across the stocks in the sector.
Low-ranked stocks within XLP and IYZ include Proctor & Gamble (NYSE: PG), Whole Foods Market (Nasdaq: WFMI), Sprint Nextel (NYSE: S), and Virgin Media (Nasdaq: VMED).
These scores represent the view that Energy and Healthcare stocks may be undervalued overall, while Telecom and Consumer Staples stocks 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, 3/30/2010.
The market has been flat over the past week, and so has the model long/short ETF portfolio. Long position XLF from the 3/3/10 portfolio has shown extraordinary performance. But since XLE has taken over the top spot with its strong valuation, it has only recently begun to show some indication of outperformance. I am expecting April to be friendlier to Energy stocks after a tough March.
As a short position, XLI has been a poor performer, so I’m happy to see it drop out of the model portfolio this week. The other short position IYZ finally began to show the predicted market underperformance over the past week.
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.