Sector Detector: Technology Rises while Basic Materials Falls in Rankings

The stock market has been on cruise control for the holidays, with the bulls teasing the bears occasionally but giving little back. Powered by the Fed’s cash machine, the SPY has continued on its strong December path. The market is now in blue sky territory, and not even China interest rate hikes and lower consumer confidence readings can stop it.

I still think SPY will at least touch its 20-day moving average soon. MACD and RSI have flat-lined high in their normal ranges after futilely trying to cycle back down without giving up much in price. That’s a tough task. Nevertheless, history tells us that these key technical indicators will eventually cycle back down. Also shown in the chart is a performance comparison among SPY, IYE, IYM, and IYW later. I’ll talk more about that shortly.

The market volatility index (VIX) spiked above 18 on Monday after closing as low as 15.45 last Wednesday. It closed today at 17.28, and 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 low within its normal range, coming in at 18.11. Both indicators are relatively low and still reflect complacency, but they have elevated somewhat over the past week.

Latest rankings: In addition to the Outlook Score, which employs a forward-looking fundamentals-based algorithm to create a composite profile of the constituent stocks in each of the ten U.S. industrial sector iShares (ETFs), I am also showing the Bull Score and Bear Score for each ETF.

High Bull score indicates that stocks within the ETF have tended recently toward relative outperformance during particularly strong market periods, while a high Bear score indicates that stocks within the ETF have tended to hold up relatively well during particularly weak market periods.

Many of our clients find the Bull and Bear scores quite handy, particularly when viewed in conjunction with the Outlook Score. As a group, these three scores can be quite helpful for positioning a portfolio for a given set of anticipated market conditions.

Technology (IYW) has risen back to the top with a strong Outlook Score of 89. Healthcare (IYH) holds the second spot with an 83 – well ahead of third place Consumer Goods (IYK), a defensive ETF that scores a 55. Telecommunications (IYZ) remains in the cellar with a 27, and Basic Materials (IYW) has fallen into the bottom two with a score of 34. It is notable that 7 of the 10 iShares score a 50 or below, which indicates to me that the market is getting a little frothy.

Looking at the Bull and Bear scores, Basic Materials (IYM) and Energy (IYE) have tended to perform the best in recent periods of overall market strength, while not surprisingly Utilities (IDU) and Consumer Goods (IYK) have held up the best on weak market days. Technology (IYW) seems to boast the best overall combination of the three scores.

The chart at the top shows a performance comparison over the past six months for the SPY and three sector iShares: Energy (IYE), Basic Materials (IYM) and Technology (IYW). IYM and IYE have consistently garnered the highest Bull Scores, indicating a tendency for outperformance during bullish periods, and indeed they have been outperforming by a wide margin. On the other hand, IYW has consistently scored near the top of the Outlook Score, but its Bull Score has been average, so it continues to show good relative valuation.

The reason IYM and IYE have fallen in the value-intensive Outlook Score is because they have shown high Bull Scores and performed so well during the recent bull market. This divergence indicates that they might be getting ahead of themselves during this strong momentum run.

However, IYW has not been able to break away from the SPY, so it still appears to be undervalued, based on our 1-3 month forward look. IYW remains strong across most all factors in the quantitative model, 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.

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 Outlook Score employs a fundamentals-based multi-factor approach considering forward valuation, earnings growth prospects, Wall Street analysts’ consensus revisions, accounting practices, and various return ratios. It has tested to be highly predictive for identifying the best (most undervalued) and worst (most overvalued) sectors, with a one-month forward look.

Bull Score and Bear Score are based on the price behavior of the underlying stocks on particularly strong and weak days during the prior 40 market days. They reflect investor sentiment toward the stocks (on a relative basis) as either aggressive plays or safe havens. So, a high Bull score indicates that stocks within the ETF have tended recently toward relative outperformance during particularly strong market periods, while a high Bear score indicates that stocks within the ETF have tended to hold up relatively well during particularly weak market periods.

Thus, ETFs with high Bull scores generally perform better when the market is hot, ETFs with high Bear scores generally perform better when the market is weak, and ETFs with high Outlook scores generally perform well over time in various market conditions.

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.