Sector Detector: Market bracing for an election move

The market continues to dwell in a zone of consolidation in a virtual tug-of-war between the bulls & bears. Bears think the market needs to prove itself by testing key support levels and working off its overbought technical indicators. Bulls think that improving earnings and economic indicators (such as today’s consumer sentiment reading), coupled with the Fed’s explicit willingness to pump money into the system, gives the market plenty of fuel to continue its rise.

One big point of uncertainty that will soon be resolved is the election, although the bulls already have been using the expectation of Republican victories as yet another reason to stay bold—so we might see a sell-the-news event if it transpires rather than a big rally.

 
Last week ended with a volume whimper on Friday, achieving only about the same volume as Columbus Day, which was a bank holiday. Monday and Tuesday of this week were relatively light, too. Lower volumes make the technical picture harder to read.
 
The SPY has been consolidating around 118 for several sessions, and Monday’s run at 120 was short-lived. Each attempt to cycle back down to test support levels has been quickly rebuffed. With the Fed making it clear that they stand ready to pump money into the system, and with the money clearly finding its way into equities, the bulls have been stomping and snorting with little fear while the bears have remained in hibernation.
 
The charts have been displaying various bearish-looking candlestick formations such as “hanging man,” “spinning top,” and “doji,” which when occurring after a sustained advance usually signal an imminent change in trend. But all the market has been doing is give head-fake sell-offs before overwhelming the bears, and we are left just talking yet again about a possible trend change in the works. Still, the market is far above its 50-day moving average, making a reversion-to-the-mean more likely, and the MACD is still flat-lining at the top of its range, overdue for a cycle back down. I'm still anticipating a bearish move to confirm these indicators, which should include a retest of resistance-turned-support at 115.

After dropping to as low as 17.90 recently, the VIX is now fluctuating between 19 and 21 (note that 21 used to be the bottom of its range of 21-28). Also, the TED spread (i.e., indicator of credit risk measuring the difference between the 3-month T-bill and 3-month LIBOR interest rates) is still comfortably at the low end of its range, reflecting a lack of fear. Today, it closed at 16.17. Both indicators remain low, and complacency (or a lack of fear) still carries the day as market participants enjoy the tummy-comfort of Fed support.

Also, the major indices of course remain well above their 50 and 200-day moving averages, with the 10-day actually providing consistent support. And, of course, corporate cash continues to be put to work with the acquisitions of strong, well-positioned, undervalued companies.
 
Latest rankings:  Sabrient’s SectorCast-ETF fundamentals-based quantitative rankings has been creeping slowly towards a more optimistic slant, but this week it appears to have turned ever so slightly conservative again. This reflection of analyst uncertainty in forward projections seems to be the way things are gonna be for awhile.

Technology (IYW) continues to score well, but it again has slipped below Healthcare (IYH) by three points. IYW scores an 81 to the 84 for IYH. These two ETFs have been the clear leaders for some time now, followed closely by Financials (IYF) with a 74. None of the other sector iShares are even close, as defensive play Consumer Goods (IYK) is a distant fourth at 54.

IYH is particularly strong in return on equity, return on sales, and projected P/E (low valuation). IYW remains mostly strong across the board, scoring near the top (on a composite basis across its constituent stocks) in return on equity, return on sales, projected P/E, and projected year-over-year change in earnings. Its score has come down over the past several weeks from its dominant spot primarily because of fewer analysts increasing earnings estimates.

Top ranked stocks in IYW and IYH include Western Digital (WDC), Seagate Technology (STX), Forest Labs (FRX), and Endo Pharmaceuticals (ENDP).

Unfortunately for the bulls, Consumer Services (IYC) is continuing to drop precipitously, dropping from last week’s 36 all the way down to a 20. It remains in the bottom two along with perennial cellar-dweller Telecommunications (IYZ), which scores a 9 this week (much better than the 0 it had been scoring). IYZ has the highest projected P/E and the worst return on equity.

Low ranked stocks in IYZ and IYC include PAETEC Holding (PAET), SBA Communications (SBAC), MGM Resorts International (MGM), and Amazon.com (AMZN).

These scores represent the view that the Healthcare and Technology sectors may be relatively undervalued overall, while Telecom and Consumer Services sectors may be relatively overvalued, based on our 1-3 month forward look.

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

About SectorCast: Rankings are based on Sabrient’s SectorCast model, which builds a composite profile of each equity ETF based on bottom-up scoring of the constituent stocks. The model employs a fundamentals-based multi-factor approach considering forward valuation, earnings growth prospects, Wall Street analysts’ consensus revisions, accounting practices, 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 ten iShares ETFs representing the major U.S. business sectors

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 prefer not to bet on market direction, you could try a market-neutral, long/short trade—that is, go long (or buy call options on) the top-ranked ETFs and short (or buy put options on) 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.