Sector Detector: Technology Reasserts Itself

December must have ushered in the cavalry, because the market busted out big time today after closing November looking like it was quite ready to sell off. I have been looking for a big move during this consolidation period, and today seems to indicate that it will be a breakout rather than a failure. But one day does not make a trend. We now await bullish confirmation, which has been elusive ever since the big post-election apparent breakout. In fact, the market has preferred to test support from its 40- and 50-day moving averages rather than seriously threaten any resistance levels.

On the Tuesday before Thanksgiving, the market lost support at Nasdaq 2500 after losing S&P500 1200 the week before, and it was testing support at the psychologically important Dow 11,000. It then regained Nasdaq 2500 but then continued to consolidate just under the S&P500 1200 level before threatening to breakdown significantly this week. But today changed that negative picture entirely.

I have been talking for several weeks about how the SPY chart is shaping up for the past 4 months almost identically to the first 4 months of the year. As shown on the attached chart, the break of the 40-day moving average on Tuesday seemed to correspond to the similar break on May 4, and suggested that a similar selloff might be in the offing. But rather than another “flash crash” like we had on May 6, the market consolidated and the broke upwards today. However, I am wondering if this move lines up with the recovery that occurred immediately following the May flash crash, as shown in the circled areas. It is occurring at a higher point than it did in May, but of course that was because it had fallen so far. We still might be in a similarly developing pattern that will play out in the next few days.

I have been expecting a retest of prior resistance-turned-support at SPY 115 and then 110. It might be delayed by the holiday season…or it might not happen at all. To be sure, there are plenty of market observers calling for the start to a very strong and sustained rally.

I’m still prepared to see further downside in the near term.

After spiking during Tuesday’s weakness to almost 24, the market volatility index (VIX) fell hard today to as low as 20.40 before drifting higher all day to close near its high at 21.36. 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) remains very low in its normal range, clocking in at 14.62, reflecting complacency among bond investors.

Latest rankings:  Sabrient’s fundamentals-based quantitative SectorCast ETF rankings are holding mostly stable. Healthcare (IYH) still holds the top spot, but Technology (IYW) is reasserting itself. Overall, the rankings still reflect a cautious bias on the market, as traditionally defensive sectors like Healthcare, Consumer Goods and Utilities continue to show up in the top 5, and the more economically-sensitive sectors like Energy, Industrial, and Consumer Services rank in the bottom 5 with scores below 50.

Healthcare (IYH) stays flat with an 87 this week, while Technology (IYW) jumps from 74 to 82, and Financial (IYF) moves up from 64 to 69. IYH continues strong in return on equity, return on sales, projected P/E (low valuation), and analysts increasing earnings estimates that really drove its dominant ranking. IYW remains pretty strong across the board, too, scoring highly (on a composite basis across its constituent stocks) in return on equity, return on sales, projected P/E, projected year-over-year change in earnings, and analysts increasing earnings estimates. In fact, while analyst upgrades tapered off among the other sectors, stocks within IYW held strong among the analysts.

Top ranked stocks in Healthcare and Technology include Kinetic Concepts (KCI), Endo Pharmaceuticals (ENDP), Xyratex (XRTX), Flextronics (FLEX).

Telecommunications (IYZ) remains at the bottom with a score of 13, and Consumer Services (IYC) remains in the bottom two with a score of 21, although analysts continue to show some boldness with increased earnings estimates for stocks in the sector. IYZ has by far the highest projected P/E and the worst return on equity. It also has the least support from analyst earnings revisions. And it is still a bit disconcerting to me that Energy (IYE) has been scoring so poorly, although it appears to have stabilized somewhat, scoring 34 compared with its 36 last week.

Low ranked stocks in Telecom and Consumer Services include Sprint Nextel (S), Crown Castle International (CCI), Barnes & Noble (BKS), and MGM Resorts (MGM).

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.