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Sector Detector: Bulls Pause to Celebrate 2-year Anniversary

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Courtesy of Scott Martindale, Senior Managing Director

Today marks the two-year anniversary of the V-bottom that launched an impressive bull market. Since then, the SPY large cap is up about 95%, while MDY mid cap and IWM small cap are up about 135%. Leading sectors include Basic Materials, Industrials, and Financials, which are each up at least 150%. Pretty impressive.

Much of the fuel for the persistent rally has come from QE2, in which the Fed prints money and employs its Permanent Open Market Operations (POMO) to buy Treasuries from the primary dealers in order to keep rates down, and that cash generally goes into equities and commodities. However, QE2 is supposed to end in June, and the promise of a QE3 is dependent upon things like oil prices, which could undo all that the Fed has accomplished in stimulating the economy if they continue to climb much higher. Oil is hanging around the $104 level.

China has already slowed its purchasing of U.S. Treasuries. So, the two main purchasers of Treasuries, China and the Fed, may both be sitting on the sidelines, which makes me wonder where the cash will come from to further the rally. With the market tending towards falling on heavier volume and rising on lighter volume lately, you have to wonder how much more it can run.

The SPY chart pattern since mid-February continues to develop very much like it did from early to late November, when price fell from the upper Bollinger Band, down through the 20-day moving average to the 50-day, and then tried to recover before making another test of support at the 50-day and lower Bollinger Band. Like it did in November, RSI is bouncing along the neutral line, and MACD had a bearish crossover and is now seeking support.

 

Right now, the pattern is consolidating in a pennant shape, which should soon lead to a breakout or breakdown. My guess is that even if it initially breaks down through the bottom of the pennant, it will soon find buyers again.

Fear as measured by the market volatility index (VIX) closed today at 20.22, after reaching above 23 recently. It was as low as 14.86 on February 8. 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) is down from last week, coming in at 22.03. This is still low in its normal range. 

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.

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

There were few changes in Sabrient’s SectorCast model this week. Basic Materials (IYM) remains in the top spot, but only by a point over Technology (IYW). IYM dropped from an Outlook score of 85 to 78, while IYW rose from 73 to 77. IYM has risen spectacularly over the past several weeks, but now seems to have peaked. Healthcare (IYH), Consumer Goods (IYK), and Financial (IYF) round out the top 5 with scores well above 50.

Telecommunications (IYZ) remains at the bottom with an improved score of 17, as the U.S. Telecom companies continue to languish. Utilities (IDU) remains in the bottom two with an Outlook score of 29.

Looking at the Bull scores, Basic Materials (IYM) is now matching Financial (IYF) as the winners during particularly strong markets with a leading Bull score of 59. Stocks within Energy (IYE), Industrial (IYJ), and Technology (IYW) have also tended to perform relatively better during recent periods of overall market strength. These five sectors are clearly the more “offensive” sectors. Healthcare (IYH) and Utilities (IDU) have shown better strength on strong market days, but IDU is still relatively weak, along with Telecommunications (IYZ).

As for the Bear scores, traditionally “defensive” sectors represented by Healthcare (IYH), Utilities (IDU), and Consumer Goods (IYK) not surprisingly have held up well during recent periods of overall market weakness. But Utilities (IDU) remains by far the biggest “safe haven” sector, with Bear score of 65. Energy (IYE) continues to hold the second highest Bear score of 60.

Overall, Basic Materials (IYM) still displays the best combination of the three scores, while Energy (IYE) has distanced itself from the others with the best combination of Bull and Bear scores. The analysts are clearly favoring natural resources, miners, and aluminum and chemical producers. It also illustrates that investor sentiment is bullish on Energy in all market conditions even though it appears to be getting ahead of itself on a forward-looking valuation basis – perhaps reflecting a speculative bet due to unrest in key energy-producing regions of the world. 

IYM is particularly strong in the important metrics of analysts increasing earnings estimates and projected P/E. 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 year-over-year change in earnings, and analysts increasing earnings estimates.

Top ranked stocks in Materials and Technology include Mercer International (MERC), Innospec Inc (IOSP), Rubicon Technology (RBCN), and Brooks Automation (BRKS).

IYZ has by far the highest projected P/E and the worst return on equity, although it scores reasonably well in return on sales. It also continues to be plagued by more analyst earnings downgrades. IDU is particularly weak in projected year-over-year change in earnings and analyst upgrades.

Low ranked stocks in Telecom and Consumer Services include SBA Communications (SBAC), Crown Castle International (CCI), EnerNoc (ENOC), and Clean Energy Fuels (CLNE).

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

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