Sector Detector: InfoTech and Energy Hold Top Rankings

Amazingly, the market has given us four major trend changes in the past month alone, which apparently hasn't happened with such frequency in over 10 years. Last week, the market was staring into the proverbial abyss as the S&P 500 incurred the dreaded “death cross,” in which the 50-day moving average of price crossed down through the longer-term 200-day moving average. But alas, rather than fold its tent, the market decided instead to use that event, and its retest of the 2010 lows, as a springboard to a nearly 9% gain (and counting). Afterhours trading today is quite positive after a good report from Intel, which is up a hefty 7% afterhours.

Nevertheless, the 50/200 crossover is still intact for the large caps, so this might be only a short-covering reflex rally that will soon run out of steam as it hits tough resistance levels.

Sabrient’s SectorCast-ETF rankings continue to display remarkable stability. Back in January, after the market had become a bit frothy with speculative optimism in the wake of the bull run off the March 2009 V-bottom, the SectorCast-ETF model took a decidedly conservative turn, with defensive sectors Healthcare, Consumer Staples, and Utilities at the top and Financials, Industrials, and Materials at the bottom. But that has not been the case lately, despite the likes of 50/200 crossovers and other ominous signs of impending doom.

Latest rankings:  As we have come to expect, Information Technology (IYW) once again scores at the top of the rankings with a score of 74. IYW fares the best (on a composite basis across its constituent stocks) in the percentage of analysts increasing earnings estimates, and it ranks high in return on equity, return on sales, and projected year-over-year change in earnings.

The second place spot has been moving around among XLE, XLF, and XLV, but this week we find Energy (XLE) just barely holding on with a score of 66. Despite struggling with analysts reducing earnings estimates, XLE has by far the best score in projected price/earnings ratio (PPE). Its aggregate PPE is now 9.3 (compared with last week’s 8.7 in the midst of extreme market weakness), which easily outdistances the 10.0 of second-place Financials (XLF). XLE is the second highest in projected year-over-year change in earnings (after XLB).

Notably, despite the oversold market rally, Wall Street analysts were somewhat cautious over the past week, with 5 of the 10 sectors showing a net negative in the percentage of analysts increasing earnings estimates – i.e., analysts generally have been reducing estimates for stocks within XLE, XLF, XLB, XLP, and IYZ. Nevertheless, top-ranked IYW has held quite strong on this important metric.

The biggest movement occurred in the middle, with XLF falling from 61 to 54 to switch places with Industrials, which continues to rise in the rankings as its score improved from 54 to 58.

Top-ranked stocks within IYW and XLE include Micron Technology (MU), Xyratex (XRTX), Chevron (CVX), and ConocoPhillips (COP).

Telecommunications (IYZ) remains firmly at the bottom of the rankings with a score of 38. It scores poorly on a composite basis (across the U.S. telecom stocks that make up the ETF) in almost all metrics, particularly projected year-over-year change in earnings across the stocks in the sector, projected P/E, return on equity, and the percentage of analysts increasing earnings estimates.

Consumer Staples (XLP) is solidly back in ninth place with a score of 46, joining IYZ in the short portfolio.

The spread between the top and bottom sector scores remains at 36 for the third week in a row, which is still tighter than the mid-60’s we were seeing earlier in the year. I prefer to see wider top-bottom spreads to provide added confidence in the relative rankings, but this range seems to be the new reality for now – at least until a firmer market trend develops.

Low-ranked stocks within IYZ and XLP include Verizon (VZ), Frontier Communications (FTR), PepsiCo (PEP), and Campbell Soup (CPB).

These scores represent the view that InfoTech and Energy stocks may be relatively undervalued overall, while Telecom and Consumer Staples stocks may be overvalued.

Performance: I have tracked the performance of each of the prior four weekly portfolios as of the market close on Tuesday, 7/13/2010. Each portfolio assumes that the top two ETFs are entered long and the bottom two are entered short, all at the opening prices on Wednesday. Of course, for those who prefer not to sell short, this could be run as a sector rotation strategy – with perhaps the top 3 or 4 sector ETFs long.

As the market has suddenly flipped from crash mode to rally mode, our top-ranked sector ETF (IYW) has outperformed the SPY. However, the more defensive XLV, which held up well during the downturn, has lagged, as you might expect, holding back the relative performance of the 6/23 and 6/30 portfolios. The 6/16 portfolio, which was the only negative portfolio last week with underperformance from XLF, is now in the black as XLF has greatly outperformed over the past week. Last week’s long/short portfolio performed well as it got strong performance from long positions IYW and XLE.

This week’s fundamentals-based quantitative model portfolio has us positioned to thrive in a bull market that favors high-quality stocks, while also being prepared to protect the investor if the market turns around yet again.

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

About SectorCast: The rankings are based on Sabrient’s SectorCast model, which builds a composite profile of each of the ten 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 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 eight 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: 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 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 (2 longs and 2 shorts) 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. You might also watch just the two long positions as a separate long-only sector rotation strategy.