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Sector Detector: 1999 Redux?

Posted on the 29 March 2012 by Phil's Stock World @philstockworld

Sector Detector: 1999 redux?

Despite Wednesday’s stock market weakness, selling remains contained. Round-number resistance-turned-support levels at 13,000 on the Dow, 3000 on the Nasdaq, and 1400 on the S&P 500 have held up. The S&P was the last to breakout and the first to test support. In fact, it has been testing support at 1400 almost every day since it broke out two weeks ago.

For its part, the Nasdaq 100 Index, which is tracked by PowerShares QQQ Trust (QQQ) and is dominated by Apple (AAPL), has held up the best. In fact, as AAPL continues its inexorable trek “to infinity…and beyond,” QQQ is on track for its 13th consecutive weekly gain. This is an even longer streak than the 11 straight weeks back in 1999, thus bringing up the inevitable comparisons to that heyday of “irrational exuberance.”

Many market observers who have doubted this rally since the beginning are throwing up their yellow caution flags yet again. Eventually they’ll be right, as the market can’t go up forever. But I’m not seeing any major worries reflected in either the charts or the Sabrient SectorCast quant rankings.

Among the ten U.S. sector iShares, Technology (IYW), Healthcare (IYH), and Financial (IYF) have been the strongest this week through Wednesday, and they remain the top three in the SectorCast rankings. Energy (IYE) has been the decisive laggard this week, down more than 2%, followed by Materials (IYM) and Telecom (IYZ). Bank stocks were leaders on Wednesday, and in fact the Financial sector ending up finishing positive on a negative market day.

Not surprisingly, given the market’s strength since the start of the year, the more aggressive and economically-sensitive sectors like Financial, Technology, and Consumer Services/Discretionary have shown the best year-to-date performance. Last year’s leader Utilities, the ultimate defensive sectgor, has been a laggard.

Although Europe is sinking into an inevitable recession, fears of a global recession have subsided, and Greece seems stable for the moment. Nevertheless, risks remain. Sabrient’s newest publication for investment professionals examines those risks within a scenario analysis.  The MacroReport is co-published with MacroRisk Analytics (MRA), a firm that provides a scientifically tested methodology for measuring the economy’s influence on investment prices. Each month, The MacroReport focuses on a specific macroeconomic situation or global hot spot. The inaugural March report focused on the Eurozone, and you can view it here:  The MacroReport.

This week, I’m showing the weekly chart of the SPY for the past 6 months. Whereas the daily chart continues to threaten to roll over to work off its overbought technical conditions, the weekly chart looks quite healthy, thank you very much. SPY closed Wednesday at 140.47. Resistance remains around 142 and near-term support at the uptrend line around 138.

Sector Detector: 1999 redux?

At these elevated price levels, risk and reward are in better balance than they were at higher levels of investor fear. Notably, a weak dollar has been essential to the market’s strength, but now it is stuck in a tight trading range and appears to have stabilized at a strong support level. We’ll see how this development impacts stocks going forward.

The VIX (CBOE Market Volatility Index—a.k.a. “fear gauge”) closed Wednesday at 15.47, which is just about exactly where it was last two Wednesdays. It remains comfortably below the important 20 threshold. The TED spread (indicator of credit risk in the general economy, measuring the difference between the 3-month T-bill and 3-month LIBOR interest rates) closed Wednesday at 39 bps, where it has held flat since mid-February. This appears to be the level or credit risk at which investors are comfortable.

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: 1999 redux?


1. Technology (IYW) remains at the top of the Outlook rankings with an 82. IYW is particularly strong in its return ratios as margins remain high in tech products, but it is strong pretty much across the board on all relevant factors. On its projected P/E is mediocre, as prices continue to soar within the sector.

2. Financial (IYF) moved back ahead of Healthcare (IYH) for second place with a score of 66, but IYW, IYF, and IYH have been dominating the top three. Financial and Technology stocks are getting the most support from Wall Street analysts, along with Industrial (IYJ).
3. Energy (IYE) and Materials (IYM) continue to be beaten down and now reflect the lowest projected P/Es. IYM continues to get smacked with net earnings downgrades from the analysts.

4. Telecom (IYZ) remains at the bottom of the rankings with a 2. IYZ remains saddled with the worst return ratios and the highest projected P/E. It is again joined in the bottom two by Utilities (IDU) with a score of 20. IDU has poor long-term growth projections and relatively high projected P/E.

5. Looking at the Bull scores, Financial (IYF) has been the leader on strong market days, scoring 55. Materials (IYM), Industrial (IYJ), and IYF are the only ones scoring above 50. Utilities (IDU) is by far the weakest on strong days, scoring 32.

6. As for the Bear scores, IDU is the investor favorite “safe haven” on weak market days, scoring 59, followed by IYK, IYC, IYH, and IYW. IYM shows by far the lowest Bear score of 38. This means that Basic Materials stocks tend to sell off the most when the market is pulling back.

7. Overall, IYW still shows by far the best combination of Outlook/Bull/Bear scores. Adding up the three scores gives a total of 186. IYZ is by far the worst at 95. IYW also shows the best combination of Bull/Bear with a total score of 104. IYE now has the worst combination at 87, as investors don’t seem to want to hold Energy stocks under any circumstances.

These scores represent the view that the Technology and Financial sectors may be relatively undervalued overall, while Utilities and Telecom sectors may be relatively overvalued based on our 1-3 month forward look.

Top ranked stocks within Technology and Healthcare sectors include Apple (AAPL), Acorn Energy (ACFN), Zions Bancorporation (ZION), and PacWest Bancorp (PACW).

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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