Courtesy of Sabrient Systems and Gradient Analytics
In this weekly update, I give my view of the current market environment, offer a technical analysis of the S&P 500 chart, review our weekly fundamentals-based SectorCast rankings of the ten U.S. business sectors, and then offer up some actionable trading ideas, including a sector rotation strategy using ETFs and an enhanced version using top-ranked stocks from the top-ranked sectors.
Market overview:
The fear of broader fallout from issues like Ebola, ISIS, Russian aggression, European malaise, and slowdown in China had subsided, so the market has been waiting for next big worry to spike the fear gauge and cause a selloff to test support levels. The Dow Industrials suffered its biggest weekly percentage loss in three years. After all, it is hard to break out to new highs when bullish conviction has not been recently tested and reconfirmed. Well, it found its next big worry in the fall of oil prices and all that it might be foretelling, such as defaults in the high-yield bond segment of the Financial sector and recession in global economies.
Crude oil fell another 3% on Friday to 5-year lows and 46% below the June highs after the International Energy Agency cut its outlook for 2015; and it expects prices to fall further. Tremendous increases in domestic production through enhanced recovery techniques and the prospect of energy independence in the U.S. (which once was considered an impossibility) has led to a global glut, but OPEC has decided not to reduce production. The U.S. dollar has gained 77% year-to-date against the Russian ruble.
As a result, Energy sector investments are likely dead money for the near term, although the downside might be less onerous. Moreover, those investors who sought to leverage the easy money of high oil prices and enhanced production through the high-yield market are no concerned more about their return OF capital rather than a return ON capital. Any surge in defaults could be a game-changer, but for the moment it appears that prices will remain above the profitability thresholds. Eventually, the search for higher returns through risk assets will shift away from leveraged plays and back to unleveraged investments like Technology and Industrial stocks, and that will be bullish for the broader markets.
To be sure, the Fed’s monetary policies of zero interest rates and quant easing gave the U.S. economy of tremendous boost, but now the economy has its own momentum that can’t be stopped with anything the Fed might have in store. As it stands, leading economic indicators are strong, GDP forecasts are being raised, job growth is the strongest since the ‘90s, and corporate profits sit at all-time highs.
But there is no denying the cautious behavior of investors at the moment. The 10-year U.S. Treasury bond yield closed Friday at 2.09% as capital flowed out of equities. Its 52-week range is 1.86-3.06. The CBOE Market Volatility Index (VIX), a.k.a. fear gauge, closed at 21.08 on Friday after reaching as high as 23.06 intraday. This is still well below the October highs that spiked above 30. Also, year to date, the Healthcare and Utilities sectors (which are traditionally defensive or all-weather) are the clear leaders. And then there is the condition of Europe’s economy and the imminent expiration of the ECB’s long-term refinancing operations, which will result in a whole bunch of assets rolling off balance sheet just when it needs to expand it.
All of this warrants a degree of caution. In addition, keep in mind that this is an option expiration week, and a lack of put open interest could result in delta-hedge selling that exacerbates the downside in equities and spike in VIX.
Nevertheless, 2015 seems to be shaping up to indicate more of what has worked this year, i.e., owning large cap equities (particularly the NASDAQ 100), longer-term bonds (and a flattening yield curve), and the U.S. dollar.
But simply buying a portfolio of stocks you like probably is not the right strategy. Rather, a thoughtful approach to creating a diversified portfolio of high-potential stocks is more appropriate. For example, Sabrient’s annual Baker’s Dozen portfolio employs a “quantamental” approach that starts with a GARP (Growth At Reasonable Price) quantitative model and then applies a fundamental overlay, including a forensic accounting review by our subsidiary Gradient Analytics to help avoid the landmines among stocks with strong apparent growth prospects but poor earnings quality and sustainability. The portfolio is completing its sixth straight year (since inception in 2009) of market-beating returns.
SPY chart review:
The SPDR S&P 500 Trust (SPY) closed Friday at 200.89, which is -3.6% below its all-time highs from the previous Friday. This is the minor (but still significant) pullback that I projected, which is allowing the severely overbought technical condition to cycle back down to oversold, test support levels, and reconfirm bullish conviction. Oscillators RSI, MACD, and Slow Stochastic appear have a little further to go to the downside, but could begin a reversal at any time. I think the 50-day simple moving average will provide good support this week and the market will stabilize. Otherwise, additional levels of strong support should come from the 100-day SMA at 199, the bottom of the bullish rising channel approaching 198, and the 200-day SMA around 195.
The Russell 2000 small cap index held up much better than the large caps on Friday, which is bullish for the market at this point, and in fact it might find support from the lower line of 1-month sideways channel that appears to be forming. Both the NASDAQ 100 and Composite indexes also held up better than the S&P 500 on Friday. Looking at the weak Energy sector, the price chart hardly could be uglier, but the oscillators look more promising. RSI is showing a positive divergence versus the October lows, and MACD and Slow Stochastic easily could bounce strongly from their severely oversold levels.
I am hopeful that this was the minor technical pullback the market needed in order to avoid a more dramatic event in early January.
Latest sector rankings:
Relative sector rankings are based on our proprietary SectorCast model, which builds a composite profile of each equity ETF based on bottom-up aggregate scoring of the constituent stocks. The Outlook Score employs a forward-looking, fundamentals-based multifactor algorithm considering forward valuation, historical and projected earnings growth, the dynamics of Wall Street analysts’ consensus earnings estimates and recent revisions (up or down), quality and sustainability of reported earnings (forensic accounting), and various return ratios. It helps us predict relative performance over the next 1-3 months.
In addition, SectorCast computes a Bull Score and Bear Score for each ETF based on recent price behavior of the constituent stocks on particularly strong and weak market days. High Bull score indicates that stocks within the ETF recently have tended toward relative outperformance when the market is strong, while a high Bear score indicates that stocks within the ETF have tended to hold up relatively well (i.e., safe havens) when the market is weak.
Outlook score is forward-looking while Bull and Bear are backward-looking. As a group, these three scores can be helpful for positioning a portfolio for a given set of anticipated market conditions. Of course, each ETF holds a unique portfolio of stocks and position weights, so the sectors represented will score differently depending upon which set of ETFs is used. We use the iShares that represent the ten major U.S. business sectors: Financial (IYF), Technology (IYW), Industrial (IYJ), Healthcare (IYH), Consumer Goods (IYK), Consumer Services (IYC), Energy (IYE), Basic Materials (IYM), Telecommunications (IYZ), and Utilities (IDU). Whereas the Select Sector SPDRs only contain stocks from the S&P 500, I prefer the iShares for their larger universe and broader diversity. Fidelity also offers a group of sector ETFs with an even larger number of constituents in each.
Here are some of my observations on this week’s scores:
1. The rankings continue to remain stable, as Technology and Healthcare stay at the top. Technology is in the top spot with a robust Outlook score of 90. Tech stocks display the best return ratios, a good forward long-term growth rate, a reasonably good forward P/E, and solid support among insiders (buying activity). Healthcare scores a 73 and displays good sell-side analyst support (recent upward revisions to earnings estimates), a strong forward long-term growth rate, solid insider sentiment (buying activity), and good return ratios, although its forward P/E is on the high side. Financial remains in third with a score of 65, and it continues to display one of the best (lowest) forward P/Es. Next in the rankings, Industrial has vaulted into fourth with a more attractive forward P/E, followed by Utilities and Consumer Goods/Staples (a.k.a., Non-cyclicals). Notably, prices for Consumer Services/Discretionary (a.k.a., Cyclicals) have held up well during market weakness on the strength of strong retail sales, but this made it fall in the rankings due to a relative weaker forward P/E, but the sector continues to get solid support from both analysts and insiders and boasts the best forward long-term growth rate.
2. Price weakness and an improving forward long-term growth rate in Basic Materials stocks has allowed its Outlook score to rise, as its forward P/E is now much more attractive. But Wall Street analysts’ downward earnings revisions in the Energy sector (as oil prices plummet) have kept Energy at the bottom of the rankings. Even the insiders have reduced their buying activity in this beleaguered sector. Joining Energy in the bottom two again is Telecom, which generally scores poorly across the board in most factors in the Outlook model.
3. Looking at the Bull scores, Industrial, Energy, and Basic Materials all come in with the highest score of 58. Telecom scores the lowest at 48. The top-bottom spread is only 10 points, reflecting high sector correlations during particularly strong market days, i.e., highly-correlated risk-on action. But it is generally desirable in a healthy market to see low correlations and a top-bottom spread of at least 20 points, which indicates that investors have clear preferences in the stocks they want to hold, rather than the all-boats-lifted-in-a-rising-tide (risk-on) mentality.
4. Looking at the Bear scores, Utilities again displays the highest score of 65 this week, as one would expect for this traditionally defensive sector. Utilities stocks have been the preferred safe havens on weak market days, and it is followed closely by Consumer Goods/Staples, Consumer Services/Discretionary, and Healthcare. Energy displays the lowest score of 36, followed by Basic Materials. The top-bottom spread is a wide 29 points, which continues to reflect low sector correlations on particularly weak market days. In other words, certain sectors are holding up relatively well while others are selling off. Again, it is generally desirable in a healthy market to see low correlations and a top-bottom spread of at least 20 points.
5. Technology displays the best all-around combination of Outlook/Bull/Bear scores, followed closely by Healthcare, while Energy is the worst. Looking at just the Bull/Bear combination, Utilities and Healthcare are the clear leaders, indicating superior relative performance (on average) in extreme market conditions (whether bullish or bearish). Energy is still the worst, indicating general investor avoidance (no surprise here).
6. Overall, this week’s fundamentals-based Outlook rankings still look bullish to me. Downward earnings revisions from Wall Street have subsided (with the exception of Energy) and in fact some sectors are getting increasingly positive revisions. The top four sectors are all economically-sensitive (or in the case of Healthcare, all-weather), and they also display some of the highest Bull scores. Furthermore, Basic Materials and Consumer Services/Discretionary are also scoring fairly well. Keep in mind, the Outlook Rank does not include timing or momentum factors, but rather is a reflection of the fundamental expectations of individual stocks aggregated by sector.
Stock and ETF Ideas:
Our Sector Rotation model, which appropriately weights Outlook, Bull, and Bear scores in accordance with the overall market’s prevailing trend (bullish, neutral, or defensive), continues to indicate a bullish bias this week, and it suggests holding Healthcare, Industrial, and (surprise!) Basic Materials (in that order, for those portfolios that might be due for rebalance). (Note: In this model, we consider the bias to be bullish from a rules-based trend-following standpoint because SPY is above both its 50-day and 200-day simple moving averages.)
Other highly-ranked ETFs from the Healthcare, Industrial, and Basic Materials sectors include Health Care Select Sector SPDR Fund (XLV), iShares Transportation Average ETF (IYT), and PowerShares DWA Basic Materials Momentum ETF (PYZ).
For an enhanced sector portfolio that enlists some top-ranked stocks (instead of ETFs) from within the top-ranked sectors, some long ideas from Healthcare, Industrial, and Basic Materials sectors include Celgene (CELG), Amgen (AMGN), Alaska Air Group (ALK), United Parcel Service (UPS), The Valspar Corp (VAL), and Westlake Chemical (WLK). All are highly ranked in the Sabrient Ratings Algorithm and also score within the top two quintiles (lowest accounting-related risk) of our Earnings Quality Rank (a.k.a., EQR), a pure accounting-based risk assessment signal based on the forensic accounting expertise of our subsidiary Gradient Analytics. We have found EQR quite valuable for helping to avoid performance-offsetting meltdowns in our model portfolios.
However, if you prefer to maintain a neutral bias, the Sector Rotation model suggests holding Technology, Healthcare, and Financial (in that order). And if you prefer a defensive stance on the market, the model suggests holding Healthcare, Utilities, and Financial (in that order).
IMPORTANT NOTE: Some readers have been asking for more specifics on how to trade our sector rotation strategy based solely on what I discuss in my weekly newsletter. Thus, I feel compelled to remind you that I post this information each week as a free look inside some of our institutional research and as a source of some trading ideas for your own further investigation. It is not intended to be traded directly as a rules-based strategy in a real money portfolio. I am simply showing what a sector rotation model might suggest if a given portfolio was due for a rebalance, and I may or may not update the information each week. There are many ways for a client to trade such a strategy, including monthly or quarterly rebalancing, perhaps with interim adjustments to the bullish/neutral/defensive bias when warranted — but not necessarily on the days that I happen to post this weekly article. The enhanced strategy seeks higher returns by employing individual stocks (or stock options) that are also highly ranked, but this introduces greater risks and volatility. I do not track performance of the ETF and stock ideas mentioned here as a managed portfolio.
Disclosure: Author has no positions in stocks or ETFs mentioned.
Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into account their personal financial circumstances in acting on any rankings or stock selections provided by Sabrient. Sabrient makes no representations that the techniques used in its rankings or selections will result in or guarantee profits in trading. Trading involves risk, including possible loss of principal and other losses, and past performance is no indication of future results.
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