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Sector Detector: Quant Easing Back on the Table

Posted on the 14 July 2011 by Phil's Stock World @philstockworld

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Courtesy of Scott Martindale, Senior Managing Director, Sabrient

After an 8-day bull run through last Thursday, the market has been consolidating those gains and trying to determine its next move. Mixed economic news has given the market both optimism and pessimism. Last Thursday’s promising ADP Employment Report gave way to Friday’s disappointing unemployment rate, showing an increase to 9.2%. Unemployment remains unacceptably high despite the expensive stimulus packages, and the Congressional fight rages on about how to handle the problem with the Federal debt ceiling. On the other hand, China’s torrid growth report gives hope to the state of the global economy.

But the big news today was Ben Bernanke’s testimony on Capitol Hill that the Fed stands ready to provide additional stimulus (read: QE3) if necessary, although it is far from unanimous among the Fed governors, particularly the inflation hawks. When QE2 ended at the close of June, the market kept on rallying without a hitch. Although no further dollars were to be printed and put into circulation, the dollars that already out there will keep circulating for the foreseeable future, and that seemed to be enough. Now it is all being reconsidered.

This is a tacit admission that the Fed underestimated the pace of economic recovery. The dollar weakened on the news (after recently strengthening on a flight to safety, given credit woes in Europe), and gold spiked to new highs. But despite the big drop in the dollar and an initial pop in stock prices, at the end of the trading day today, stocks were only up only slightly. The reality is that consumers drive economic growth long term, and they require both jobs and the “wealth effect” of rising asset prices—primarily housing. Although Federal stimulus has propped up the stock market, the primary engine for the wealth effect is real estate, and this asset class is showing no signs of life. Coupled with the dearth of new jobs, it appears that consumer spending doesn’t stand much of a chance.

As the market consolidated over the past week, Utilities and Healthcare have held up best, while Industrial, Financial, and Tech have lagged. Tech has been particularly weak this week.

Let’s examine the SPY chart. It made a double-bottom in June at the 200-day moving average followed by a textbook rise back to the upper Bollinger Band. Now it appears to be consolidating gains and clinging to support at the convergence of prior support at 132 and the 50- and 100-day simple moving averages while forming a bull flag pattern—all of which I suggested last Wednesday it might try to do. RSI and MACD are trying to hold the line and perhaps turn back up.

Sector Detector: Quant Easing Back on the Table
 

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 25.43, which is slightly above its recent 20-25 trading range. Last week, I suggested that it might be forming a bullish ascending triangle, and this might be the breakout through resistance, which is an indication of elevated levels of fear. The CBOE market volatility index (VIX) closed at 19.91 and has reached above 20 for the first time this month, after falling to as low as 15.12 several days ago. This indicator also is reflecting rising levels of investor fear.

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.

Sector Detector: Quant Easing Back on the Table

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

1. Technology (IYW) fell 19 points to an Outlook score of 76, barely clinging to second place ahead of Healthcare (IYH), as its long-term growth rate and projected P/E have fallen relative to the other sectors. 

2. Basic Materials (IYM) returns to the top spot with an Outlook score of 82. It carries a strong projected P/E and return on equity. The sector has been a leader in this market rally, as reflected by its leading Bull score of 63. 

3. Financial (IYF) remains moribund in both the rankings and in actual performance. It is the only sector that is still below all of its major daily moving averages, even though it carries the best aggregate projected P/E, which reflects favorable valuations at current levels. Investors appear to be unconvinced as analysts continue to downgrade forward estimates.

4. Utilities (IDU) and Telecom (IYZ) remain near the bottom as they receive little enthusiasm among analysts and relatively high projected P/E (unfavorable valuations). 

5. Although its overall Outlook score is modest, Consumer Services (IYC) continues to get the bulk of the analyst upgrades and still sports one of the highest projected long-term growth rates. It is held back primarily by the worst return on sales (poor margins) and a high projected P/E.

6. Overall, the Outlook rankings are moving away from a cautiously bullish stance to more of an uncertain status, in my opinion. Only 3 of the 10 sectors have Outlook scores above 50.

7. Looking at the Bull scores, Basic Materials (IYM) and Energy (IYE) are clearly the leaders on strong market days with scores of 63 and 62. Utilities (IDU) is the weakest with a 39. 

8. As for the Bear scores, Utilities (IDU) is the clear investor favorite on weak market days with a score of 62. Basic Materials (IYM), which has the best Bull score, has been the laggard on weak market days along with Financial (IYF), Technology (IYW), and Industrial (IYJ). 

Overall, Basic Materials (IYM) displays the best combination of Outlook/Bull/Bear scores. Adding up the three scores gives it a total score of 187. Energy (IYE) now has the best combination of Bull/Bear with a total score of 108.

Top ranked stocks in Basic Materials and Technology include Kennametal (KMT), Sociedad Quimica y Minera de Chile (SQM), KLA-Tencor (KLAC), and Apple Inc. (AAPL).  

Low ranked stocks in Utilities and Telecom include Cheniere Energy Partners (CQP), Calpine (CPN), SBA Communications (SBAC), and DigitalGlobe Inc. (DGI).

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