Sector Detector: Stocks Seeking Traction in Fits and Starts

The market isn’t making it easy for investors, as a tug-of-war has ensued between the “sell in May” crowd and those who see more upside ahead. Despite the imminent end to QE2 stimulus, mixed economic recovery signs, and plenty of global turmoil, there are many reasons to stay long. Sure, it can be unnerving to see the leading sectors from the bull run making haste to the downside. Nevertheless, when you consider the host of positive trends, the overall technical picture, and Sabrient’s fundamentals-based SectorCast model, they all point to the likelihood of a strengthening stock market rather than a steep sell-off.

For starters, the Fed will remain accommodative, despite the demise of QE2. They will keep their balance sheet steady by continuing to reinvest maturing assets into the debt markets. Regarding corporate earnings reports, beats have outnumbered misses by 4 to 1, and analysts continue to upgrade projections. Valuations are attractive on a historical basis. And there is still plenty of cash on the sidelines and in the corporate coffers.

M&A activity continues. Microsoft this week agreed to buy Skype for $8.5 billion. Although there is concern about why Skype couldn’t follow through on their IPO filing, I think it has more to do with the stand-alone value of their technology and services rather than the overall health of the stock market and its appetite for IPOs.

One smoldering issue that is getting hotter by the day is the Federal debt ceiling.

It is currently limited to $14.29 trillion, but within a matter of weeks Congress will either have to raise it or risk defaulting on obligations. This is one of those no-win situations, like the recent fight over the Federal budget and the associated threat of having to shut down government offices and services. But like the budget situation, there likely will be a last-minute compromise that includes both raising the debt ceiling and some commitment to budgetary concessions.

Oil prices have come down quite a bit, but an expanding global economy will likely stem the fall, and higher oil prices are likely in our near future. That’s not a problem, so long as there isn’t a massive supply disruption that creates a huge spike.

Let’s look at the SPY chart. The bull flag I show almost confirmed itself in textbook manner with a big breakout last Friday, but the late-day pullback had it close right at the upper trend line of the flag, so it needed Monday and Tuesday to confirm, which it did. 

We also can see that today’s pullback puts the SPY right at the convergence of two support lines – the rising trend line since mid-March lows, and the flat line of resistance-turned-support at 134. RSI and MACD remain at important convergence points, and bulls are trying hard to prevent a bearish crossover.

The TED spread (i.e., indicator of credit risk in the general economy, measuring the difference between the 3-month T-bill and 3-month LIBOR interest rates) closed at 24.70. It has been gradually creeping higher, but is still relatively low in its range. Fear as measured by the CBOE market volatility index (VIX) closed at 16.95, which is still quite low in its range (it spiked as high as 48 last May). Neither indicator is flashing warning signs.

Latest rankings: The table ranks each of the ten U.S. industrial sector iShares (ETFs) by Sabrient’s proprietary Outlook Score, which employs a forward-looking, fundamentals-based, quantitative algorithm to create a bottom-up composite profile of the constituent stocks within the ETF. In addition, the table also shows Sabrient’s proprietary 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. Bull and Bear are backward-looking indicators of recent sentiment trend.

As a group, these three scores can be quite helpful for positioning a portfolio for a given set of anticipated market conditions.

The most notable observations in this week’s Sabrient’s SectorCast Outlook scores are:

1. Basic Materials (IYM) remains solidly in first place with an Outlook score of 92, as its valuations continue strong in the face of price weakness while analysts reaffirm their projections for stocks in the sector. 
2. Healthcare (IYH) remains second with a 74. It is solid in most of the model’s factors, with the exception of year-over-year projected growth rate, which is average. We continue to find excellent individual stock plays in this sector.
3. Telecommunications (IYZ) has risen off the bottom and out of the bottom two, as it continues to shuffle around in the bottom three with Utilities (IDU) and Consumer Services (IYC). In fact, there has been quite a wide gap in Outlook scores between the top seven sectors and the bottom three. This week, Industrial (IYJ) is seventh with a 47, which is well above eighth-ranked IYZ with a 23. 
4. The Outlook rankings continue to reflect a bullish bent, with Basic Materials (IYM), Healthcare (IYH), Financial (IYF), and Technology (IYW) leading the way, followed by Energy (IYE). If Industrial (IYJ) and Consumer Services (IYC) were ranked a little higher, and if Healthcare (IYH) and Consumer Goods (IYK) were a little lower, the overall rankings would be clearly bullish. But as it is, the SectorCast model appears to be cautiously bullish.

Looking at the Bull scores, Energy (IYE) has reemerged as the strongest during strong markets, followed by Basic Materials (IYM) and Industrial (IYJ). Surprisingly, Telecom (IYZ) continues to strengthen in its Bull score. Consumer Goods (IYK) is the biggest laggard on strong market days.

As for the Bear scores, Healthcare (IYH), Telecom (IYZ), and Consumer Goods (IYK) are the favorite “safe haven” sectors. Energy (IYE) and Basic Materials (IYM), which have led the bull charge, are now the clear laggards on weak market days, reflecting quick abandonment among investors. Industrial (IYJ) is the only other sector scoring below 50. For a time, Energy was holding up in all market conditions, but worries of severe supply disruptions due to unrest in the Middle East seems to have faded.

Overall, Basic Materials (IYM) still displays the best combination of the three scores. And surprisingly, Telecom (IYZ) has strengthened in its position as having by far the best combination of Bull/Bear, scoring with the same levels that Energy previously did. 

Top ranked stocks in Basic Materials and Healthcare include Innospec (IOSP), Domtar Corp. (UFS), Teva Pharmaceutical Industries (TEVA), and Humana (HUM).

Low ranked stocks in Utilities and Consumer Services include DigitalGlobe Inc. (DGI), National Fuel Gas (NFG), StoneMor Partners (STON), and Media General (MEG).

These scores represent the view that the Basic Materials and Healthcare sectors may be relatively undervalued overall, while Utilities 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 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.