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Sector Detector: Contrarians Push for a Stock Market Rally

Posted on the 05 October 2011 by Phil's Stock World @philstockworld

Sector Detector: Contrarians push for a stock market rally

Beaten-down Materials and Energy stocks led the market rally off its 52-week lows. Financials and Technology showed impressive leadership, too. The last 45 minutes on Tuesday started it all in impressive fashion after reports came out in the Financial Times that finance ministers in the European Union are considering plans to recapitalize banks that hold loads of PIIGS sovereign debt. In that brief window of time late Tuesday, the S&P 500 rose a whopping 4% to close up +2%, and then it climbed another +1.8% on Wednesday. Small caps performed even better, indicating an embracing of risk. Shorts were running for cover.

Sentiment could hardly be worse, which from a contrarian standpoint is a good thing. Down volume has been trouncing up volume. Investors have been streaming out of equities and into money market funds. Some are looking at the extremely negative sentiment and this sudden bounce and saying that the bottom is in … and that the year-end rally is ready to rumble. However, despite compelling forward valuations – assuming the EU can save itself and keep the rest of the world out of another global recession — it probably won’t be quite so clean and monotonic as the March 2009 V-bottom.

Tech and the Nasdaq have both shown relative strength despite the limited participation of mega-cap Apple (AAPL), which disappointed after unveiling an atypically uninspiring iPhone 4S. It appears that the widely anticipated iPhone 5 is still a year away.

But a much bigger blow to Apple and the business world came late in Wednesday’s afterhours trading when it was announced that Steve Jobs had finally succumbed to his long battle with cancer. Jobs was more than just the co-founder of one of the iconic brands of all time, he himself was an icon of innovation, creativity and marketing genius. While late-90’s juggernauts like Microsoft (MSFT), Dell (DELL), Cisco (CSCO), and Oracle (ORCL) have seen little to no stock appreciation in the last 10 years, Apple is up something like 3,500%. Apple has been the consumer technology successful story of the 21st century and the company to be emulated with respect to innovation, brand loyalty, and customer service. And it’s all because of Steve Jobs.

Gold has been seeking a foothold this week after its precipitous fall. It rallied in a traditional flight to safety on Monday while equities faltered, then fell hard along with equities most of the day on Tuesday before rallying with equities late Tuesday and Wednesday. Junior gold miners made up even more ground, including Richmont Mines (RIC), up nearly +10%.

Looking at the SPY chart, the SPY closed at 114.42 on Wednesday, which is back inside the channel between support at 112 and resistance at 122. After a significant breakdown of support on Monday, it appeared that Tuesday was going to see the start of yet another massive October selloff. But that huge reversal in the last 45 minutes of trading resulted in a 4% move, from down -2% to up +2%. And after a little hesitation on Wednesday, the bounce continued. Let’s see if it can ultimately break through resistance at the top of the channel.

Sector Detector: Contrarians push for a stock market rally

The VIX (CBOE Market Volatility Index – a.k.a. “fear gauge”) fell back below 40 to close Wednesday at 37.81 – down 7.4% on the day. This still reflects investor uncertainty.

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 inch higher, as it closed today at 38.36. 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: Contrarians push for a stock market rally

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

1.   Despite very little movement in their Outlook scores, Technology (IYW) takes the lead from Healthcare (IYH) by a small margin. IYH dropped 6 points to 74 while IYW gained only a point to 76, but that shows how close the top two are. IYW has an improving projected P/E with recent weakness, while IYH continues to maintain reasonable support among analysts, with little net reduction in earnings projections.

2.   There is an 18-point gap down to Consumer Goods (IYK), with an Outlook score of 56. Like IYH, IYK is not seeing a lot in the way of analyst downward revisions. It continues strong in ROE and ROA but is a bit high in its projected P/E.

3.   In the fourth spot with an Outlook score of 50 is Basic Materials (IYM). You’ll recall that IYM held the top spot in the SectorCast rankings for a long time, but these days it continues to get the bulk of the analyst downgrades. So, we now see the unusual situation in which IYM ranks last in net revisors (i.e., the most net downgrades) but highest in Projected P/E (i.e., the lowest 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. This likely will lead to a recovery in this ETF – and in fact we saw that Wednesday as IYM gained a robust +4.44% (while the SPY gained only +1.85%).

4.   Consumer Services (IYC) and Telecom (IYZ) are still in the bottom two, as they now score a 30 and 17, respectively. Both are weighted down by weak return on sales (poor margins) and high projected P/Es.

5.   Overall, the Outlook rankings are still on the defensive side, as IYH and IYK are ranked on higher while IYF, IYJ, and IYC are ranked lower.

6.   Looking at the Bull scores, Financial (IYF) and Industrial (IYJ) have been the leaders on strong market days, scoring 57, followed by Basic Materials. Utilities is the weakest with a 43.

7.    As for the Bear scores, Utilities is the clear investor favorite “safe haven” on weak market days with a score of 69 (it keeps on rising). Consumer Goods takes second at 62. Financial and Materials reflect the lowest Bear score of 42, as they have led the market up on strong days and down on weak days.

Overall, both IYW and IYH display the best combination of Outlook/Bull/Bear scores. Adding up the three scores gives a total score of 181. Utilities (IDU) still sports the best combination of Bull/Bear with a total score of 112. This is still a mostly defensive sign.

Top ranked stocks in Technology and Healthcare include Hi-Tech Pharmacal (HITK), NxStage Medical (NXTM), Jabil Circuit (JBL), and Spreadtrum Communications (SPRD).

Low ranked stocks in Consumer Services and Telecom include Shutterfly (SFLY), Green Mountain Coffee Roasters (GMCR), CenturyLink (CTL), and Sprint Nextel (S).

These scores represent the view that the Technology and Healthcare sectors may be relatively undervalued overall, while Consumer Services 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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