Sector Detector: Stocks spar with the dollar

Basic Materials and Energy have been the leading sectors so far this week, as the overall market continues to seek support, as well as leadership for moving higher. But the dollar seems determined to spoil the party.

Crude oil closed today at $101.32, and the dollar has flattened out a bit after steadily rising most of this month. I believe the dollar’s strength mainly has been due to the announced end of QE2 (freshly minted bills won’t keep flooding into circulation), the sovereign debt woes in Europe, and unrest in so many regions of the world. No matter what you hear about the U.S. losing its status relative to China, when the world looks for leadership, it still looks here first.

However, as the chart illustrates, a weak dollar has been good for stocks, gold, and oil. So, somewhat perversely, market participants tend to root for a weak dollar. The 1-year chart illustrates that stocks, gold, and oil have behaved as virtual mirror images of the dollar (as represented by UUP).

Oil got a little ahead of the others during March-April due to worries about supply disruptions, but has now settled in to the same roughly +25% gain, while the dollar is down closer to -14%, over the past 12 months.

Despite the alternately positive and negative news events, economic reports, and earnings announcements that we hear on a daily basis, it seems that, on balance, things are improving. First off, we survived the weekend “Judgment Day” warnings (although with all of the conflicts, tsunamis, tornados, volcanos, and floods that have been devastating the globe lately, I was beginning to wonder). So, we have that going for us. Furthermore, corporate earnings are at all-time highs, despite ongoing problems in the Financial sector, and we know that stock prices generally follow earnings. Valuations are attractive on a historical basis, with 2011 estimates for the S&P 500 indicating a P/E ratio around 14. And there is still plenty of cash on the sidelines, both with investors as well as in the corporate coffers.  

Given that a strong dollar has been a drag on stocks, some market participants might be concerned that, once QE2 has ended, the Fed will then start planning for the process of re-normalizing toward a Fed Funds rate of 1.0% (from 0.25% today). Such action by the FOMC would result in a much stronger dollar, which theoretically would precipitate a sell-off in stocks and commodities. But that doesn’t appear to be imminent.

Oil price has moderated and doesn’t appear to threaten economic recovery like it did earlier in the year. The Federal debt ceiling is still an issue that must be resolved this summer. The biggest risks remain the contagion of PIIGS sovereign debt, starting with Greece and possibly leading to big dog Spain.

Let's take a look at the SPY chart. It closed last Friday at 133.61, which was right at former resistance turned support around 134 (as shown by the flat line). It was inside the neutral symmetrical triangle (from mid-March), which I expected would break to the upside. Instead, we have seen the SPY fall well below 134 and the bottom line of the symmetrical triangle. However, I also have drawn a longer-term trend line from December 1, which could be lending support. In addition, the market has been regularly using the lower Bollinger Band as a reversal point during its long bull run, and it is at that spot now.

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 20.89, which is still relatively low in its range. Fear as measured by the CBOE market volatility index (VIX) spiked above 20 at the open on Monday, but closed today at 17.07, which is still quite low in its range (it spiked as high as 48 last May).

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.

Here are some notable observations in this week’s Sabrient’s SectorCast Outlook scores.

1. Basic Materials (IYM) remains solidly in first place with a “perfect” Outlook score of 100, as its valuations continue strong in the face of price weakness while analysts reaffirm their projections for stocks in the sector. 

2. Healthcare (IYH) fell 10 points this week into a second place tie with Financial (IYF). Stocks within IYH didn’t get quite the same support from analysts as they have been getting, probably as a result of their strong price performance.

3. Industrial (IYJ) enjoyed a 12-point bump in its Outlook score from 48 to 60, which is a welcome development. And in fact, 7 of the 10 sectors are now scoring above 50, which should be encouraging to the bulls.

4. We now have a 3-tiered ranking, in which IYM leads by a large margin, while six sectors (IYF, IYH, IYW, IYJ, IYK, and IYE) are bunched in a tight range in the middle, and then IDU, IYC, and IYZ remain mired at the bottom.

5. The Outlook rankings continue to reflect a cautiously bullish bent. The bump in Industrial (IYJ) is encouraging, but Consumer Services (IYC) is still quite weak. That is now the only score that is preventing the overall SectorCast rankings from being strongly bullish.

Looking at the Bull scores, Basic Materials (IYM), Energy (IYE), and Industrial (IYJ) tend to lead on the strong market days, which is back to “normal.” Financial (IYF) is the biggest laggard on strong market days, reflecting ongoing uncertainty in that sector, but that shouldn’t continue indefinitely, especially if this market intends to resume its rally.

As for the Bear scores, Utilities (IDU), Healthcare (IYH) and Consumer Goods (IYK) are the favorite “safe haven” sectors. Energy (IYE) and Basic Materials (IYM), which sport the best Bull scores, have been the clear laggards on weak market days, reflecting quick abandonment among investors. 

Overall, Basic Materials (IYM) still displays the best combination of the three scores. And Healthcare (IYH) has the best combination of Bull/Bear. 

Top ranked stocks in Basic Materials and Financial include Polypore International (PPO), Freeport-McMoran (FCX), Delphi Financial (DFG), and American Capital Agency (AGNC).

Low ranked stocks in Telecom and Consumer Services include SBA Communications (SBAC), American Tower (AMT), StoneMor Partners (STON), and amazon.com (AMZN).

These scores represent the view that the Basic Materials and Financial 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 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.