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Sector Detector: Breakout!

Posted on the 27 October 2011 by Phil's Stock World @philstockworld

Sector Detector: Breakout!

Looks like a jailbreak–but there’s no need to call the police. The stock market finally broke out of the prison it had been in, i.e., a 10-week trading channel that saw multiple successful tests of support and resistance (for example, between SPY 112 and 122) and a few attempts at breakouts and breakdowns—each time failing to confirm the move with a follow-through. Well, this week we got the technical breakout, as I suggested last week we would. Materials, Financials, and Energy have led the charge.

As everyone knows, the wildcard continues to be Europe, as we have anxiously awaited a decision on a bailout package for the EU’s ailing financial system. Late word on Wednesday night as I write this is that a deal has been reached. 

Every hint of progress in the negotiations emboldens the market bulls. The G20 meets on November 3-4, so European leaders have been meeting yet again in Brussels to hammer out something in advance to shore up the contagion that has moved from Greece to Ireland to Portugal…and now Spain and Italy (a.k.a., PIIGS). For those of you scoring at home, the Greece 1-year bond is now yielding 190% and the 10-year yields 25%.

Word on the street is that French President Sarkozy will call Chinese leader Hu Jintao to discuss China possibly throwing in some cash for a fund that would further expand the $600 billion European Financial Stability Facility (EFSF). The EFSF spokesman is calling this simply “a normal round of discussion with important buyers of EFSF bonds.” Okay, whatever you say.

The SPY closed Wednesday at 124.30. Friday gave bulls their low-awaiting breakout, and Monday provided strong confirmation. Some jitters about Europe on Tuesday and Wednesday caused the requisite pullback and a minor test of resistance-turned-support before pushing higher into the close. The 200-day simple moving average is just above at 128. RSI, MACD, and Slow Stochastic are all hanging in there okay. My main concern from a technical standpoint is the possibility that Wednesday’s candlestick turns out to be a bearish “hanging man” formation. But overall, the breakout looks promising—it just needs support from our friends in Europe.

Sector Detector: Breakout!

The VIX (CBOE Market Volatility Index – a.k.a. “fear gauge”) closed Wednesday at 29.86, which is back below the important 30 mark. However, 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) continues to remain elevated, as it closed Wednesday at 41.46, which is right around its 52-week high. Although not nearly so high as it was during the 2008 financial crisis, it nevertheless indicates elevated investor worry about bank liquidity and a preference for the safety of Treasuries bonds over corporate bonds.

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: Breakout!

Here are some observations about Sabrient’s latest SectorCast ETF scores.

1.  Healthcare (IYH) and Technology (IYW) iShares continue to dominate the rankings. IYH again takes the top spot with an Outlook score of 81. IYW dropped 12 points 70, but still holds second place because of the big gap down to third place. IYH is stronger in its support among analysts, with little net reduction in earnings projections, while stocks with IYW got hit relatively hard this past week with earnings downgrades.

2.   Industrial (IYJ) makes nice 8 point jump to an Outlook score of 55 to take third place this week, after coming in sixth or lower for quite some time. This is a bullish sign. Materials (IYM) has fallen to fifth place, as Energy (IYE) takes fourth. IYM continues to get the bulk of the analyst downgrades, so the unusual situation continues in which IYM ranks next to last in net revisors (i.e., the most net earnings downgrades among the analysts) but highest in Projected P/E (i.e., the lowest—best—valuation). So, although the analysts have been reducing earnings projections, the fall in price among stocks within IYM seems to be out of proportion to the magnitude of the earnings revisions.

3.   Consumer Services (IYC) moved out of the bottom two, as the Utilities (IDU) and Telecom (IYZ) sit at the bottom. Stocks within IDU and IYZ are saddled with high projected P/Es and low long-term growth projected growth rates.

4.   Overall, I would say that the Outlook rankings have taken a bullish turn, in alignment with the technical charts. I say this because economically-sensitive iShares like IYW, IYJ, IYE, IYM, and IYF now rank higher than IYK and IDU. Only IYC continues to lack relative fundamental support, although it did move out of the bottom two this week.

5.   Looking at the Bull scores, IYF has been the leader on strong market days, scoring 60, followed by IYM. IDU is by far the weakest with a 38.

6.    As for the Bear scores, IDU is the clear investor favorite “safe haven” on weak market days with a rising score of 71. IYK is a distant second at 63, followed by IYH. IYM and IYF reflect the lowest Bear scores of 38 and 39, respectively, as they have led the market up on strong days and down on weak days.

Overall, IYH now displays the best combination of Outlook/Bull/Bear scores. Adding up the three scores gives a total score of 185. IYW and IDU display the best combination of Bull/Bear with a total score of 109.

Top ranked stocks in Healthcare and Technology include Triple-S Management (GTS), WellPoint (WLP), VMware (VMW), and Spreadtrum (SPRD).

Low ranked stocks in Utilities and Telecom include Clean Energy Fuels (CLNE), Calpine (CPN), Crown Castle International (CCI), and Sprint Nextel (S).

These scores represent the view that the Healthcare 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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